Crunching the figures

As the housing sector enters unfamiliar and more difficult territory, will the nature of project financing change? And what will the sector look like once the current financial crisis is over?

Nathan North

The halcyon days of two or three years ago, when finance was cheap and house prices were soaring now seem like a distant memory. Towards the end of last summer, the extent of the crisis on the US sub-primes market became apparent. As the stock markets took a pounding, banks began to batten down the hatches, imposing stricter conditions and increasing interest rates. Eric Dapoigny, managing director of Yareal Polska, recalls that: “I remember last year everyone was saying this is specific to the US market, with no impact on western Europe. But at the Mipim real estate fair recently, everyone was thinking differently – that 2007 was the last good year. In Poland it too will have an impact.”

According to Michał Kubicki, the Polish partner of joint-venture developer Volumetric: “Finance just costs more – it is not more difficult to get. Banks think there is a higher risk, so the interest is higher.” Eric Dapoigny adds to this that: “Banks have become more conservative. They require at least the land to be in place.”

The Devil and the deep blue sea

The situation we have now is that on the one side, mortgages will not be given out so freely and under such favourable terms; and on the other, finance for residential projects will become harder to secure and more expensive. This poses a particular problem for developers in the CEE region, caught in a pincer movement between tougher credit conditions and falling sales. Until the turn around in events, the situation on the Polish market was extraordinary in that something like 85 pct of residential projects could be financed from pre-selling homes before the construction work on them had even started. This is unknown in more mature economies, where developers usually secure most of their financing from bank loans. But with sales drying up, the first option is now closed to developers, who are now going to have to go down the traditional route of bank loans, or find finance from elsewhere.

There is also another danger specific to the development market in the CEE region to contend with: the speculative nature of the residential sector, which is itself a consequence of its relative lack of maturity. Many small developers appeared during the boom years, who could finance projects without resorting to banks loans to the same extent as large developers do. According to Michał Kubicki: “Small developers in 2004-5 observed the growth and saw an opportunity. They went on with their usual businesses of selling shoes or being pharmacists – but decided to do a project too.” He adds that: “With the growth 2-3 years ago, everyone could be called a developer.”

Łukasz Madej, CEO of Pro-Development – a company offering advisory and other services to developers – describes the current situation: “Currently only 15-20 pct of developments are financed by banks and commercial loans. When we had a situation when all new flats were sold immediately, developers could finance their projects from sales. Now we have a hole between 2 situations. Developers are less willing to take out loans, due to the high costs of credit – it had previously been easier to take this money from customers. And now customers aren’t buying from the beginning of the project, but are instead waiting to see the completed buildings.”

Finance floats away

Faced with no longer being able to rely on the pre-sale of homes for financing, where should residential developers turn now? One option for financing – raising it from share flotations – would seem to be closed at the moment, as the world’s stock markets continue to suffer. Nearly a year after Polish developer J.W. Construction debuted on the Warsaw stock exchange, its share price has devalued by around 60 pct. Gant Development’s recent Warsaw flotation resulted in a re-thinking of the company’s strategy for financing as the required capital failed to materialize. The developer will now only be going ahead with future projects if those completed in the second quarter of the year are sold.

So what about investment funds as a means of finance? Popular in the West they may be, but in this part of the world they are relatively unfamiliar, as Łukasz Madej explains: “Although this is a well known financial instrument in the US and UK, it is not so in Poland. Banks are the natural partner for developers in Poland. From the business perspective, to leverage your instrument with a commercial loan, is profitable – to take out a loan and not use your own capital to buy land etc. Funds would probably need more documentation and business plans – but the main thing is the cost, which would always be lower with a bank. To find a fund is not so easy. The funds themselves are awaiting developments on the market.”

Smartening up their act

Turning to the banks for finance, therefore, would seem to be the only credible option open for developers at the moment. But to do this successfully, Eric Dapoigny feels that a more professional approach is needed: “Most small developers are more like speculators. They must improve and have some equity. If you are professional, you feel more comfortable than if the situation is anarchic. Your risk should be anticipation of the market.”

