She loves me, She loves me not

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The City was just beginning to fall in love with regeneration as a sector to invest in when its amorous overtures were cut short by the credit crunch. So is this the end of the affair or will potential returns of 15% keep things sweet?

To hear people in the sector talking, you could be forgiven for thinking that regeneration has become the new dotcom. Talk of City institutions falling over themselves to grab a slice of what are forecast to be bumper returns has even led to talk of creating a specific regeneration asset class to help channel the soon-to-arrive billions into the sector.

Anticipation of the sector finding itself awash with City cash hit fever pitch in the summer when it emerged that the Royal Bank of Canada had poached English Partnerships chairman Margaret Ford to head its nascent social infrastructure and development division. Regeneration, it appears, has suddenly become as fashionable in the City as big knotted ties and Blackberrys.

“It’s true we are at a turning point in regeneration at the moment,” says Chris Brown, chief executive of Igloo Regeneration and the development manager of the Igloo Regeneration Fund. “The mainstream commercial property market is expected to show little return for the next few years, whereas regeneration is forecast to have much higher returns. City institutions understand this and that is their financial driver right now.” Trebles all round then.

Current forecasts predict a return of 15% or more for regeneration investments against forecasts of as little as 6% for the mainstream commercial property market. But after a summer of turmoil in global credit markets, many of those leading the charge from the City are licking their wounds and, in the jargon of the Square Mile, are currently busy – read desperately – reassessing their portfolios.

So if you’re looking to get your hands on Square Mile cash be warned: the sharp dressed folk, be they banks, private equity houses or fund managers, have very specific business models when it comes to parting with their cash and, even against bearish forecasts for the mainstream commercial property sector, not every scheme will match their investment criteria. Investment into the sector, like all investments, is likely to be hit by the global credit squeeze which sent a serious shiver down the collective spine of the world’s stock markets last month.

Fund managers, hedge funds and private equity, having spent much of the year desperate to find places to invest their cash, have been caught in the turbulence that has hit credit markets. Private equity firms and others are now struggling to obtain fresh credit lines at viable prices amid the turmoil. The upheaval has also impacted on banks. The Libor rate – the cost to banks of borrowing or lending among themselves has skyrocketed to an almost 10-year high in the past two months and Northern Rock was plunged into crisis, turning to the Bank of England for rescue when money markets dried up.

The manner in which HBOS last month abandoned what would have been perceived as a hostile bid for Quintain in a deal worth northwards of £1.6bn heralded for many a general tightening of investment purse strings. It is understood that the Edinburgh bank’s desire to spread its risk by taking on another equity partner before making a formal offer proved impossible as credit suddenly became more expensive and partners proved elusive. Not long after, HBOS also withdrew an indicative offer worth in the region of £460m for Erinaceous.

Prior to that Robert Tchenguiz investment vehicle R20 and pub group Mitchells & Butlers scrapped plans to form a £4.5bn property joint venture after what is understood to have been a failure to agree lending terms with Royal Bank of Scotland and Citigroup following the credit squeeze.

You don’t have to be Hercule Poirot to see a pattern emerging here. Brown says: “Basically the institutions that were providing equity to the regeneration market, such as hedge funds and private equity, are now reassessing where their money should be in the wake of the market turmoil. Credit has got more expensive.”

Is the end of investment?

So does all this mean the City’s flirtation with the sector is already over? HBOS declines to comment on Quintain and Erinaceous, but Mark Hammond, head of integrated finance at HBOS, the team behind the bank’s foray into regeneration, insists talk of an abrupt halt to HBOS investment is wide of the mark. “None of that signals a tightening of credit to me. Deals are done on merit. We have got a rich equity appetite and we will continue to lend and invest. There is a degree of permanence about equity and a commitment you don’t get with debt. We are not short term about this sector.”

Proof of the pudding Hammond says is HBOS’s backing of the £783m Keepmoat management buyout, funded by an integrated debt and equity package as well as the £410m buyout of Apollo, which will involve the bank in taking a stake in the company.

Commenting on the impact of the summer credit crisis, Hammond is equally upbeat.

“I think credit is more expensive than it was at the beginning of the summer, but I doubt if regeneration will be any more impacted than any other sector.”

Pointing again to the government’s commitment to regeneration, Hammond adds: “It’s probably a safer investment than many others at the moment.”

Steady as she goes

Though rather less bullish, Nick Salisbury, head of structured finance for property at Barclays Bank, agrees that the sector is unlikely to suffer from a shortage of investment. “It’s still up in the air and I think it’s difficult to see quite where it will fall, but I really doubt if the last few weeks will be dictating a longer term trend. While many banks are not currently providing equity for deals, I do expect that to change over the next 12 months or so; the market looks good,” he says. “We’ve got generous property limits and lots of space. We’re not going to take any silly risks, but there is a feeling that Barclays is under lent in property.”

Robert Dick, chairman of Edinburgh-based Cala Finance which provides finance to smaller developers (see box, right) for regeneration schemes up to a value of £8m is slightly more bearish. “I don’t expect the same scale of problems we saw in the 1980s but I do see a tightening of funding from banks and other financial institutions over the coming months. That said, restricted lines of funding means less competition and that will help those in the sector, like us, who understand how schemes need to be put together.”

