In today’s rapidly evolving financial landscape, the cost of capital has emerged as a critical factor influencing investment decisions, particularly concerning underperforming assets and development sites. The escalating cost of borrowing, driven by rising interest rates and tighter credit conditions, is exerting significant pressure on real estate and other capital-intensive projects. Yet, despite these challenges, banks and financial institutions continue to display an undeterred appetite for financing opportunities, albeit with more stringent criteria. This article delves into the intricate relationship between the cost of capital, its impact on underperforming assets, and the banking sector’s ongoing enthusiasm for investment in development sites.

1. Understanding the Cost of Capital

The cost of capital refers to the required return necessary to make a capital budgeting project, such as building a new factory, worthwhile. It includes the cost of debt and the cost of equity. As interest rates rise, the cost of capital increases, making it more expensive for businesses to finance or maintain new projects.

1.1 The Components of Cost of Capital

• Debt Cost: Interest expenses associated with borrowing.
• Equity Cost: Expected returns demanded by shareholders.
• Weighted Average Cost of Capital (WACC): The overall cost of financing to a firm, balancing both debt and equity.

2. Rising Interest Rates and Their Impact

Interest rates have been trending upward due to monetary policy adjustments aimed at curbing inflation. This rise directly impacts the cost of capital, making loans more expensive and increasing the financial burden on businesses.

2.1 The Effect on Real Estate and Development Projects

• Higher Loan Repayments: Increased interest rates lead to higher monthly repayments on loans.
• Reduced Profit Margins: As borrowing costs rise, profit margins on real estate and development projects shrink.
• Impact on Valuations: Higher costs can lead to lower property valuations, particularly in markets where prices were previously inflated.

3. Pressure on Underperforming Assets

Underperforming assets, whether they be real estate holdings or business investments, are particularly vulnerable to rising capital costs. These assets are often characterized by lower returns, making the increased financial burden harder to bear.

3.1 Challenges Faced by Underperforming Assets

• Decreased Cash Flow: Higher costs reduce the cash flow generated by these assets.
• Increased Risk of Default: With reduced income and higher expenses, the risk of default on loans increases.
• Difficulty in Divestment: Selling underperforming assets becomes more challenging as potential buyers are also deterred by the high cost of capital.

4. Development Sites and the Cost of Capital

Development sites, which require significant upfront investment, are also feeling the strain of higher capital costs. These projects often rely on long-term financing, which is now more expensive.

4.1 Impact on Development Site Viability

• Delayed Projects: Higher costs may lead to delays in project timelines as developers struggle to secure affordable financing.
• Reduced Scope of Projects: Some projects may be scaled back or canceled altogether due to higher costs.
• Increased Pre-Sales Pressure: Developers may rely more on pre-sales to finance construction, adding pressure to meet sales targets early in the project.

5. Banks’ Unhindered Appetite for Lending

Despite the rising cost of capital, banks and financial institutions continue to exhibit a strong appetite for lending. This might seem counterintuitive given the higher risks, but several factors contribute to this trend.

5.1 Factors Driving Continued Bank Lending

• Higher Interest Revenue: Banks can charge higher interest rates, increasing their potential revenue.
• Stringent Lending Criteria: Banks mitigate risk by implementing stricter lending standards, ensuring that only creditworthy projects receive financing.
• Diversification of Portfolios: Financial institutions diversify their loan portfolios to spread risk across various sectors and asset types.

6. The Strategic Response of Developers and Investors

To navigate the challenging environment of rising capital costs, developers and investors are adopting strategic responses that allow them to continue operating despite the financial pressures.

6.1 Adaptation Strategies

• Alternative Financing Solutions: Seeking out non-traditional lenders or using mezzanine financing to reduce reliance on high-cost bank loans.
• Joint Ventures: Partnering with other investors to share costs and risks associated with development projects.
• Asset Repositioning: Repurposing or redeveloping underperforming assets to increase their value and return potential.

7. Long-Term Outlook: Will the Pressure Ease?

Looking ahead, the question remains whether the pressures from high capital costs will ease, allowing underperforming assets and development sites to regain their footing.

