Thursday 18 July 2019

'We don't want to put a 'full till further notice' sign on Ireland'

In person: Stephen Bell

Cullaun Capital co-founder Stephen Bell reckons his experience during the crash has been of help in his new role. Photo: Gerry Mooney
Cullaun Capital co-founder Stephen Bell reckons his experience during the crash has been of help in his new role. Photo: Gerry Mooney
Donal O'Donovan

Donal O'Donovan

The first time I spoke to Stephen Bell, back in the dark days of the crash, he was grappling with mortgage arrears and ghost estates as part of the post-crisis management team at Ulster Bank. The English banker arrived in Ireland back in 2010 as part of the wave of overseas executives who came in to steady the then floundering ship of Irish banking after the property crash.

Last year he co-founded Cullaun Capital, a fund set up to lend to Irish builders that Bell said is looking at all kinds of potential developments, from financing nursing home construction to bridge loans for zoned land where developers are only seeking planning permission.

It is, I suggest, racy enough stuff for a guy who was the post-crash head of risk at Ulster Bank, a role where Bell was regularly faced with the human scale of the arrears crisis including in front of Dáil committees

Bell, a considered and thoughtful commentator accepts its been a sharp turn, but doesn't rise to the bait.

"Part of the reason we're here is a lasting consequence of the financial crisis, you can't have 10 years of no development finance and not have consequences," he says.

When it comes to risk, there isn't an absolute measure, its a question of what's a lender is set up to handle, he thinks

"You need to understand your own capabilities, what may high-risk to some isn't to others. If I was to attempt brain surgery it would be a very high-risk operation, but if a trained person did it that is quite different."

If anything, he reckons that having gone through the crisis has left him better armed against the next one.

"I suppose having had the experience of being involved and seeing restructuring through the crisis - in Spain (where he worked between 2008 and 2010) and then Ireland, you become more familiar with what makes things work and what makes things fail and you come back to some basic principals ," he says.

What works for Cullaun?

"Is the product being built suitable for its micromarket? Not Dublin, not Leinster but that house, that street.

"Is the developer or contractor experienced in delivering this product? We are not here to provide training wheels for people," he says.

"And thirdly, is the cash flow resilient for the inevitable bumps in the road that will happen."

If Bell can say yes to those three criteria, then Cullaun can probably lend, he says.

Cullaun is a joint venture between Bell along with co-founders Daire McCarthy and Noel Ross who both have backgrounds in finance and TPG Sixth Street Partners (TSSP), a global credit investment firm with more than $20bn.

The cash is US, but local control is significant Bell says. Having seen a raft of other so called non-bank and alternative lenders set up here after the crash, Cullaun was structured to avoid pitfalls spotted elsewhere, he says.

"One thing we did which is a little bit different is that we three founders co-own the holding company that owns the lending business and the local management company."

Some of their rivals have a split, with the Irish team's stake confined to the management company part of the structure which means their role in effect becomes about bringing business to the lender, he says.

"We felt it was really important to have that co-ownership model because we wanted goal alignment, it was in our interest to do that, we are a proper lending business we can make decisions quite quickly and that proved very helpful."

Another key lesson, he says, was to have a very wide lending mandate, which means the firm can lend to builders of just about anything, and just about anywhere, he reckons.

"We didn't want to be starting conversations with developers and halfway through they might say 'well actually I'm thinking of doing something else', and we'd have to say 'well we don't do that'."

"We have learned from watching this from afar that it is best to have the widest possible mandate, so if we decide to finance a hotel we don't have to go back and issue a prospectus or raise some different money, all of the financing that we offer - whether it is senior debt, mezzanine, or equity - whether it is for a residential development, a hotel or a nursing home, all that is in the same pot."

He says a funding deal with Richard Barrett's Bartra Capital is a good example. Cullaun was looking at providing finance to develop a hotel, but Bartra changed its plans, and was able to get finance for a nursing home on the site instead.

In fact Cullaun its now funding two nursing homes for Bartra - a sector where Bell sees a huge requirement for capital finance as a result of the aging population, and more particularly Hiqa regulations that mean many existing nursing homes will soon be obsolete.

Its own wide mandate means Cullaun can plug those kinds of gaps as they come along, even if it wasn't on the agenda when the idea of funding housebuilders came up originally.

Housebuilding is where the huge hunger for capital is though.

On a back-of-the-envelope calculation, based on a shortfall that may be 50,000 homes a year, Bell reckons there's a funding requirement of €8bn to €10bn.

The numbers are vast, but most alternative lenders have struggled to create large scale lending businesses.

Bell concedes the point. Some lenders have struggled with their own overly- restrictive mandates.

