The UK housing development sector is being decapitalized. Evidence? The thousands of homes in static consents across Britain’s brownfield estate.
Why is this happening? Three reasons: First a material misalignment between policy asks and what housing development can achieve.
Second, the RICS viability process has been politicised. In many cases it is now hindering developers from funding sites.
Third, capital for ‘resi dev’ faces intense competition. Pressure comes from other UK real estate sectors, real estate in other geographies and bonds, insurance, shares, infrastructure, currencies and crypto. Capital is more mobile than ever and it is choosing to go elsewhere.
To understand why these issues matter, we must first understand how developers and builders finance themselves. Below is another propviews explainer. I hope it helps the debate.
Capital intensity and the origins of market led housing
The first thing to understand is that house building is capital intensive. That’s why in the UK, the market is dominated by a handful of larger housebuilders and developers. It requires deep pockets.
But even with these deep pockets, there is no certainty that sites can come forward quickly and efficiently. Capital investment can easily exceed tens of millions even on relatively small sites.
Capital intensity means significant risk. The more concentrated the capital investment the higher the risk. If private capital is willing to assume this risk in place of taxpayer cash then this is a good societal outcome. As buildings have become more complex, the state’s role has receded further.
Cost and risk is of course why the Government chose to increasingly step away from house building in the 1970s. Indeed, a condition of the IMF bailout in 1976 was a significant reduction in direct spending on Council housing.
Wearing an economists hat, this change should have been a good thing. Why? Because despite what some politicians might sometimes say, the majority of taxpayers would not wish to be on the hook for the significant losses house building can sometimes incur.
Capital intensity and risk
If you build a tall building of one hundred homes, the capital concentration is much higher than one hundred homes on a field. One hundred homes on a field can be phased. One hundred homes in a singular building cannot.
Moreover, pound for pound, you need more capital and more capital quickly to build a one hundred home building. With one hundred homes spread across a field, you can spread your cashflow and manage inflows and outflows better.
Therefore, high density development is cash intensive and high risk. It requires a sufficiently higher return if it is to be delivered.
The UK has a smaller land mass than some of its friends and neighbours in the G20. It therefore has to embrace high density housing if it is to succeed. It is yet to work out how to do this as I will come onto.
Development cycle
From a capital markets perspective, it is helpful to conceptualise the development process in four stages. I am going to do a whistle stop tour of three of the stages.
The first stage is pre-planning, or ‘raw land’. The second stage is post planning, detailed design and now Gateway 2. The third stage is construction and the fourth is post completion sales or stablisation. Each stage presents different risks and therefore different return requirements to compensate the capital for these risks.
Larger developers are able to fund part of the cycle and possibly more than one of the four stages I have identified above. Smaller developers and builders cobble together capital as they proceed.
No matter how big or how small, most deliverers of homes are always in seach of equity and debt partners. Think of developers and builders as intermediaries between capital, skills and raw materials. They will always be looking at ways of derisking the investment requirements required to build homes. A small political point here, this is entirely reasonable and not financial speculation as some politicians might suggest. The level of real estate finance risk is high, therefore, it is unreasonable to expect an economic actor to have all its eggs in one basket so to speak. Please see my post on the financialisation of housing for more on this.
Early-stage funding
I term this entrepreneurial equity. This is the hardest part to fund and has the highest return requirements.
This is the stage from raw land to a planning permission. There are a number of drivers to why this is so hard but the main ones are to do with political ambiguity and how long it takes.
Another way to think about it: a planning permission does not pay out any income or give an owner any sales. Therefore, it rules out yield investors which are the majority of investors in the world. It is a purely speculative activity as it’s still early days. It means those who want to park their money in safe assets are not interested. It’s very much a professional investors domain.
Mid-stage funding
Before the Building Safety Act, it was possible to twin track some design costs alongside construction. That is no longer possible.
That makes it harder to finance development. Why – because the same rules apply as before, that piece of land is still not returning any capital. This is bad for smaller developers and builders because they now need to find more ‘entrepreneurial equity’ earlier in the process.
Medium term, this will work itself out but at the moment this mid stage is particularly tricky. Some will use debt or third-party equity loans to fund this work – it’s expensive stuff, particularly for high density which has complicated building layouts and M&E.