7.1 Economic Indicators to Watch

• Interest Rate Trends: Future rate cuts could lower the cost of capital, offering relief.
• Market Demand: Increased demand for real estate and development could offset higher costs.
• Regulatory Changes: Potential government interventions or policy changes aimed at reducing borrowing costs.

8. The Role of Government and Policy in Alleviating Pressure

Government policy can play a significant role in mitigating the adverse effects of rising capital costs.

8.1 Potential Policy Interventions

• Subsidies or Tax Incentives: To encourage development, governments might introduce financial incentives.
• Interest Rate Caps: Implementing caps on interest rates could reduce the cost of borrowing.
• Support for Affordable Housing: Specific measures aimed at supporting housing development can help ease the burden on developers.

9. Conclusion

The rising cost of capital is undeniably placing pressure on underperforming assets and development sites. However, the continued appetite for lending by banks and financial institutions suggests a resilient market with opportunities still to be seized. By adopting strategic approaches and closely monitoring economic trends, developers and investors can navigate this challenging landscape, ensuring their projects remain viable despite the financial headwinds.

FAQs

Q1: What is the cost of capital?
The cost of capital is the required return necessary to make an investment or project worthwhile. It includes both the cost of debt and the cost of equity.

Q2: How do rising interest rates affect development sites?
Rising interest rates increase the cost of borrowing, leading to higher expenses for development projects. This can result in delays, reduced project scope, or even cancellations.

Q3: Why are banks still lending despite the high cost of capital?
Banks continue to lend because they can charge higher interest rates, increasing their potential revenue. They also mitigate risks by enforcing stricter lending criteria.

Q4: What strategies can developers use to cope with high capital costs?
Developers can seek alternative financing solutions, enter into joint ventures, or reposition underperforming assets to enhance value.

Q5: Will the pressure from high capital costs ease in the future?
The pressure might ease if interest rates fall, market demand increases, or government policies are introduced to reduce borrowing costs.

Q6: How can government policy help alleviate the pressure of high capital costs?
Government policy can help by providing subsidies, tax incentives, interest rate caps, or specific support for affordable housing projects.

A meet-up with James Kelder from Green Finance Group

Financing commercial property and development projects is a different proposition in the upward rate cycle we are experiencing, where bank policy and hurdle rates are changing faster than applications can be processed. Recently we caught up with James Kelder of Green Finance Group to discuss the approach that major financiers are taking to the changing landscape. Here’s what we’re seeing on the ground. ​​​​​​​

​​​​​​​1. How has the appetite of the top-tier lenders changed over the past 6-months? And how is that reflected in their lending policy? (LVR, ICR, Geographical/Asset Class Appetite)

The biggest change in appetite has been driven by the rising cost of funds and its effect on the Interest Coverage Ratio’s & overall serviceability. Recently, I’ve observed some banks reducing their coverage ratios, allowing them to continue lending at traditional LVR’s. Overall appetite for certain asset classes & geographical locations remains varied across the banks; however, no major changes have been observed.  

2. Are any areas of the market or asset classes proving particularly difficult to obtain funding for?

– Tighter-yielding assets can make it difficult to meet metrics if you don’t have a substantial cash contribution.
–Partially tenanted assets, low WALE assets can be problematic in meeting bank assessment hurdles and require lenders to up the risk curve.
– Development finance has been problematic with increased funding & construction costs resulting in higher project equity requirements.
– NDIS Assets – I haven’t observed any major banks adopt a consistent approach to this emerging asset class
– Interestingly, for developments, I’m observing project-related site values coming back less than “as is” values indicating that land values or construction costs need to reduce to make sites stack for developers

3. Will the role of private lenders change as we continue this upward Interest rate cycle?

Private lending is more suitable for value-add projects looking to benefit from increased gearing against end values. Banks are reducing coverage ratios, so I won’t see this type of lending for passive hold investors. Non-bank lending may assist some commercial property borrowers if their asset values decline and they want to maintain interest rates.  If construction costs continue to rise, lower presale requirements will also make private lending attractive, allowing developers to recoup elevated costs when selling on project completion.

