4 Ways to Invest in Property Development in 2018 and beyond.

What to consider when investing in property developments :: Part I

Investing in property developments can be an attractive idea for growing your personal wealth. There are several great companies not only helping solve the housing crisis in the UK but also creating investment opportunities for first-time, retail investors, experienced institutions and everything in between.

However, these opportunities are not for everyone, and before committing, it’s paramount to understand the basic finances of property developments as well as what to look for in specific opportunities.

In part I of this series, we will be covering what the financial structure of most property developments look like. Developers enlist different kinds of finance at different stages, and each kind has a different set of pros and cons.

As an investor you can get invovled at any stage of this investment process, depending on what company you are looking to work with. So let’s look at the main kinds of finance and hopefully clear up some of the confusion that comes with this financial buzz words.

The bulk of the finance needed for a development is normally sourced from a large institution and is referred to as “Senior Debt”.

Senior debt often accounts for 60–65% of the development and has a first charge on the project. A “first charge” simply means that if the development were to run into serious trouble, this lender would have the first right to recover their investment through the company’s assets.

Typically, due to the reduced risk that senior debt investors have (remember the first charge) they typically receive 3–4% interest.

The rest of the finance is traditionally sourced from private investors and often the developers themselves. These are much more accessible opportunities with a much larger potential upside, but remember it also comes with increased risk.

The lowest risk of these alternative investment opportunities is mezzanine debt. Mezzanine debt is medium-term finance which is a hybrid between senior debt and equity finance.

Mezzanine (meaning “middle”) sits between senior debt and equity in the financial structure. Simply meaning, it gives a much better return to the investor than senior debt because remember, it comes with more more risk, but there is less risk and a lower return than equity.

Mezzanine also differs from senior debt in that the security offered to the lender comes in the form of the right to convert the debt into ownership or equity interest in the company if the loan is not paid back in full. This right comes as a second charge to the project, meaning this can only be done once the senior debt and interest has been paid off.

Now, not every development will take on mezzanine debt, but it is an interesting opportunity when available.

Short term debt, also known as bridging finance, is the debt that developers will take on as a temporary measure whilst senior debt and mezzanine debt are being secured.

The return on this type of loan can be quite high — sometimes reaching 15–20% per year. Unlike mezzanine debt, this loan cannot be converted into equity and as such has a higher risk, being the third charge on the project.

The interest is typically rolled over to the end of the loan without interest. So in the above example, you’d end up with a total return of 30–40% over a 24 month period.

The most hands-on way to invest in property development is to invest in the project’s equity. As opposed to debt, equity is an investment into the project and is not secured against any assets, although you do get to take part in the profits of the development.

Basically, as an equity investor, you would take a share of the proceeds when the development project is completed. When investing in equity, you negotiate the percentage of profits that you’ll take part in, and this will typically depend on the project itself and the rest of the financial structure.

As an equity investor, unlike debt, you would be a shareholder in the project, typically owned by a dedicated limited company known as a ‘special purpose vehicle’.

Often debt cannot be raised until there is a certain amount of equity investment already in place and although developers often put up most of the equity themselves, by building the right relationship you may have an opportunity to invest in this way during the early stages of a project.

Depending on your appetite for risk, capital available and opportunities at your disposal, you may be swaying towards one investment method or another, or you may have decided that property development is not for you.

Now, you at least enter the subject matter with a fundamental understanding of how a development is financed. This comes in handy during the next stage to consider, which we will cover in part II soon.

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