Financing the Living sector—key themes

Forward funding remains the most popular way for many investors to finance developments. What are the benefits?

Tom: Forward funding is an attractive strategy for investors, providing long-term income streams from both tenants and additional on-site services. Forward funding is seen as the ‘go-to’ option for those developing professionally managed living assets, particularly build-to-rent. It limits a developer’s need for internal equity or third-party debt, and it removes most costs relating to things such as financing, marketing and sales agent fees. Crucially, it also allows for a clear exit, removing all sales market risk by being sold to a single purchaser. However, it limits development upside as typically the institutional forward fund doesn’t allow (or limits) profit participation from yield compression and or rental inflation.

How are borrowers using alternative financing structures to maximise their returns?

Andrew: While the preference is often for finance from a single source, our team has arranged several transactions recently which utilised both senior and mezzanine debt. For example, we recently closed the refinance of a 1,200-unit multifamily portfolio in Germany. To maximise proceeds, our clients (a global private equity investor and a local German asset manager) elected to proceed with a two-lender execution. The senior was provided by an investment bank, and the mezz was provided by a debt fund. The blended pricing was more attractive than the whole loan options, while still maximising total debt proceeds.

Tom: For those with residential projects, development finance has typically been equity first. But there’s a rapid increase in pari passu funding structures. It’s naturally of great interest to the levered internal rate of return (IRR)-focused investors and can enhance IRRs by as much as 200 basis points. And on the lending side, pari passu transactions are involving debt funds, investment banks and challenger banks. We have yet to see high street banks embrace the concept, but slowly signs are emerging of that also changing.

ESG financing is becoming more common. How do you see it evolving in the coming months?

Andrew: It seems not a day goes by that we aren’t asked about ESG financing by clients, colleagues or lenders. It’s top-of-mind for many market participants—and everyone seems to be trying to ‘figure it out’ at the same time, especially as, given how new the concept is, there are very few precedents of existing products. There’s no playbook to refer to.

Green and sustainable bonds are now a mainstay of the fixed-income market and are typically oversubscribed, with institutional and listed investors leading the way as issuers. Pricing for these products can be tighter than asset-level alternatives. For example, large listed residential player Vonovia entered the green bond space by issuing one for €600 million in March 2021, which priced at 0.625 percent with a 10-year maturity.

We expect asset-level ESG lending to become much more common over the next 12 months. Finance that is ‘ESG-linked’, offering between 5 and 15 basis points of margin incentive is emerging, with green certification being the primary benchmark for qualification. We are seeing various strategies for addressing the ‘S: sustainability’ and the ‘G: governance’ in the Living space. These include KPI’s related to residents’ health and wellbeing, providing mental health hotlines and proactively offering additional affordable housing over and above that which is required as part of the planning consent.

For listed investors, we anticipate that the majority of unsecured and revolving credit facilities will soon include some element of ESG-linking, along the lines of infrastructure investor TRIG’s first ESG-linked RCF at the start of this year.

So overall, certainly more than one financing route then…

Tom: Ideally, developers should be considering the wider array of funding solutions available when looking to maximise returns. This is looking at the traditional residential sales market versus the forward funding buy-to-rent market.

And with the anticipation of likely future yield compression and rental inflation, some developers are opting to ‘stay in’ and benefit from the potential upside–something that more market players are quickly becoming aware of. There are multiple ways to create differing funding solutions, but understanding client views on appetite for risk and reward is key.

Tom Upton, Head of Funding, Living Capital Markets

Andrew Hornblower, Director, Debt and Structured Finance International Capital Markets EMEA

This article forms part of our latest European publication titled ‘Investing in Living’. To download the full brochure, please click here.