4. What are lenders saying about construction costs? Are they pricing further escalation into credit applications?

Banks are still scrutinising the builders of projects and the financial means of sponsors to complete projects in case of cost & time overruns. They are still adopting higher-than-traditional contingencies in place for overruns.
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5. Are you recommending your clients fix their rates?
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I don’t recommend fixing rates unless clients want certainty around repayments and/or are hedging against major lease expiry.  In my opinion, the premium for longer-term money compared to current floating rates makes it quite unattractive. Recently, when we have reviewed hedging strategies, capped rates or blended capital structure has provided a good combination of stability and overall cost of funding.     

If the above sounds confusing, let me break it down for you.

1. Changing Appetite of Top-Tier Lenders

What is happening?

• Over the past six months, top-tier lenders (the biggest banks) have changed how eager they are to lend money. This change is mainly because it is now more expensive for these banks to borrow money themselves.
• The key effect of this is on something called the Interest Coverage Ratio (ICR), which is a measure used by banks to see if a borrower can pay back the interest on a loan. When the cost of borrowing goes up, it becomes harder to meet this ratio.

How has this affected their lending policies?

• Some banks have slightly lowered their ICR requirements. This means they are still willing to lend money, but they are making it a bit easier for borrowers to meet their criteria.
• Loan-to-Value Ratio (LVR), which is how much the bank is willing to lend compared to the value of the property, has mostly stayed the same.
• However, banks have different levels of interest in various types of properties and locations, but there have not been any major shifts in this area.

2. Difficult Areas to Obtain Funding

Which types of properties are harder to get loans for?

• Tighter-yielding assets: These are properties where the income is lower than the cost. If you do not have a lot of your own money to put down, it can be hard to get a loan for these.
• Partially tenanted or low WALE assets: WALE stands for Weighted Average Lease Expiry, which measures how long tenants will stay in a property. Properties that are not fully rented out or have tenants who might leave soon are harder for banks to fund.
• Development finance is money for building new properties. It has become more difficult to get these loans because building costs have gone up, meaning developers need to put in more of their own money.
• NDIS assets: NDIS stands for National Disability Insurance Scheme, and related properties are still new. Banks are not yet consistent in how they handle loans for these properties.
• Land values in development: For development projects, sometimes the value of the land and the building costs do not add up, making it difficult for developers to get loans.

3. Role of Private Lenders in a Rising Interest Rate Environment

What are private lenders?

• Private lenders are non-bank institutions or individuals who lend money, often at higher interest rates than banks. They are usually more flexible than banks.

Will their role change?

• As interest rates increase, private lenders might become more popular, especially for projects that add value to a property (like renovations or developments).
• Banks are becoming stricter, so private lenders might be a good option for those who cannot meet the banks’ criteria, particularly for new developments or projects with uncertain costs.

4. Lenders and Construction Costs

What are lenders doing about rising construction costs?

• Banks are being very cautious about who they lend to for construction projects. They are checking that both the builders and the developers have enough money to handle unexpected cost increases or delays.
• They are also building in extra financial safety measures (contingencies) to cover any potential overruns in costs or time.

5. Should Clients Fix Their Interest Rates?

What does it mean to fix an interest rate?

• Fixing an interest rate means locking in the rate at a certain level for a set period, which provides certainty about how much you will need to pay each month.

Is fixing the rate a good idea?

• Fixing a rate can be useful if you want to know exactly how much you will pay each month or if you are worried about big changes in your rental income.
• However, the current cost of fixing a rate is higher than the rates you might get if you do not fix it, so it might not be the best option unless you need the stability.
• A mixed approach, such as using a combination of fixed and variable rates, can offer stability and cost savings.

​​​​​​For further information contact:

Hugh Menck MRICS
Head of Capital Transactions
0432 560 589
HMenck@bne.mcgees.com.au

Disclaimer: The information provided in this blog is for general informational purposes only and does not constitute legal, financial, or professional advice. While we strive for accuracy, we make no guarantees regarding the completeness or timeliness of the content. Always seek independent advice before making any financial or real estate decisions. We are not liable for any loss or damages arising from your reliance on the information provided.

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