The Major Difference Between Our Property Development Investment Model and Traditional Ways of Development Finance
An Introduction to Property Development Investing
Everyone knows that property development investment can be very lucrative. But, traditionally, you have needed to be a high net worth investor putting in a few hundred thousand to be able to reap the rewards. The traditional way of investing can be immensely profitable, but also comes with a high degree of risk- meaning that you could end up losing your shirt if something went wrong, such as house prices falling in value for example.
At The House Crowd we do things differently.
I am going to explain in this blog how you can do your bit and help Get Britain Building much-needed quality houses and at the same time, earn a very attractive return on your money. I will also explain how peer to peer development loans offer a much better level of security to protect you should things not go according to plan (which, sometimes, even with the best will in the world they don’t).
Traditional Development Finance Methods
Very few developers have access to enough funds to finance the whole of a project themselves. This being the case, they normally raise some of the equity needed from private investors, and often go to banks to borrow some of the money, (typically 60% LTV). Then they may raise an additional 10% in funding from a mezzanine debt provider (someone that provides a hybrid loan of debt and equity), which can get very expensive. Development finance can get very complicated with many different layers and structures.
Here are some flow charts illustrating some typical traditional structures:
There are all sorts of ways and, as you can see, they can be very complex with their many different layers and types of funding. The only thing that’s certain using these sorts of models is that they’re always very profitable… for the lawyers. But for ordinary investors, the risks are much higher. Most developments are, as you can see, funded by a mix of equity and bank borrowing, and borrowing money from banks can be a double-edged sword for both developers and their investors. When things go well they can use this leverage to maximise their profits, but if things go wrong …. and we saw a lot of this in the financial crisis… it can very easily bankrupt the developer and investors can very easily lose ALL of their money. For most developers, it’s the nature of the business and they are prepared to take that risk, but if you’re an investor, it changes the game entirely.
It really shocks me when I meet people who have put money into property development investment opportunities that have been highly leveraged, and it becomes apparent that they clearly don’t understand the high levels of risk. All they see are the forecast returns. But, they will only ever receive those fantastic returns if everything goes right (and it often doesn’t). It’s very possible to lose every single penny of your money if things go even slightly wrong. Using a traditional model, a developer would put up 30% of the money either themselves or, through private investors who become shareholders in the project. The developer would acquire (if he can) the remaining 70% from a bank/ mezzanine finance company which we call debt finance.
The process of borrowing this extra money is called leverage, simply because it allows you to do more with less. The bank will receive a relatively low-interest rate in exchange for having watertight security and first call on any profits. There’s nothing wrong with this, and plenty of developers do it successfully in a rising market, but – and this is the BIG BUT – it means the bank has the first legal charge and the mezzanine financier a second legal charge. And if you have any issues or complications, the bank can call in that loan, refuse to lend you any more money, and even step in to take the development away from you, EVEN IF you believe it is viable to continue. The banks can do this because they have very strict terms in their contracts with developers. This enables them to step in and take over in all sorts of circumstances – such as in the event of a breach of Loan To Value covenants. That means even if everything is going well, the bank’s surveyor can decide that the market has fallen, and the Gross Development Value has fallen, and therefore, the bank is lending money on a higher Loan To Value than it agreed to.
Unless the developer puts in more money immediately, the bank can step in and force the developer out. They can and will do this if they think they can profit from it. Just cast your mind back to 2008/2009 – there were plenty of developers who fell victim to clauses just like these. Many of them were forced into bankruptcy and the investors that were in with them, lost every penny they invested.
And don’t expect the banks to behave fairly: they acted reprehensibly in many cases. Charging their clients huge fees, the banks would often force them into financial difficulty, seize their assets and then profit from their sale- at the clients’ expense. We know a number of people who have lost hundreds of thousands of pounds investing into someone else’s development, simply because the bank called in their debt, stepped in and sold the development off cheaply to recover their money. There are numerous cases and allegations of systematic fraud at banks including RBS and Lloyds, some of which are still going through the courts.
So, the fact is, if you are using debt from banks they are ultimately your lord and master, and they can step in and take the development away from you. From an investor’s point of view, I believe this is a very risky way to invest. It might be that you are comfortable with such risks in exchange for a return of 20%-25% – if it all goes right- but at The House Crowd, we prefer to provide a lower risk investment coupled with what are still very attractive returns.
The Major Difference
The major difference in our peer to peer development investments and how it keeps your money safer is very, very simple … we don’t use bank finance to leverage the development.
At the House Crowd, instead of going to the banks like most developers, we have a community of thousands of investors that we raise the money from, hence the term ‘crowdfunding’. Our investors act as the sole lender, and they have the first legal charge over the development. Essentially, for all practical purposes, our investors become ‘the bank’ and are lending to a developer with all the protections that a bank would put in place. What this means for you as an investor is that you are in a much stronger position. The key points to appreciate are as follows:
- It is a debt-based investment with a fixed annual rate of return providing greater certainty over what you will receive.
- As it is a debt investment, rather than an equity investment, you the investor get paid out as first priority from the profits- before the equity stakeholders i.e. the developer and its shareholders.
- You will be paid all your capital and interest before the shareholders/developers take their profits, and if the prices moved downward it would first be absorbed by the developers forecast profit. This would typically have to fall by at least 20% before any downturn in values affects your investment money.
- Therefore, it represents a more robust investment for you and, with typical returns of 10% p.a., I believe our peer to peer development loans offer our members the optimal balance of risk and reward. If you would like to read more about our development opportunities visit our dedicated property development investing page. Or if you would like to discover more about our most recent development opportunity ‘The Downs’ click here. Of course, as with all investments your capital is at risk and returns are not guaranteed. Please read our Important Information page and Risk Warning before investing.