Construction and beyond
The most capital intensive aspect of the development but a little easier to fund. The majority of developers will use a combination of equity and debt to fund this stage. The addition of Gateway 3 has potentially elongated programmes for High Risk Buildings (over 6 storeys) by circa three months but there is little evidence as yet because so few have gone through Gateway 3. The longer it takes the more interest you pay and the more prelims you pay to manage the site. Not good.
What keeps developers up all night on this stage? The idea that Gateway 3 could keep buildings sitting empty that have completed for many months whilst they are being processed. A nightmare scenario for capital investment.
The term profit
In very basic terms, when people look at the development model many start and stop with the perceived returns a development makes across the cycle. The cycle is very long, up to 7 years now for a high-density single building development now.
Here’s the important point. There is a fundamental difference between actual profit and the profit margin on an early-stage viability appraisal which is shared with the Council and what people get heated up about.
Earlier, I set out the majority of developers will not put all their equity into a scheme. No matter how big or how small, housing is expensive.
Profit is headroom and it is headroom in two ways. Developers seek a return of circa 20% because it means they can capitalize a development site. Put another way, they can invite third party equity and debt to come into the project and help them get from A to B. A is where the adventure sits. B is where yield investors perch. We often hear talk of a wall of capital ready to invest in residential development. But that money is normally institutional capital and it is a rare thing indeed for that kind of investment to come in much before construction starts.
Back to profit and or headroom, behind the promotor, there will often be several parties investing in an early stage project and as the development becomes more capital intensive this normally becomes more complex and varied. The end profit to the actual developer is likely to be much lower than 20%. Much of the 20% pays the costs of capital layered through the cycle So, 20% is a buffer. It allows room to fund with third party equity, mezzanine and other sources of funds.
The second function of profit or headroom, is it allows for things to go wrong. It’s an iterative process. Your need a buffer to attract capital and then you need that buffer to protect that capital. If something goes wrong, it is that buffer that protects the principal i.e. the money invested without any interest accounted for. The more risk, the more headroom needed. The larger and more capital intensive a project, the greater the risk. A viability appraisal by the way, really struggles to price these risks and can often make little distinguishment between a high density development and say five houses. Problematic.
Why decapitalization is occurring
Decapitisation is a consequence of a significant deterioration in market conditions. Capital – and mainly equity capital is no longer about to invest into high density development.
There are lots of reasons for this, but I am going to give two very important ones that can be corrected by UK policy makers and are relevant to this post.
- Elongation
A development cycle for a high density building is now up to 7 years. This is a model shift as the cycle had before been conceptualized as a five year haul. This is a very big challenge. It detracts equity capital which works on a five year horizon. Most other sectors offer infrastructure exists of 3-5 years. Res dev at 7 years in the UK is now materially out of step.
The longer the capital is at risk, the higher the return it needs to make and the fewer shillings available to come into the sector. The appraisal simply doesn’t have the headroom in many cases now. Capital has switched off.
The decrepit planning system and the gateways are purging equity from the development system. This can be rectified with simplification and more resourcing. I advocate zoning and there will be more on this over the coming months.
- Viability testing
Viability testing decapitalizes developments and is particularly harmful for SMEs. Why? It squashes profit thresholds down to as low as 12% and it sets land at existing use value often without any premium. This is out of step with the market and reality. Landowners normally want to sell land at a premium or it will stage in existing use.
With artificially set perimeters and a low threshold, late-stage reviews than bite into the profit buffer. This effectively robs a developer of the flexibility to finance the project and we return to my point about headroom which is probably a better term that profit at early stages of a housing scheme.
It is not impossible for a project to still progress under these circumstances and in a stronger market they may sometimes do. By stronger market lets say a rising one with low interest rates. Not this one.
But, with so many challenges particularly facing high density development, capital and principally equity capital chooses to go elsewhere. Hence decapitalization.
As I said earlier, it is forgotten that developers are intermediaries – even the big ones to some extent. Policy makers find it difficult to break open risk and reward. Early stage viability appraisals use assumptions on profit, land and cost of capital which are not accurate. Capital is mobile.
If capital doesn’t want to play because the operating environment is elongated, gamed and low yielding, then it will go elsewhere.
Skillful operators and clever local authorities can still make housing work, but with so much complexity, it makes it difficult to scale and you can easily get stuck. On a professional note, this all keeps me very busy as my advice and counsel is sought after. But at the same time, this operating environment is neither sustainable or scalable if we want to build the thousands of new homes this country needs.
