A recent increase in appetite for refurbishment in the purpose-built student accommodation (PBSA) space raises questions around how to secure the optimal funding solution for this type of activity.
This article firstly examines why refurbishment is an interesting investment proposition in the PBSA sector. It subsequently demonstrates how understanding the unique features of capital expenditure (CapEx) financing can help secure more favourable debt terms. Finally, it details the two most typical structures for financing this type of investment and the advantages and disadvantages of each, with particular respect to leverage, cost of capital and flexibility.
Unlocking value through refurbishment
Refurbishment as an asset management proposition in the PBSA market is supported by a number of drivers. For example, the now ubiquitous ESG angle should feature in almost any asset management play. In addition, the opportunity to reconfigure the internal layout during refurbishment also makes it a more attractive proposition. Furthermore, undertaking refurbishment allows access to vintage PBSA assets in locations that would be otherwise unavailable. In a world of ever-rising build costs, however, what really distinguishes refurbishment is the ability to unlock this value without the need for increased expenditure through ground-up development. It’s well understood that funding this type of investment through debt can unlock greater returns than equity funding - provided that the opportunity is understood and presented through a lender’s lens.
CapEx projects through the lender’s lens
There are a number of characteristics of capex funding which must be understood to secure debt on the best available terms. A common theme is the misconception that credit worthiness is directly related to returns. Whilst there is some correlation between creditworthiness and returns, lenders’ focus will be on repayment rather than supernormal returns. Therefore, borrowers should focus on mitigating risk through demonstrating sustainable, reliable income.
Another key consideration is the operational disruption required during refurbishment. From an equity investor’s perspective some minor disruption to operations (and thus revenues) during the refurbishment process will be largely immaterial to initial rate of return. However, a key credit consideration is the ability of the investment to service the interest of the debt during the loan. Naturally, any operational disruption will hinder the ability of the investment to service the debt. Borrowers should plan strategically to minimise disruption (e.g. plan works outside of term time) and where coverage falls below thresholds, careful structuring of facilities should be used to mitigate any deficit at the outset.
Typical debt structures
There are a number of options for financing this type of capital expenditure, but these can largely be categorised into Transitional Debt or Senior Plus/Traditional. The key differences of these lie in flexibility, required equity contribution and cost of funds.
In the Senior Debt Plus scenario, a lender would provide finance to purchase the asset plus a proportion of the capex. This structure will likely come at a lower cost of funds, but require a higher overall equity contribution. For the period when the asset is not in operation, it’s likely the lender would need the interest cover to be held in account. This interest would be deducted from the facility (i.e. would reduce the amount which can be drawn down).
In the Transitional Debt scenario, the lender focusses on the development value GDV post-capex, on the proviso that the debt would be refinanced post-completion of refurbishment onto core senior debt terms (the loan could also include a “tail”, whereby it exists for a period post-completion). As a result, a higher leverage on Day 1 could be achieved. A debt advisor would also likely be able to negotiate for up to 100 per cent of the capex to be financed and interest rolled up. This luxury would have to be paid for through a higher interest margin.
In reality, there are a myriad of options all with varying benefits and drawbacks and the ideal debt structure will depend on the sponsor’s appetite for leverage, their cost of their equity or hurdle rates and the value they place on flexibility. There may also be an opportunity to rationalise the current debt portfolio of the borrower and improve margins. As a result, borrowers are advised to engage their debt advisors early, who can provide strategic advice in line with the investment aspirations of the client.
The PBSA sector offers a number of opportunities for existing and future owners. The majority of stock across the country is naturally reaching a place in its lifecycle where refurbishment is necessary, and those who understand the funding landscape will be better equipped to secure the best debt terms.
About the author
Eamon Sweeney is an associate director in the Debt Advisory team at Colliers. He has significant experience raising finance for trading and operational real estate businesses across the full transaction, and funding advised on by Eamon has resulted in the delivery of more than 6,000 housing units.
To contact Eamon, email firstname.lastname@example.org.