All of us who work in the real estate sphere will have been relieved to see the construction market come back to life in 2021, after an unprecedented 2020. Whilst 2022 has not kicked off as we would all have hoped, our prediction is that, armed with the knowledge we have gathered over the last two years and the continued growth of alternative sectors and increasing need to repurpose assets, the construction industry’s recovery will continue in 2022 and, consequently, the demand for development finance will steadily increase. The Covid-19 pandemic has however changed how the construction industry operates and, combined with the now unavoidable ESG agenda, underwriting a development financing has gained an added layer of complexity. Below are five hot topics we believe all lenders should have at the forefront of their minds when looking at development finance transactions this year:
The Cost of Cladding
The 'cladding crisis' and the remediation of cladding continued to garner interest in both the sector press and mainstream media through 2021. As we turn the year into 2022, Government has announced plans to address who will be liable for the costs of removing unsafe cladding, with the expectation that they will look to the industry to bear these costs.
Recognisant of the potential for future changes in policy and/or minimum standards applicable to building safety, or, worse, possible future situations highlighting issues with replacement materials, some building owners and investors have begun to consider whether alternative approaches to how cladding is owned and funded may be possible – seeing cladding akin to F&F or even a service, rather than an intrinsic part of the building.
Although, currently, the prospect of leasing cladding appears to be remote, we believe that the market will continue to look at alternative models to avoid or at least reduce the risk of future remediation costs. The fundability of such models, and how they will impact lender security structures, will be an interesting problem to solve as such models become more likely.
Sustainability
Although the Green Loan and ESG lending market has been steadily growing over the past decade or more, sustainability remains a critical issue both across society as a whole but also, more specifically, to our sector and, if anything, has become more significant in the recent years.
We have seen an increasing number of stakeholders push sustainability to the fore of their investment and development strategies and expect this trend to continue into 2022. Unusually, it has not been the legal framework that has driven sustainable investment and lending historically, but instead the competitor and consumer markets. Although these market drivers will continue to be a key factor in shaping corporate strategy, with the likely introduction of new rules and regulations relating to sustainability and sustainable finance across Europe and the UK in 2022 (in particular following publication of Government’s 'Sustainable Finance Roadmap'), we do anticipate the regulatory landscape to begin to shape the ESG agenda.
2021 was a bumper year for sustainability-linked, and green, loans and we have already seen at the start of 2022 green loans being written against asset-classes and parts of the sector where traditionally they haven’t been used. All of this points to these loans making up a greater proportion of the development finance market in 2022.
We do, however, anticipate that there will begin to be a greater standardisation of KPIs and criteria attached to these loans. Where these have been traditionally driven by customers, inevitably there will become greater consistency driven by the market more generally to give genuine credibility to these products. Although there is unlikely to be centralised standardisation of KPIs, we do foresee certain markets moving towards a more homogenous approach.
Main contractor insolvency resilience
Lenders focus very much on the ability of the main contractor to 'deliver' the development, and the majority of the construction due diligence and protective documentation resolves around that main contractor. However, the experiences of the last few years (including significantly reduced profit margins in the sector) have shown that main contractors are not infallible; think of Carillion and NMC. The failure of the main contractor does not have to be terminal for a development provided that the borrower and lender can act promptly to step in to fill the void. In an ideal situation, a replacement contractor is appointed but that nevertheless causes significant delays and repricing issues. There can be an alternative to this: in recent months we have seen a number of situations where a proactive lender and borrower have been able to act quickly to keep the sub–contractors on site and switch the development to a construction management model. This isn’t an option for the fainthearted. It requires a hands-on lender who can act quickly and an experienced borrower. It also shows the importance of a greater focus on the sub-contractors both at the outset and during the development.
Availability of Materials
Much of 2021 was spent talking about a shortage of both materials and labour in the construction industry. Whilst – certainly in England – construction was not brought to a halt by the pandemic, productivity was still affected by a lack of materials and the inability of the supply chain to meet demand. There are signs of this improving (the number of projects reporting supplier delays in December 2021 was 34 per cent - down from 47 pre cent in November), but the Construction Leadership Council has confirmed that challenges remain and the industry should still expect longer lead times and price increases in 2022. Key materials affected include roof tiles, bricks and blocks, cement, and timber, to name but a few. Shortages are caused by a number of issues, from a lack of HGV drivers, labour shortages, Brexit and the pandemic, to macro-economic factors affecting the availability of raw materials around the globe.
All of this is leading to higher than anticipated tender returns, and some projects going on hold until there is more certainty. Developers should be encouraged to plan as far ahead as possible when it comes to securing its contractor team and supply chain, enabling long lead orders to be placed in good time, and programme flexibility to be able to react to short term shortages. Contractors should be pushed to provide contingency plans should shortages of certain key materials occur. We are seeing contractual arrangements put in place to allow a degree of flexibility in the selection of materials (subject to strict criteria), but that will require developers and contractors working very closely together in an effective – and sometimes fast-moving way – in order to prevent project hold-ups. Lenders should ensure that they (and their project monitors) are able to respond just as dynamically when the inevitable requests come in from their borrowers. We are also seeing lenders looking to their project monitors to carry out enhanced due diligence over key parts of the supply chain (in particular where projects involve a significant element of off-site manufacture).
Finally, the backlog is leading to manufacturers (especially steel) insisting on significant up-front payments to secure manufacturing slots. These advanced payments are being paid by developers to their contractors, and it is crucial that lenders explore ways in which advanced payments are protected, whether by advanced payment bond, listed item bonds, or other means, in order to minimise the impact of insolvency – another risk area affecting the construction industry at all tiers of developers, contractors and the supply chain.
The logistical issues that have contributed to the largest number of contractor failures since before the pandemic may also see contractors seeking more restrictive remedies in relation to programme delay e.g. 'delay damages holidays' where the first period of delay doesn’t attract the payment of damages with the contractor’s overall liability subject to more stringent caps reflecting the contractor’s inability to fully pass on this risk to its supply chain.
Price Certainty and Fluctuations
Closely linked to materials shortages, we are seeing the rise of fluctuations affecting the construction industry. Materials costs increased monthly between September 2020 and September 2021, and prices for building work generally increased by 24.5 per cent between October 2020 and October 2021. We still have rising inflation and energy costs, as well as continuing materials shortages leading to soaring costs.
Developers seeking a fixed price lump sum cost from their main contractors are struggling; in some cases, they are having to pay a significant premium as their main contractor passes the risk on through artificially high pricing, or they are finding that their main contractor is seeking to share the risk of price inflation by utilising the JCT ‘fluctuations’ provisions, terms that have largely remained dormant and unused for more than two decades.
Lenders will need to ensure their project monitors are satisfied that borrowers are carefully considering and mitigating this risk as far as practicable and that they have sufficient contingency in their cost plans to account for likely price inflation. Project monitors will need to reacquaint themselves with the pricing inflation principles to ensure monthly applications accurately reflect the contractor’s entitlement.
Conclusions
Underpinning all of the above topics is the need for a lender to understand the specifics of each project and to engage with and connect it’s project monitor and construction finance lawyer at the earliest stage so the finance documentation can be tailored to reflect and adapt to the position on the ground.
If you have any questions or would like to discuss the above trends, please contact a member of our Real Estate Finance team.