Equity Parading as Debt – Are you being Short Changed?

Equity Parading as Debt – Are you being Short Changed?

Recently several clients have mentioned they are receiving high returns investing in property development funds, Some of the funds forecast returns greater than 12% p.a.

On just about every occasion, what we have found is that clients in these investments are being short-changed on their investment returns and are taking more risk than they intended.

This additional risk occurs when investors assume their investment is backed by a first mortgage over property when in fact it is not.

Understanding the Capital Stack

This stems from what is often referred to as the Capital Stack and where your investment sits in this Capital Stack. If you rank first in the Capital Stack you get paid first, if you rank second, you get paid second and so on…

By way of example, when a property is sold, 1st mortgage holders are the first to be repaid.

Any available funds remaining after the first mortgage has been repaid in full are then used to repay 2nd mortgage holders.

Lastly, any proceeds remaining after both the 1st and 2nd mortgage holders have been repaid in full are available to the equity investors.

Equity Investors are buying into the success of the project and their return is dependent upon the commercial outcome of the project. Equity has the greatest risk but can provide the greatest returns.

As at the date of this document, pricing of the capital stack looks something like this:

Position in Capital Stack Typical LVR or Gearing Level Indicative Return
1 1st Mortgage Investors Up to 65% 8% to 10% p.a
2 2nd Mortgage Investors 65% to 75% 15% to 20% p.a
3 Equity Investors 75% to 100% 30%+ returns

 

How do I know where I sit in the Capital Stack

Debt investments, particularly property developments, are generally secured against the underlying property via a 1st mortgage.

Equity investments, particularly property developments, are investments in the outcome of the project and are akin to being an owner of the project. For example:

  • If an investment is secured by a 1st mortgage, it should clearly state this fact.
  • If an investment does not clearly state it is secured by a 1st mortgage, then it is likely that it is are either a 2nd or 3rd ranking security.
  • If a portion of an investment return is dependent on the outcome of the project, then it is likely that it is are either a 2nd or 3rd ranking security.

Match where you sit in the Capital Stack with the risk

Generally, property development opportunities will be secured via a first mortgage debt facility. If an investment does not clearly state it is secured via a 1st mortgage, then it is likely that the investment is either a 2nd mortgage or equity.

2nd mortgage & equity investments contain higher risk than first mortgage investments and as a consequence they should provide a higher return.
Equity investments, particularly property developments, are dependent upon the commercial outcome of the project and are akin to being an owner of the project.

If a portion of an investment return is dependent upon the commercial outcome of the project, then your investment is starting to look like equity, and you need to be satisfied that you are receiving a commensurate equity like return.

Beware of Equity Parading as Debt

Sometimes, equity investments can be parading as debt and blur the line
between these two types of investments, potentially leading investors to take on unintended risk.

Investors may be attracted by higher returns without fully understanding where they sit in the capital stack and as a consequence are being short changed on their returns.

Conclusion

In summary, there is nothing wrong with a good property development investment, however before you invest have a look under the hood and make sure you are not taking on more risk than you are comfortable with.

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Can Low Volatility and Low Liquidity Prevent Illogical Investing Behaviour?

Can Low Volatility and Low Liquidity Prevent Illogical Investing Behaviour?

This article tells a story about the psychology of investing and examines the hypothesis that investments with low volatility and low liquidity may prevent irrational investment behaviour which in turn may provide higher overall investment returns.

Firstly, a few quick definitions

Volatility is generally referred to as price swings or movements in value of an investment asset. For example, when the stock market rises and falls more than one percent over a sustained period, it is called a ‘volatile’ market.

Liquidity refers to how easily assets can be converted into cash.  For example, your savings account is liquid, but if you owned land and needed to sell it, it may take weeks or months to liquidate it, making it less liquid.

Buy low/sell high

Logically, any investor knows that is better to buy an asset for a low price and sell for a high price, hence the term ‘buy low and sell high’.

However, because we are human beings with emotions, we do not always invest logically.

We can end up doing the opposite of what is logical – and end up buying high and selling low.

By way of example, let’s look at investment inflows or ‘buys’ into the stock market.

Most investment inflows or ‘buys’ occur when stock markets are buoyant, and prices are generally high.

By comparison, most investment outflows or ‘sales’ occur in low or poor performing stock markets when prices are generally considered low.

It is not within the scope of this article to discuss why we as humans behave in this manner.

However, I am pretty sure that emotions such as ‘fear of missing out’, herd mentality, etc play a role in our illogical investing behaviour.

Let’s look at illiquid and low volatile unlisted property funds

Unlisted property funds tend to have a lower price volatility than listed property funds.

This means that their value does not go up as much in a buoyant market and similarly their value does not go down as much in a flat or falling market.

Because unlisted property funds do not go up in price as much as listed investments, they do not tend to have as large a quantum of money investing at full or high prices when compared to listed property funds.

The lower volatility in unlisted property funds reduces the ability for investors to act illogically and ‘buy high’.

Further, due to their illiquid nature, unlisted property funds tend to have ‘gated’ or ‘limited’ liquidity capacity.

