Picture this potential scene: near-term property values collapsing 5-10% in the UK; sites completing in the next 12 months sitting idle and accruing interest towards the peak of their drawdown curve; builders triggering force majeure, causing all delays to be paid for by the developer.

This will be discussed in every lender’s risk meeting in the next few weeks — if not already.

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Contraction of GDVs, coupled with interest accruing on empty sites could put unbearable strain on loan covenants. The first step will be to ask the developer to raise more cash to put into the deal. However, some may have already stretched themselves and their precious equity quite thin. Valuations will also be looked at. With the Office for Budget Responsibility (OBR) predicting two million job losses, and numerous products pulled from the mortgage market, the longer the shutdown continues, the less enticing those new flats will look for new buyers expecting discounts. 

Mezzanine lenders will be anxiously looking at their intercreditor agreements. Once the math is done and sites near to completion are marked to market, they may realise the developer’s equity cannot be stretched further. If the covenants have been breached, mezzanine lenders are next in line. The second step would be to trigger step-in rights. However, for many funders, they are designed to lend from their offices, not be on site completing developments. 

The difference between this crisis and the previous one in 2008 is that the senior banks are in much better shape. In my opinion, the senior lenders who have enough buffer with their LTVs coming in at 50-60% LTV can afford to sit and wait out the next 12 months. The risk here lies with the developers and the alternative/mezzanine lenders. 

Just like with Covid-19 attacking the most vulnerable, the development world will have a hierarchy of site vulnerability, ordered by:

1. how far the site’s drawdown curve is. To take this point to the extreme, the day before practical completion the site is shut down. Paying interest at the maximum interest curve point will be painful. Each month is an erosion of the developer’s profit

2. sites which are coming to completion in the next three to six months. If short-term property values fall at a magnitude of five to 10%, this will blow out covenants. If this down valuation is applied to loan books, then the short end of the completion curve is looking shaky

3. Leverage — the higher this is, the more quickly the interest costs will breach covenants

While lenders have bravely battled on and communicated that they are still open for business, the worry is not on the new loans being issued. The worry is with those that are expiring in the next 12 months, and whether lenders are comfortable marking their books to market in this new normal.