What if there was a magic formula that could help you compare investment options faster than ever before?
And what if this formula also gave you more peace of mind that you were not ‘picking and praying’ the investment would do well based on the return alone?
If only right?
In Preer, many of our clients are turning their attention to property development at some point of their investment journey to boost their wealth independently of organic property market returns.
But this presents its own challenges. Should you chase the high return alone? How do you differentiate a good investment from a bad one? Which project has a higher risk? How can you balance the risk & reward?
Hence, today I want to introduce two basic investing concepts that might make your life a lot easier when deciding between (property development) investment opportunities in the market:
1. CAPITAL STACK – wherein the financial structure of a project your capital would be used.
2. DEVELOPMENT RISK STAGE – wherein the development process your funds would be deployed.
Each has their levels of risk and expected returns. When you examine both, you can quickly decide if the gains offered are in line with general market expectations.
First, Let’s talk about the Capital Stack
In a simple term, the capital stack is made up of debt and equity.
It’s one of the most valuable tools available to investors for evaluating and comprehending risk in direct real estate investments. For property development, the capital stack is the different layers of financing sources that go into funding the purchase and development of a project.
Like any investment, property development has its own downside risk. The capital stack provides investors with valuable information about where they fall in the pecking order of cash flows, what that order means for the likelihood of repayment and, ultimately, whether the targeted return on investment is worth the assumed risk.
While there is theoretically no limit to the number of layers a capital stack may contain, we will keep our analysis to the four most commonly used types of capital in ascending order of priority:
Equity owners share in the profits of the project with their returns being uncapped.
They are in the riskiest position being the last to be paid and therefore expect the highest returns to compensate for the risk.
Equity investors also own the asset which means they only get paid when they sell the asset or sell their interest in the asset.
2. Preferred Equity: 10-20%
These investors get paid a fixed return before the remaining profits are paid to the developer and other lower ranked investors in the capital stack. If you want a slightly higher yield with a level of certainty, this option may be for you.
3. Subordinate Debt: 10-20%
Subordinate debt is a debt which ranks after senior debt if a company falls into liquidation or bankruptcy. Its priority is next to the senior debt on the property. Hence, it usually has a higher return (10%+). In property development industry, it’s often referred as “Mezzanine Finance”. It is merely the term used for funding the gap between your primary or first mortgage and the total development costs.
4. Senior Debt: 4-10%
The senior debt (usually “bank debt”) is typically provided by a lender with a 1st mortgage on the property. They take the least risk but also get paid the least in the form of interest.
A better way to think about how capital stacks relate to repayment is to imagine a rectangular prism that is full of water. At purchase, pour the water into a separate container. If things start to go awry, you begin removing water from the separate container. If they start to go better, you replace some of the water in the separate container. If things go great, keep adding water to the separate container. Upon sale, pour the water from the separate container back into the rectangular prism. If you fill the entire prism and it begins to spill over, the amount of spillover is your profit! If it correctly refills the rectangular prism, then everyone is repaid, but you broke even. If it fails to refill the entire prism, then the unfilled portion is your loss, and the owners of the unfilled area are the investors in the deal that have incurred the loss.
Development Risk Stage
Now that you know where in the capital stack you’re investing, next you need to know where in the development process you will invest your money since it has a different risk implication.
You’ll notice the earlier in the development process you invest, the more risk you encounter, and the more you should be paid for this risk.These risks can be broken down into the following general categories:
Site Acquisition – was the site purchased for the right price under the correct terms? If this is wrong, then the project may not be feasible or profitable from the outset.
Council Approvals – What if the DA is approved, but without the necessary yield the profit assumptions were based on?
Pre Sales – Banks will often only lend when there are enough pre-sales to prove demand for the end product from the market.
Bank Funding – Is the bank prepared to back the project and developer on reasonable terms? If the developer cannot get funding, then they may have to seek alternative (and costly) options that can reduce the overall profit shared with the equity investors and the developer.
Construction – Has a builder with a strong reputation for building on time and budget been appointed on a fixed price contract? Weather delays, Industrial action, delays from contractors can make or break a project’s profitability, and the investors return.
Settlement – Are the end buyers of the finished properties able to settle on time at the contracted price so that profit expectations are achieved?
Like any investor, a capital investor needs to determine their strategy before contributing to a capital stack. What’s more important: a steady income, or the opportunity for sizeable capital gains? How much risk is acceptable? A careful examination of the asset, as well as the proposed capital structure, is as essential for a capital investor as any other investor — wherever they want to be in the capital stack.
Where would I normally allocate my fund If I’m investing in other people’s project?
This question was one of the most frequently asked ones whenever I did a presentation on this topic in the past. I think it’s beneficial to include my answer here in case you have the same question:
For me, every project has to be assessed on a case by case basis. But if I have to pick, here’s the short answer:
Capital Stack: Mezzanine Debt with 20%+ return per annum
Development Stage: Construction Stage (when senior debt was already in place)
Sounds interesting to you?
If you are a select few who would like to discover:
1. how you too can put some “lazy equity” to work
2. and fast track your financial freedom via participating in a share of property development returns
I’m happy to have a casual chat with you to see if we are the right fit for each other. Just leave your application here, and we’ll have a quick conversation.