In some cases they came in to the market too early, before builders were in a position to drive schemes forward while everyone in the space has had to find their feet in a new market, he thinks.

"It takes a while for a business to set up - we opened the doors on May 30th (2018) and closed our first deal on the 16th of November; and we weren't sitting on our hands, it was working hard on what at any point in time might have been 16 or 20 different opportunities. So we shouldn't underestimate how long it takes to get up and running.

"If you go back to 2014 house-price inflation was pretty aggressive but there were fewer developers operating, many that had exited - voluntarily or otherwise - were still outside the sector so it tended to be that there was an appetite for relatively small amounts of credit from a relatively small number of developers."

Now, Bell is convinced demand is there for development capital, in part because its a financing segment banks are no longer willing to get involved in, aside from large-scale lending to some of the PLC-scale players.

"I think the banks do some things really, really well, but there is a general disaggregation of the banking sector, so really what you have, what I see, is the banks will continue to be really good at some things and then will say - 'Actually we can't be good at this other thing'."

Typically, what a builder needs to make a project work is to stretch their equity contribution, he explains, a bank will want to stick at a loan-to-value ratio of 55pc to 60pc, he says. That's driven in part by bank regulators' toughened capital rules.

Funds like Cullaun are able to provide as much as 90pc of a scheme's costs, by contrast.

"I think we are entering an era where there is more specialism - so people funding a smaller range of things better; and I'd like to think that the place we are operating is in doing a small number of things really well."

Banks will continue to play a big role, including replacing the development finance once a project is complete - whether that is a mortgage for a homebuyer, or term financing for a nursing home operator.

As we speak, a year after Cullaun's launch, house-price inflation in Dublin has stalled, although demand for housing - to buy or rent - remains high. So who is building, I ask?

"Its a combination - you'll find people who were substantial players before the crisis, who have very legitimately created wealth and are looking to bring some of that wealth back to start up again at what they know best.

"There are developers who had their time in Nama and are looking to re-establish themselves.

"There'll be developers who were part of larger firms and have set up on their own, so its a real mix-and-match."

Of that market, Cullaun has segmented it into four parts

"You've got the amateur developer - people who've got a big garden they can put a couple of houses into; then you have returning developers or the new-start developers re-establishing; the growth sector developers and then you have the big established major players."

Bell says his focus is on the middle two.

"We wouldn't realistically see ourselves dealing with people who just want to knock up a couple of houses on a side garden and we don't see that we would bring value to the very large developer who is bankable by AIB and Bank of Ireland."

Even excluding the biggest players doesn't cut Cullaun off from backing the bigger deals, he says.

"I don't think every large development will be done by Cairn or Glenveagh - you'll see some done by other returning players and some interesting equity-backed players who have strong track records doing things on a smaller scale and are now emerging."

Multi-phase developments - doing 50 or 60 houses and then doing another 50 or 60, and then another - can make a lot of sense for builders who haven't built up huge sub-contractor network, and don't necessarily want to, he says.

A slower return of capital on phased schemes isn't an issue, Bell thinks.

"It doesn't matter to me whether a site for 200 units is done all in one go or whether it is staged development."

"We've done 20 unit apartments, have a pre-planning deal for 240 units and we are looking at one scheme now that could be over 800; so scale is of no consequences to us, we don't have any hold size - no maximum."

What can be a factor is whether a builder can be sure any critical subcontractors will be there when work needs to be done.

"Its not necessarily who is doing the carpentry; but is it a specialised form of carpentry?

"Our approach should be: Look at the developer and look at the specialist contracting where there may be only a few people that do that type of work and, yes, we'd want to be comfortable at the degree of resilience."

Those consideration become even more acute when it comes to specialist fit-out for the likes of nursing homes of housing authorities, he says. While Cullaun is willing to lend, it isn't cheap. Debt costs are likely to push up into double digits.

"We normally have a 1pc to 2pc arrangement fee, a high single-digit interest rate and an exit fee - in some permutation."

The details are less important than the overall return, Bell says.

"We can be very open to a customer who says they want to pay a lower interest rate and put more on the back end, or would rather pay more upfront and less at the end - we don't mind, we are very, very flexible."

"On a blended basis I think we are competitive, but absolutely everything is done on a case-by-case basis because it is so heavily driven by the cash flow."

One reason development finance is expensive is the risk to lender, and builder, of being caught by the market.

UK housebuilders can anticipate a margin of 20pc to 25pc over costs. In Ireland it is more like 10pc, Bell says.

"One of the red flags for me when I am looking at something is, where the return on costs is quite tight and the profitability is heavily dependent on house price inflation, what happens if this goes wrong?"

