Industrial Valuation and Funding in a Changing Market

Although the UK industrial market has been one of the strongest performing sectors since the start of the market downturn in H2 2022, the viability of new industrial development schemes has still been severely tested over this period, particularly when land was acquired at elevated levels before the market started to deteriorate.

Many developers inevitably looked to delay the start of construction, but schemes that did commence had to contest with a myriad of financial issues, including high construction costs, rising costs of debt and softening investment yields.

If we take an example of a Southeast multi-unit development where the land was acquired in, or before, H1 2022, this may have been underwritten at exit yields sub-4.00% and rents of, say, £15.00 per sq ft. These schemes may now only be reaching completion, having spent 18–24 months going through the planning and delivery phases. Some developers may have been lucky enough to secure fixed-rate development finance; however, most will have experienced a rise in development finance costs in line with the sharp increase in SONIA (Sterling Overnight Interbank Average) and SONIA Swap rates seen over H2 2022 and H1 2023.

Despite investment yields stabilising and even hardening marginally in some sectors of the industrial market, they have remained higher for longer than many investors and developers had anticipated. Even with continued strong levels of rental growth over the same period, in many cases, this has not been enough to offset negative capital growth. A 2022 underwrite at a sub-4.00% exit yield and £15.00 per sq ft rents might now look like 5.25% and £17.50 per sq ft on completion, which would reflect a c.15% reduction in overall capital value terms.

Having reached practical completion, the developer now may face another potential challenge – refinancing. In a stronger market where schemes are delivered at or above underwrite levels, many developers would willingly sell the completed schemes to investors. However, faced with eroded profit margins and a repriced investment market, developers may prefer to hold these new schemes in the short to medium term, capturing both further rental growth and, hopefully, hardening investment yields.

Whilst notionally cheaper than development finance (i.e. priced at lower margins), investment loans are still not ‘cheap’ by historic levels, being pegged to SONIA rates, which are still much higher than over recent years. Furthermore, over the same period, many lenders’ appetite for risk has reduced, meaning that LTV ratios have reduced and interest cover requirements have increased, especially for the least expensive debt.

Lower capital values, lower leverage and higher investment finance costs may leave developers with a financing shortfall which needs to be plugged, particularly where schemes have a degree of vacancy. Where shortfalls are limited and/or developers have deployable equity, this is unlikely to pose a big issue. Larger shortfalls might be plugged with some form of mezzanine or gap funding, but this itself can be expensive and sometimes complex to retrospectively weave into existing loan structures with senior debt providers.

What we are also seeing in the market is that many lenders are taking a less hard-line stance and working with developers to provide solutions. Ideally, this is some form of paydown to bring the LTVs back into check, but we are also seeing loan extensions to allow developers to maximise values through fully letting schemes post-completion, capturing rental growth and, hopefully, a continually improving investment and cheaper debt market into which to sell or refinance. As the market improves, particularly in London and the South East, this is a positive approach that is to be welcomed.