Forward funding – how it works and new complexities
Alan Twine and Celia Berg are partners from law firm BCLP
Forward funding structures are typically used when developers have obtained detailed planning permission for a site. The site is sold to a funder and simultaneously a development funding agreement is entered into between the same parties under which the developer will deliver the completed site and the funder will fund it.
The developer achieves an earlier land sale at a guaranteed price and avoids the need to secure development financing. The funder has protections around specification, timing for delivery and a capped financial commitment (part of which – the developer’s profit – is deferred until practical completion/handover to hedge against developer default). Forward funding structures can be SDLT efficient for the funder and can give both parties the opportunity to share in development profit.
The structure is not new but had become more prevalent in recent years as investors/funds compete to scale portfolios in the most efficient way and market understanding of occupancy risk matured in the living sector. The structure is also seen in light industrial, distribution and pre-let office development. Most forward fundings under negotiation aborted in the second half of 2022 as a result of the macro-economic headwinds affecting the real estate sector – including inflation, rising utilities costs (going straight to the bottom line of student and BTR investments with inclusive rents) and increased borrowing costs. However, forward fundings gradually re-surfaced during 2023 as pricing expectations softened, inflation stabilised and interest in the living sectors remained resilient with investors/funders keen to selectively acquire good opportunities that will be delivered into a better market.
Forward fundings can be complicated and there are numerous considerations to be taken into account in negotiations. Examples include the importance of the specification, developer responsibility for cost overruns, performance guarantees for both parties, funder controls (including over the developer’s building contractor appointed to actually undertake the works) and development cash flow protections required by the funder (and potentially its bank), any role and fee of the developer under a separate development management agreement and securing payment of delay LADs by the developer.
Unfortunately, events in 2023 added further complexities to the mix.
Building Safety Act – the piecemeal introduction of the new legislation created uncertainty but the position is now clearer. What remains to be seen is the delays that could be caused to occupation due to the requirements that need to be satisfied under the Act (including registration) and how the market will address this. Typically funders may not be prepared to take any risk of delay to investment returns. The new information requirements will also make the lists of documents required to achieve handover (and payment of the developer’s profit) more onerous and critical, whilst funders are also focussing on the design of proposed schemes (including cladding).
Developer protection – the above is a good example of new delay risks which may have to be assumed by developers as building contractors are unlikely to accept the risk for such delays (unless they have been fully priced in). Many developers and building contractors are scarred by recent supply chain and other delays resulting from COVID-19 and the Ukraine conflict. Ensuring that liability for delays in the development funding agreement is backed off as much as possible into the building contract is of growing importance for developers.
ESG – this is a topic in its own right, but naturally there is an increased focus on ESG matters by funders who are keen to future proof investments. This has placed greater emphasis on the specification, whilst some developers have had to revisit undeveloped schemes which do have a recent design.
Second staircase requirements – this has also caused market disruption, with the consultation based on a 30 metre height requirement before Michael Gove’s sudden announcement of 18 metres. This has left numerous proposed developments either undeliverable (as they would not be “sufficiently progressed” in the transition period) or grappling with the question of whether Michael Gove is right that current (lawful) single staircase developments will not be priced at a discount.
Building contractor insolvency – as witnessed with Buckingham Group and Henry Construction, rising costs can force building contractors to cease trading very suddenly. For this reason (and many others) it is critical for a funder that developer profit is not extracted before the development is completed, as there will undoubtedly be increased costs if the contractor has to be replaced and the developer may not be able to meet its cost overrun payment obligations.
Notwithstanding these challenges, the market is adapting and forward funding structures remain popular for the right opportunity and are expected to increase in popularity as market conditions improve and investors/funds seek investment opportunities and/or scale.