This limited liquidity restricts the ability for investors to act illogically and ‘sell low’ when markets are flat or falling.

Conclusion

We are not saying that unlisted property funds are the panacea to your investment woes, however it may be worthwhile considering a good quality unlisted property fund for your investment portfolio.

Disclaimer Information contained within this document does not constitute financial advice, nor is it a personal recommendation. Capital Property Funds is not authorised or qualified to provide financial advice or to make an investment recommendation.

Information contained within this document is general in nature and has been prepared without regard to the individual objectives, financial situation, or requirements of any person.

This document is not an offer to invest.  Applications can only be made by completing an application form attached to the relevant fund offer documents.

Prospective investors should seek personal financial and legal advice before deciding to invest.

Equity Parading as Debt – Are you being Short Changed?

Why would borrower choose to pay higher rates to borrow from CPF?

Why would a borrower pay a higher interest rate to borrow from CPF?

Sometimes we get asked why would a borrower pay a higher interest rate to borrow from CPF when they can get a lower rate of interest from a bank?

As explained below, the main reason our customers borrow from us is because they can generate more profit when they borrow from CPF.

Typically, our borrowers are experienced property developers with a strong track record who enjoy fully integrated skill sets within their business.

By this we mean they have in house origination skills, project management skills, and project marketing skills, amongst others.

So why would these good quality borrowers use CPF when our interest rates are typically higher than a bank?

CPF’s Flexible lending enables more profits

The main reason our customers borrow from us is because our funding enables them to generate more profit.

Like any business, if a developer’s business is not doing its business (i.e., completing development projects), then they are not making profits.

Our flexible lending parameters mean that a developer can generally start and complete a project in less time than if they tried to complete the development using bank funding.

This means they can finish projects or stages more quickly and enjoy the development profits from their completed development projects.   As opposed to waiting an inordinate amount of time until a project satisfies a bank’s lending criteria.

High Pre-Sales can reduce gross revenue

Usually, traditional bank lending will require a high level of pre-sales. Pre-sales are where the developer is required to sell the end-product before they commence the construction phase of the development. An example of this is apartments sold off the plan.

In order to achieve the required pre-sales required by a traditional bank lender, the developer may have to offer the end product at a discount to its market value.
Often, we find the developer is able to achieves a higher price for their end-product once the development project has been completed and construction is finished.

Allowing the developer to commence their project with a lower level of pre-sales when compared to a traditional bank, may increase the profit available to the developer.

Fiance costs are generally only 8-10% of the overall project costs

For most property development finance costs are generally between 8-10% of the overall project and paying more for finance may not have a material impact on the overall costings on a property development project.

Customer focused lending allows developers to be developers

Often, borrowing from a bank, will take an inordinate amount of time.

By borrowing from CPF, our clients can focus on doing what they are best at and in the end, this results in less stress, higher productivity, and a more successful business outcome.

Conclusion

We are not saying our loans are risk free, however we hope this article clarified that our borrowers are typically astute business owners focused on development outcomes.

Disclaimer Information contained within this document does not constitute financial advice, nor is it a personal recommendation. Capital Property Funds is not authorised or qualified to provide financial advice or to make an investment recommendation.

Information contained within this document is general in nature and has been prepared without regard to the individual objectives, financial situation, or requirements of any person.

This document is not an offer to invest.  Applications can only be made by completing an application form attached to the relevant fund offer documents.

Prospective investors should seek personal financial and legal advice before deciding to invest.

Liquidity versus Volatility – which is more important?

Liquidity versus Volatility – which is more important?

We find retirees are more concerned with preserving their capital than having the ability to convert their investments into cash

This article raises the issue of higher volatility typically associated with liquidity which may not suit all investors.

Just quickly – liquidity refers to the ability to convert your investment into cash.

For assets listed on the ASX liquidity can usually be achieved within 3 business days.

Some investors are happy to accept a lower investment return in order to have liquidity within their portfolio.

You may have heard of the ‘liquidity premium’ a reference to the higher rate of return to compensate investors for having their funds invested in illiquid funds like unlisted property.

Unlisted property investments are not as liquid and can take as long as 6 to 12 months or even longer to be converted into cash.

The liquidity premium can be evidenced when you compare the returns of listed property funds to unlisted property funds.

Generally, unlisted property funds provide a higher return when compared to listed property funds.

What about Volatility?

We believe that all assets should be priced based upon their risk and we agree that liquidity is an important factor to consider when considering risk.

However, we believe investors should also consider another measure of risk which is volatility.
Volatile assets are often considered riskier than less volatile assets because the price is expected to be less predictable………for investors with a limited time horizon a loss of capital due to volatility can be risky……

Not being listed on the stock market means unlisted property funds are less volatile than funds or investments listed on the stock market such as shares or listed property funds.

In summary, 3 things we know about unlisted property when compared with listed property are:

  • Unlisted property will generally provide a higher overall return when compared to listed property
  • Unlisted property is less volatile when compared to listed property
  • Unlisted property is less liquid when compared to listed property