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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