The Rise to Prominence – Commercial to Residential Conversions

CONTRIBUTORY FACTORS

Recently a number of factors have taken place which have created an upsurge in commercial to residential conversions. These are being seen as profitable opportunities to property developers and we have seen an increasing demand for funding to complete these schemes.

These factors are not exhaustive but I would see the key ones as follows:

Demise of the retail sector – The economy for high street retail has been in trouble for years and empty shops are littered around the UK cities and towns leaving planners and governments scratching their heads and landlords looking to dispose.

Impact of COVID19, particularly on demand for office space – The impact of the COVID-19 Virus has not only impacted on an already struggling High Street. In addition it has forced people to work from home and the businesses that have survived this ‘new way of working’ will be considering exiting from expensive office leaseholds which are no longer seen as essential.

Economy/Shortage of residential housing stock

The government have been under pressure for many years to deal with a chronic shortage of housing in the UK. One of the strategies implicated has been to relax planning legislation to encourage the conversion of redundant commercial buildings into residential accommodation.

ADVANTAGES FOR DEVELOPERS

Project costs are significantly lower for a conversion compared to a new build ground up scheme. Imagine an office building as a simple big box. Then split the big box into 9 smaller boxes within the big box. You may only need partition walls for this and no structural work. You now have 9 apartments – probably with parking spaces and all connected to the utilities. No foundations to lay or breaking ground in this scenario.

There is an increasing consumer demand for good quality well located apartments with parking.  Developers see apartment conversions as a less expensive and therefore an attractive way of delivering this product to market whilst also achieving good rental returns, should they retain the asset longer term. We are now seeing a spike of activity in this area.

 

The Funding Options

This breaks down into 2 headline options:

Option 1 – Refurbishment Finance

This can provide up to 75% of the purchase price and an additional 10% towards the renovation costs. Or if you have bought the property for cash it can provide 100% of the build out costs. Generally this type of finance is designed for projects with no structural work because if that’s the case you will likely need option 2 instead.

Within option1 there are further categories of light refurbishment and heavy refurbishment. Each has a different criteria from the lender and is dependant on the type and scale of the building work needed to complete the project. We can help to assess the likely category the lender will assign the project when we have viewed the development appraisal.

For new developers with cash or joint venture funds this can be a very low cost short term finance with rates from 0.55% pcm – 0.8% pcm depending on the project attributes and lender. This is because the lender is supporting a currently built asset with a value that should only increase from when works start. Buying a building which is a disused shop will have a limited value, any work you put in to improvements should only increase the value and therefore the lender is at less risk than a project with structural requirements as this decreases the value of the property before it increases.

Standard loan term is likely to be 12 months duration and exit via sale.

Option 2 Development Finance

Property developers will be more familiar with this type of funding. There are lenders that provide 100% finance for land and build costs provided the developer can demonstrate their experience for the project. It is achievable albeit at high interest rates and possibly some element of profit share as the lender is taking all the risk.

Generally available is finance funding 50% of the land cost plus 110% of the build out (includes a 10% contingency) As the developer is now more personally invested, the risk is lower for the lender and the interest and costs are lower as result.

In all cases the lender will require a full schedule of works and cashflow forecast demonstrating that the developer has considered and costed in all the requirements to complete the project. The developer does not need to do the work themselves or with their own team of employed labourers and can outsource the work to a suitable contractor via a JCT contract or similar. This therefore allows new developers to enter the market leveraging the skills and expertise of subcontractors and essentially making the developer more of a project manager ensuring all the contractors deliver on their quote on time and within budget.

Exit and refinance options

When you have completed the project you can refinance using developer exit which pays off the existing lender, provides additional funds for the developer and allows up to 2 years for the units to complete their sales.

You can also look to take out a long term buy to let mortgage product on part or all of the units. Some investors look to sell the amount of units they need to pay off the development lender / investors leaving them with the remaining units as their profit. They can then take a long term view (monthly income + asset appreciation) and rent the stock extracting 60%-75% of their equity in cash at the same time. With interest rates at historic lows these investment options become more attractive especially when you can fix a low interest rate for 10 years and use an interest only repayment option.

In summary the market for commercial to residential conversion is heating up, the lenders are aware of it and have products to accommodate projects with high potential for success and profit returns.

If you are a developer and would like to know more simply email aaron@specialistpropertyfinance.co.uk for an informal, no obligation discussion.