The institutions that were providing equity to the regeneration market are now reassessing where their money should be
Chris Brown, Igloo

Tim Hayward, finance director at regeneration specialist builder St Modwen, agrees: “The recent tightening of credits means banks may well get fussier about which schemes they finance, but we haven’t encountered any shortage of offers from banks. Some are even offering equity although we never take it up. All this means is that banks will simply look more towards schemes with developers that have proven expertise.”

Where’s the money?

So who has all this money? Well, the first thing to remember in the dash for cash is that you’ve got to distinguish between different types of capital coming from the City. For all the apparent bullishness of the regeneration market, banks remain primarily involved as debt providers. Some do provide equity as well now, but for the most part the big equity investment in the sector is coming from the institutional investors, the real estate fund managers, hedge funds and private equity.

One of the few banks that isn’t shy about equity investment in the sector is HBOS. The Edinburgh-based bank has splashed a lot of cash around in the last year, acquiring, among others, McCarthy & Stone and Crest Nicholson as well as stakes in a clutch of traditional social housebuilders, and HBOS is keen to continue its largesse.

“Basically we are latching onto the government’s objective of improving schools and housing,” explains Hammond. “There is good government expenditure coming into the sector, as well as government commitment, so we are happy to provide funding along with that.

“The leveraged structure for the sector is usually 65% debt and 35% equity. It’s reasonably highly leveraged in terms of normal corporates, but government commitment to the sector makes that possible.”

Hammond insists his division doesn’t “really invest in property” and as such has no set criteria for investment in regeneration schemes which he says are judged on an ad hoc basis when it comes to funding decisions. “Our criteria for funding regeneration schemes are the same as for any industry we look at investing in. Are the people sensible? Is the proposition viable? Right now regeneration is a viable proposition and what we see are very good private sector companies working well with the public sector,” he says.

One of the better known investors in the sector is Igloo, the fund set up by fund manager Morley specifically to invest in locations that have suffered economic decline. Igloo has around 15 investors, including local authority pension funds and so called “ethical investors” such as charities. It also includes a number of City institutions seeking what amounts to commercial returns on their investments while at the same time patting themselves on the back for doing good.

“Our investment model is based on locations at the edge of the top 20 city centres,” explains Brown. “We only get involved in schemes that are well designed, environmentally sustainable, mixed use and strongly focused on creative industries. Creative industries can include anything from artists, to architects or web designers, that type of thing. For example, in Bermondsey we’ve got a market with antique traders, fashion designers and workspaces for creative industries.”

Ken Dytor, managing director of consultancy Regeneration Investments, also emphasises the importance of the creative link when it comes to attracting City cash. “Art galleries or other things that attract lottery or Arts Council funding are being introduced into schemes because it gives confidence a scheme can get funding from agencies to start with. That initial commitment can enable a scheme to leverage cash from other potential investors. It gives confidence to the market that funding is coming into an area or scheme and a confidence that there is more to a scheme than simply its residential element.”

Barclays is one of the City stalwarts that has put equity into Igloo, but it is also heavily involved in a raft of other investments in regeneration. “We invest in different ways,” says Salisbury. “Development finance is the way forward for us at the moment, providing both senior finance and mezzanine finance to schemes. We also invest through SPVs [companies created for the acquisition or financing of a specific deal] that are sold to institutions.”

Lending criteria

Salisbury continues: “It’s hard to generalise about how we would look at one-off developments that take place in what can be termed deprived areas. Essentially we would look at who the sponsor of the scheme is, which could be either private sector or public sector, and then apply all the normal lending criteria, such as number of pre-lets, etc. Like all banks, we have moved away from speculative risk in commercial property, but we do take speculative risk on residential.”

Warming to his theme, Salisbury adds: “Good deals can be those that are sponsored by local authorities who don’t have money to invest themselves and want a private sector partner. If you take the example of Croydon, where we’re supporting one of the bidders for the Croydon regeneration scheme, the local authority wants new offices for their staff and will commit to a longish lease so that in itself acts as a carrot for investment.”

All this sounds wonderful, but obstacles remain. One is the oft-expressed complaint that the City and regeneration people don’t fully understand what the other is after from a scheme. “In many respects fund managers are still struggling to find routes into the market,” says Igloo’s Brown. “The problem is they don’t always talk the same language as regeneration people. Basically the regeneration people aren’t doing enough to learn the language of fund managers. But the money in regeneration has to work alongside the expertise. Where that happens it works well, where it doesn’t happen it doesn’t work well.”

His view was echoed by Salisbury: “I don’t think any of the banks view regeneration as separate from the rest of the sector, yet regeneration is slightly more complicated.”

Salisbury was also formerly head of Barclays PFI division which he believes has served a useful learning curve for both the City and public sector in delivering what each requires from a scheme. “I think there was a misconception in the City that property in regeneration didn’t perform in line with other prime properties. But you have to take a long-term view. The area you invest in could take longer to improve and provide yields, but the returns are there.”

Hammond agrees that not everyone has been singing from the same hymn sheet, but believes the situation is improving fast. “They do tend to talk in different terms. But social investing is a relatively new phenomenon, I think it is being better understood now.”

There was a misconception in the City that property
in regeneration didn’t perform in line with other prime properties. But you have to take a long-term view
Nick Salisbury, Barclays