Eric Dapoigny goes on to outline the problems for the smaller developer in the present state of affairs: “There are still many pre-developers, who are not so professional, buying and selling land, but not thinking in the longer term. But now it is difficult to get finance and buy speculatively. There is a mix of 2 problems: crisis and maturation. Projects are going to be more selective. Sales of flats have completely stopped since the end of the summer, but are starting to grow again. Prices are very high – so developers have to give incentives – eg. VAT free. If finance is not coming from the buyers, then there are 2 options for financing – put your equity on the table or get a loan. If developers are reliable with good quality projects and have the equity, then the finance will be forthcoming. Some developers will collapse, have their assets taken by the banks and sold by them. Quality, security and equity will be the main factors allowing developers to survive.”

Adapt to survive

So how can developers manage to adapt to the present situation? Łukasz Madej suggests that to get financing from banks, “you need to have a sales plan eg. 20 pct should be sold at the beginning. This can’t be done at the moment, because sales results are too low to comply with the agreement.” He adds that: “Some projects will stop without payment from customers – there will be no money for constructors. Those with financing will have to meet with banks to agree an annex, rescheduling payments. Banks will not cancel agreements with developers – this is the worst-case scenario – but they will look for a solution instead.”

According to Zbigniew Koryl, managing director of Upper Finance, an advisory for developers: “Banks will only co-operate with the more established, experienced developers, as it is only with these that the project will be sure to be finished. Projects with higher prices – unless unique - will be stopped. Only those with lower prices will go ahead, and only in the suburbs or secondary cities.”

It takes two to tango

However, it is not just developers who may have to adjust to the situation in the CEE region, but the banks also. There are currently only between 15 and 20 banks that provide finance for real estate development, as Łukasz Madej explains: “There is stiff competition for mortgages – with 30-40 banks offering loans to individual customers. In 2005-6 they began to be more open for commercial loans. Around 15 banks do this – so the number is not as high as for individuals. There are different criterias and different maximum amounts, and some can only grant small loans.”

In Zbigniew Koryl’s experience: “There are more applications to banks now – developers must go to the banks, and cannot finance from sales. But there is a lack of personnel in banks and many more developers applying.”

Small is safe

Łukasz Madej claims that: “Banks with HQs in other countries have been given a signal to stop or limit loans to developers. They will only want to finance safe investments, and not very big ones, which will be divided into small parts, lowering the risk of investment. This is a completely different situation from when the dynamics were high, when even a medium-risk project would immediately bring a profit,” explains Łukasz Madej.

The question arises is that if developers in the CEE have to become more professional, then are we going to see the more amateurish ones disappear or get swallowed up by the more established players? Zbigniew Koryl is of the opinion that due to the harsh market conditions, including land prices and labour shortages, that “consolidation is likely to take place and only the biggest will be left standing.” Eric Dapoigny of Yareal Polska agrees with this view: “Small and middle-sized companies will be fewer on the ground, because it will be more difficult to finance their projects.”

However, Michał Kubicki of Volumetric begs to differ: “I don’t think we are entering a consolidation phase. Small developers in 2004-5 observed the growth and saw an opportunity. But they went on with their usual businesses of selling shoes or being pharmacists or whatever they normally do – and did a project too. What they may now decide to do is divest and sell their projects and sites. If the situation doesn’t change next year, only then may there be some mergers and acquisitions between companies which have eg. 500-1,000 apartments underway in 5-6 projects. But this makes no sense for companies with smaller projects of 150 apartments – there is no added value in doing this.”

In every cloud…

Nevertheless, a consolidation of the market – although maybe a tragedy for some smaller companies, is the usual sign of the onset of maturity. Eric Dapoigny of Yareal, for one, is of the opinion that this is no bad thing: “The situation cannot be like a casino – it cannot be without rules. The market will now start to work in a good way – most developers had been basing prices on land prices and construction costs – but now it will be demand which determines the price.” n