But, uncertainty around house prices and a shifting regulatory environment are things to be mitigated rather than outright barriers, Bell reckons.

"Its always a bit of a futures business. Look at a transaction we've recently closed that's at pre-planning and it may be two to three years before it delivers the housing that we have in mind.

"The person that we are working with acquired that site two to three years ago - so this is not a short-term."

"So what we are trying to do is to identify what appear to be under-served sections of the market and do what we can to help.

"That's why we've said - from our point of view - we would only deal with sane proposals."

For Bell that comes down to whether housing is being created that meets a genuine demand.

"Why would you build those houses in that place and expect to get those prices for them?"

"Having lived though some of these horrible corrections you do ask yourself, 'What would this look like in a downturn?'. So our approach is very simple - we don't enter a room unless we know where the exit is."

That isn't just a financial calculation.

"We saw a proposal quite early on and it wasn't the value of the houses that put me off - it was they were very contemporary for what was typically quite a traditional area.

"In the event the market did soften I wouldn't like to be selling a very contemporary house where people typically want a traditional Georgian terrace house."

Availability of facilities - 'place making' in property market jargon - also comes into play.

Bell sits on the board of Homes England, an advisory body on housing to the UK government, which he says has also taught him a lot.

"There's no point in building a hundred houses with no roads, there is no point in building 100 houses with no schools."

That said, some of what Cullaun is backing is highly speculative. For Bell its partly down to the high cost of land that has planning.

"One of the reasons we thought of moving into backing acquisition of zoned land that's pre-planning is its a better way of creating value - from a proportionate perspective you make a higher proportionate return taking land from zoned to planning then you will taking it from planning to construction."

The price of land with planning in particular has soared since the crash, as the tide of money that went out between 2008 to 2012, flooded back in.

"Ireland is a small market and its a very open market, and you will get waves of capital that are supporting different things and they don't - conveniently turn up at one time - so people spot an opportunity go in and it drives up prices and then they go over there and drive up that price."

Bell think land prices will start to stabilise simply because the end product - the houses that will be built on it, don't have elastic prices themselves.

That lack of house-price elasticity is in large part because the Central Bank stepped in post-crash to restrict lending.

Having seen the fall-out from rampant boom-era lending during his stints at Ulster Bank and AIB, Bell sees the value of the mortgage caps, but says one consequence has been to hamstring owner occupiers competing with investors to buy new homes.

"The Central Bank made a very balanced decision quite a long time ago to bring in the mortgage limits - 3.5 times income and 20pc deposit - and that has successfully reduced the possibility of a credit-fuelled bubble."

"But there is also no doubt that some projects wouldn't get built if that is the price that could be obtained."

The prices that do obtain in such cases are what builders are able to command from non home owners, increasingly including so called cuckoo funds.

"When there is still such strong demand for rented properties and people will pay what they'll pay - I don't think there is a simple answer.

"Its very difficult because interventions tend to have all sorts of downstream consequences whether you mean them to or not."

"(The rules) the Central Bank brought in are some very positive dynamics in avoiding a credit boom - chasing house prices on ever more ludicrous income multiples - but it has then meant that there is a potential dislocation between supply and demand."

For Cullaun the reality is that they just need a buyer.

"There is an accommodation problem and accommodation needs to be produced on a very significant scale so its not necessarily for me to make value judgements about what tenure that is - it's more are we producing quality volume accommodation whether that is student rooms, houses, flats, whatever it may be," Bell says.

Interestingly, he doesn't accept the possibility that new housing in the Irish market is over-specced to the point where that is driving up costs.

"You can think about other ways of simplifying the value chain - looking at modern methods of construction and onsite assembly and things like that - but I think quality of housing is really important.

"The legacy of the 2000s was a lot of very low-spec, low-quality identical houses. Do people really want to live in that style accommodation if they have a choice?"

In terms of the legacy of the crash, Bell sees little prospect of a substantial correction in house prices.

In fact, he reckons that in significant parts of the country its still not financially viable to build.

"Because the economics mean the cost of building would not be met by what is typically available - that's just how the market works."

That said, as far as Cullaun is concerned, given the right conditions, nowhere in Ireland is off limits.

"It may be that there are parts of Ireland that had inward investment in terms of employment but not the corresponding investment in terms of accommodation - so you have CEOs of major US tech firms saying I'm having to give allowances to employees to room-share with other people.

"We don't want to put a 'full till further notice' sign on Ireland.

"There is no such thing as one market. There are thousands of different markets.

"When we look at Ireland 2040 and the expectations of the population over a 20-year period then that is going to bring with it some interesting challenges.

"The beauty of being a multi-asset class lender is we don't have to follow the trends, we can follow the opportunities."

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