The pandemic has exacerbated longstanding problems for physical retail and put further pressure on owners to reconsider the future use of outdated space, including offices.
As they aim to future-proof underutilized assets, sponsors are increasingly repurposing properties from troubled sub-sectors, such as town-center retail and secondary offices, into in-demand uses, including housing and logistics.
Yet property conversions are often perceived by lenders as a tricky call. Such projects often encompass multiple hurdles and risks that not all financiers are willing to underwrite.
According to Michael Kavanau, head of debt and structured finance for Europe at JLL, alternative lenders dominate the financing of such schemes as they look for returns in parts of the market underserved by traditional banks.
He says most of the conversions the consultancy has advised on in recent months have been financed by non-bank lenders. Among them was the £15 million ($21 million; €17 million) loan that alternative financier ASK Partners wrote in May for the redevelopment of InterContinental Hotels Group’s global headquarters. The office building in Broadwater Park in Buckinghamshire, on the outskirts of Greater London, will be converted into housing.
Kavanau says the project did not receive wide interest from lenders because the borrower did not have planning consent when sourcing the loan. “Most lenders are not willing to commit to an unconsented plan,” he says. “But we were still able to get it financed at 70 percent loan-to-value based on the likelihood that it would get planning consent for residential, a popular use for equity and debt players.”
Similar levels of risk
Market sources agree that lenders generally see the risks attached to financing repurposing projects as similar to those inherent to new developments, though individual schemes have unique challenges.
For Martin Wheeler, co-head of ICG Real Estate, the London-headquartered property division of asset manager Intermediate Capital Group, conversions can be harder to underwrite than ground-up developments because “there are more moving parts involved.”
“Since the underwriting of the business plan is tricky, you need to partner with a strong sponsor, with the skillset and track record of doing repurposing or value-add projects,” he says. “Understanding what you can do within the existing building framework is also challenging, because issues may get discovered along the way, which is why you need to have the right partners and right contingency.”
ICG Real Estate has been financing repurposing schemes for a decade via its partnership capital strategy – through which it provides whole loans, mezzanine and preferred equity – as well as its senior lending business. Wheeler says that during the pandemic it has committed more than $500 million of debt capital to value-add projects.
Damien Hughes, senior director of property finance at UK challenger bank OakNorth, says another challenge for lenders is to ensure the asset is appropriate for the proposed use: “If you are converting an existing property, you don’t know how it was built 50 years ago, so there could be surprises, which is why we often factor in slightly higher contingencies to allow for that. Rather than a 5 percent contingency [of total build costs], we may build [in] 7-10 percent depending on what our surveyors advise us.”
In recent months, the challenger bank has backed several property conversions in the UK. These include a £22 million loan provided alongside ASK Partners for the repositioning of Broadoaks, an office building in Solihull, into a residential asset; and a financing facility to redevelop the Chalk Lane Hotel in Epsom, Surrey, into a 21-unit luxury residential scheme.
According to market sources, lending terms for repositioning projects vary depending on the underlying features of each scheme, although up to 60-65 percent LTV is common. Kavanau says: “For a development loan, involving consented repurposing and meaningful preletting, pricing would be in the high 2 percents, while for a speculative scheme, it would be in the mid-to-high 3s.”
Kavanau adds that lenders often adjust pricing if their risk perception lowers during the repurposing process: “When a project achieves certain completion or letting milestones, lenders often adjust the price. Some prefer to lend more money and keep the same price as the deal de-risks while others ratchet down the margin.”
Financing repurposing typically falls into the lending territory of those with value-add strategies. Sources predict non-bank lenders will lead activity as banks continue to pull back from those parts of the market they perceive as riskier.
For Hughes, the withdrawal of traditional lenders from the development market, where he places asset repositioning, has increased financing opportunities for organizations like OakNorth. “Alternative debt providers and challenger banks now have the opportunity to further capitalize on the widening debt gap left by banks, particularly in the development space,” he says.
Wheeler expects those debt fund lenders that have historically financed value-add strategies, including ICG Real Estate, to continue dominating the space. He says the amount of debt capital available to fund value-add projects is lower than it was before the pandemic: “The majority of debt available is targeting the more stabilized assets, so we have now a £2 billion-plus pipeline of value-add debt deals, which is roughly double the pre-covid equivalent. As more lenders across Europe focus on financing core assets, more complicated value-add plays are available for whole loan providers from the debt fund universe, like us.”
According to PERE data, $8.6 billion of equity was raised in 2020 for Europe-focused value-add funds, up from $7.1 billion in 2019. This figure suggests that demand for debt finance for such projects will continue to grow.