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Activity levels in the residential development market remain lower than developers, lenders and other real estate professionals have become accustomed to over the last 15 years.

With 14 base rate rises implemented by the Bank of England (BoE) in the last 18 months - now at 5.25% - the UK is currently subject to the highest base interest rate since 2008.

It is recognised that raising the base rate is necessary to halt and lower high rates of inflation brought on by the COVID-19 pandemic, supply chain pressures, increased global economic costs and prices, alongside the war in Ukraine and resulting energy price crisis.

Despite the challenging consequences of the BoE’s repeated base rate increases, there is evidence that the approach is working. The rate of inflation in the UK has fallen since October 2022, with energy and food price growth also slowing. This is, however, leading to a tightening in the lending market and overall slowdown in residential development.

Property agents are reporting a fall in the sales of new homes, as well as sales and acquisitions of development sites. Savills recently reported that it expects the sales of new homes to drop by 50,000 annually due to market conditions and the planning system. This is coinciding with an increase in the time it takes developers to sell the majority of properties in a development, with buyers facing an average two-year fixed-rate mortgage of 6.50%.

Debt

The availability of accessible, and until recently, relatively cheap, debt has powered the residential development market over the last two decades. The majority of property development projects in the UK are often reliant on debt provided by a third party lender.

As an industry dependent on debt to operate, higher rates of interest have a direct and material impact on the cost of funding a development. When combined with higher material costs and a skilled labour shortage in the construction industry, successfully completing a project, as well as extracting profit from it, is becoming more challenging.

To compound matters, there are millions of pounds of existing loans in place that will be maturing in the next six-24 months. The large chunk of which will need to be refinanced at significantly higher interest rates. This is already evident in the residential mortgage market, but is more than likely to impact an increasing number of developers.

These pressures could risk developments not commencing or being suspended, and unfortunately, potential developer and contractor insolvencies.

As lawyers in the real estate finance market, we are increasingly being instructed on transactions that include pre-dispute factors, such as contractor insolvencies, re-negotiation of commercial terms, reduction in loan amount - due to falls in asset value - and financial covenant breaches. The real estate industry must recognise and prepare for these risks.

Outlook

The BoE’s next decision on the Bank Rate is due on 21 September. Financial markets are predicting an 80% chance of a 0.25 percentage-point rise, to 5.5%. The wider outlook is that further rises are likely, as the BoE aims to put further downward pressure on inflation.

Though some analysts are predicting that the base rate should level off or even decrease by the end of 2024, the BoE’s recent base rate announcement was accompanied by a commitment to ‘ensure that Bank Rate is sufficiently restrictive for sufficiently long to return inflation to the 2% target sustainably in the medium term, in line with its remit’.

Those operating in the real estate industry should anticipate that a return to the ultra-low interest rates seen in recent years is highly unlikely, at least in the short to medium term. Rather, the ‘new normal’ could likely be a base rate of around 2%.

Mortgage approvals in the UK did hit their highest levels in June since October 2022. This is in part due to slightly lower mortgage rates, as well as an increase in the typical mortgage term to between 31 and 35 years according to the RICS Economy and Property Market Update August 2023. It could also indicate that the market is slowly adjusting to higher rates.

Demand for rental properties also remains high, meaning the requirement for new homes is still the same. When financial conditions improve, housebuilders and property developers will be able to increase their activities knowing that the market appetite is high – a report from Centre for Cities found that Britain has 4.3m homes missing from supply.

Other parts of the real estate market are also showing their resiliency. For example, the strong levels of demand for student accommodation, coupled with a shortage of private sector rental properties, means purpose-built student accommodation projects are going to remain essential. Investment into the sector reached a record £7.2bn in 2022.

A drop in development sales could also see housing associations – with good access to funds - begin to acquire more sites, while providing developers with opportunities to partner on schemes as the sale market cools. There are also a growing number of examples of traditional housebuilders partnering on build to rent schemes, with 2022 seeing several forward funding agreements agreed, including in the single-family housing sector.

Ultimately, opportunities will arise and the UK’s real estate market will recover.

Businesses will remain invested and, with the assistance of professional advisors, continue exploring innovative ways to sustain the production of quality and profitable developments.

Simon Hart is a legal director specialising in banking law at Shoosmiths

 

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