The 100k question: is my development loan interest rate fixed or variable?
An unpleasant surprise may be coming for Britain’s property developers. If predictions are correct and the Bank of England base rate climbs by 1% over the next 12 months, a developer borrowing £10 million on a typical two-year variable rate could see their borrowing costs soar by £100,000 - a hit that will come straight out of their bottom line.
The decisions of the Bank’s Monetary Policy Committee seldom keep anyone but the most dedicated macroeconomic wonks awake at night. And in truth, an increase in the Bank’s base rate from its current, 300-year low, won’t immediately impact many homeowners - as the majority of those with a mortgage are on a fixed rate.
Nevertheless the debate about interest rates has shone a welcome light on an important, but often overlooked, corner of the property finance market - the rates on development loans.
While few homebuyers would dream of borrowing £250,000 from a high street mortgage lender without asking if the interest rate was fixed or variable, the same question is seldom posed by developers seeking a loan of tens of millions.
That’s not just irony. It’s verging on insanity.
Unlike the residential mortgage market, where three quarters of homeowners have insulated themselves with a fixed rate deal, the vast majority of professional developers borrowing to fund a land purchase or construction costs are currently on a variable rate.
Despite repeated hints from Threadneedle Street that the Bank plans to raise the base rate in an effort to tame surging inflation, many developers who have grown their portfolios with the help of years of cheap debt have yet to wake up to what interest rate volatility might mean for them.
The knock-on effect of all this is that development lenders may see their borrowers’ shrinking profit margins as a reason to take a more risk averse approach, meaning developers may soon face the double-whammy of having to put more money into each deal while simultaneously seeing their profits eroded.
It doesn’t have to be like this. Amid soaring input cost pressures and supply chain disruptions, the case for borrowers to fix their interest rate has never been more persuasive.
At Atelier we can offer the certainty of a fixed interest rate to all our borrowers, thanks to the funding that underpins us. Lending is all we do and we are extremely well capitalised.
By contrast, institutions whose lending is funded by savers’ deposits are likely to have to increase their interest rates once the Bank finally takes the plunge and starts raising base rate.
Their variable interest rates are often euphemistically described as an “all-in rate”. This is code for a lender margin tacked onto a benchmark, typically the BoE base rate or Libor. As the benchmark rate rises, so too will the borrower’s interest payments.
Such loans are all well and good in a benign interest rate environment. And for more than a decade - ever since the Global Recession of 2008 and 2009 - that’s what we’ve had.
In fact, interest rates have been so low for so long that there is a whole generation of developers who’ve never known anything different.
But things are set to change dramatically in 2022. With consumer inflation currently 14 times higher than it was last November, and more than double the 2% target the Bank of England is mandated to keep it at, the Bank has no choice but to act. And its inflation-reduction measure of choice is to push up interest rates.
Traditionally the Bank has shied away from raising interest rates just before Christmas, and there is some speculation that surging cases of the new Omicron variant of COVID-19 may persuade the Bank’s rate-setters to delay pulling the trigger until the New Year.
But it’s a question of when, not if. With the prospect of rising interest rates feeding through directly into the cost of their borrowing, developers need to factor this possibility into their calculations when seeking finance.
Variable rate loans are fine in a long and unbroken period of abnormally low interest rates. But after nearly two years of pandemic-inspired abnormality, interest rates are now set to creep back up towards more normal levels.
Those planning a development next year should bear this in mind, and put prospective lenders on the spot about rates. Getting it wrong now could prove a very costly mistake.