Banking regulations stifling UK development lending

* Investors miss spec. development debt due to Basel II

* Mezzanine funds seen to reap benefits of funding gap

LONDON, June 28 (Reuters) - Tough rules to eradicate risky lending are blocking banks from supporting potentially lucrative speculative UK development, putting mezzanine debt funds in pole position to bag the bulk of profits in a new construction cycle.

European banking rules known as Basel II have all but shorn banks of their ability to lend to office development projects without committed tenants, even as prime office space supply in London plumbs once-in-a-generation lows, three senior real estate bankers told a conference on Monday.

"I don't want to say it is impossible but at the moment it is certainly looking challenging," said Max Sinclair, co-head of the UK division at Commerzbank (CBKG.DE) unit Eurohypo.

"It is very much an equity risk ... there are so many economic uncertainties around at the moment, it is not a slam-dunk," he told the Urban Land Institute Europe Trends conference.

Sinclair hoped the brains behind Basel II's next incarnation would offer leg room to lenders willing to lend speculatively at conservative levels.

"At the moment Basel II is saying that at 0 percent prelet you can do nothing, at 50-60 percent prelet you can do something but what it hasn't worked out is how to deal with the bit in between," he said.

Sinclair advocated deals with 30-40 percent of space prelet, if the developer has a strong track record in securing tenants.

Memories of the losses incurred as a result of over-zealous lending during the 1980s building boom remain fresh in the minds of many bankers, Sinclair said, dampening enthusiasm for new development financing deals following the 2007 credit crunch.

Even large balance sheet lenders such as HSBC (HSBA.L) and German lenders such as like WestImmo [WDLGW.UL], which enjoy access to the fruitful Pfandbriefe market, are restricting loans to 65-70 percent debt-to-cost to limit reserve capital costs.

"I am a bit peeved that bankers are now seen as really boring, unimaginative or that we're not willing to take risks," said Peter Denton, managing director of Westdeutsche ImmobilienBank AG.

"The fact is we have to deal with a number of factors that frankly real estate people don't appreciate," he said.

"Banks are not moving beyond this range because of risk, it is because of liquidity," he said.

Specialist real estate lender WestImmo was toiling to find innovative ways to meet rising demand for UK office development finance as rents started to recover, but other larger lenders had yet to be persuaded to push precious funds into speculative development, he said.

Matthew Webster, managing director of HSBC Real Estate Finance said credit committees at his bank were likely to shun speculative financing opportunities until the market recovery gained further traction.

"We lent through the entire downturn, we never closed shop but ... with spec development, I would say there is no place where they are comfortable right now," Webster said.

"Under Basel II, in order to make it work, you're looking at some kind of recourse going back to the borrower. If you can't get that, the model just doesn't work and the price just gets outrageous," he added.

While banks and borrowers struggled to find common ground under the fog of tighter financial regulation, Webster said he had been approached by a number of mezzanine debt funds keen to help bring the two parties together.

"If you ask would we go above 70 percent loan-to-value today, the answer is no, definitely not. But there is more appetite from a number of mezzanine investors that are raising new capital and who are saying we want to come in and support you as a bank to help you reconstitute some of your exposure on balance sheet," he said.

This window of opportunity would likely create a sustainable market for mezzanine debt funds in Europe for the first time, Webster said.

All three panelists said developers that had accused banks of starving the UK real estate market of credit had forgotten about the banks' own obligations to deliver equity returns to their own shareholders.

"As an individual, the rationale for investment in London is of course compelling ... but we're not here to buy into the equity story," Denton said, underlining the ultimate aim for banks originating senior debt today "was not to lose it".

"People's knowledge of Basel II or Pfandbriefe or credit processes are woeful within the property industry ... there is usually a rational argument as to why we will or won't do something," he said. (Reporting by Sinead Cruise; Editing by Andy Macdonald) (See www.reutersrealestate.com for the global service for real estate professionals from Reuters)