The private rented sector could offer contractors both risk and reward, says Patrick Gloyens.
Patrick Gloyens
What a fascinating idea from housing minister Brandon Lewis that contractors should develop directly in the private rented sector (PRS). And what a challenge to the industry.
At first sight, the idea that contractors simply become developers overnight seems more than faintly risible, given the very different business models involved. Most companies that carry out both development and construction will be careful to have separate legal entities performing each function. They will usually contract with each other, formally or informally.
There are three important reasons for this separation, although all relate to risk. First, the company itself will want to separate risk into different buckets. Development risk (and reward) is very different from construction risk (and reward). If one goes very badly wrong it is important that the losses do not contaminate sister entities. Only very rarely will a parent company guarantee be given by the parent of both entities, for the same reason.
Second, lenders will want to understand and limit their risk. Lending for development is very different from lending for construction.
Third, there is an insurance issue. Insurers will want to understand the nature of what they are insuring and will price it accordingly. In practice, obtaining insurance under one policy for different activities is not always straightforward.
There is a bigger issue as well, which is not just the development risk. Developers look to add value; contractors look to drive down cost. There is a different attitude of mind required for each discipline and while, of course, it is possible to understand and manage both, it is not a change to be undertaken lightly or ill-advisedly.
Developer Essential Living’s 249-flat PRS scheme in Greenwich is expected to appoint a contractor shortly
It is always easy to find a reason not to do something, and one man’s problem is another’s opportunity. Assuming one can satisfy one’s inner lawyer and get both the structure right and the insurers squared, it is possible for contractors to take on a development role to deliver PRS schemes single-handedly?
There are attractions. Look at the returns and compare them with current construction margins. That alone is a good reason for getting out of one’s comfort zone.
But there is potentially another very interesting reason for doing this: by forward funding a scheme via the long-term owner and operator, two of the major risks associated with development – sales risk and financing – are diluted. Indeed, this may work better in a PRS scenario than in many others. The end operator wants a product, the development process is simply one way to get there. Another way is to buy off-plan.
Forward funding typically involves a developer (or in this case a contactor-developer) agreeing to build only once a purchaser, usually a pension or other fund, has contracted to buy the finished product at a price agreed in advance. Often the price will be by reference to a formula depending on the lettings that the developer has been able to put in place before completion.
“Brandon Lewis’s cheerful conviction about the speed and ease of the planning process is not shared by the entire industry.”
The funder will pay the developer the construction costs as they arise during the development period on receipt of the relevant certificates, so the costs wash through. In principle, there is no reason why the same mechanism should not apply to a PRS model with the end operator acting as funder and receiving a turnkey product on practical completion. There are no lettings to be put in place as the operator will want to control this itself.
The attraction of this arrangement is that it would eliminate sales risk and provide development funding. In fact, a contractor or a construction company might be better placed than a typical developer in the market as, certainly until now, there has been little attraction to a developer in selling at a discount to a PRS operator rather than holding on and selling to individual purchasers at a much higher return.
What seem like modest returns for a developer, however, can look quite different when compared with construction margins, even now.
Of course that still leaves the need to find sites and invest time and money in obtaining planning consent – a whole new set of skills – and Lewis’s cheerful conviction about the speed and ease of the planning process is not shared by the entire industry. There is also the small matter of the supply chain, which in practice may be the biggest drag anchor of all.
Nonetheless, there is the glimmer of a good idea here. It will be fascinating to see whether the challenge is taken up.
Patrick Gloyens is real estate partner at law firm Michelmores
