About This Lesson
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How do investors mitigate risks and maximise developer loan note potential?
The benefits of investing in developer loan notes include a lower point of entry (some loan notes allow investment from £5,000), a known and enhanced regular income (typically between 10% and 15% in the first year, and often benefitting from bonuses in subsequent years), and flexibility of investment (you can develop a portfolio to suit your objectives with developer loan notes offering different payment periods and maturity dates).
However, as with all investments, there are risks. In this article, you’ll learn about the main risks and how these risks can be mitigated and managed to maximise your return from investment in developer loan notes.
Risks of developer loan notes
Developer loan notes are considered a higher risk than direct property development – hence the higher potential returns. The primary areas of risk are as follows:
1. Developer risk
When you invest in a developer loan note, you are investing in the ability of the developer to deliver on their promise to complete the development scheme. If the developer fails to complete the development, the scheme may need to be sold to another developer. If the purchase price is less than the expected completion value, you may lose interest and capital.
To mitigate this risk, make sure that the developer is experienced and has a good track record of delivery. By carrying out comprehensive research and due diligence on the developer and the development proposed, you should ensure you invest in the best developer loan notes.
Another element to ensure is attached to a developer loan note as collateral, by way of a charge of the property or other assets. This will maximise the chances of being repaid in full should a development not realise the expected profits to repay the loan note in full.
2. Late repayment
If the developer has been unable to sell the development in time to repay the developer loan notes, you may have to wait for the return of your capital. This could jeopardise other plans you have for your invested capital.
It can be difficult to accurately predict the completion date of a development. There are so many variables that come into play that may cause delays. These include adverse weather conditions, problems with suppliers and contractors, and a slower sales market than anticipated.
By examining the past performance of the developer’s projects, you will get a good feel for how good the developer is at planning a scheme and working with others. This is part of your due diligence work. By investing in developer loans with penalties attached for late payment, you further incentivise the developer to deliver as planned.
3. Market risk
Market risk is inherent in any property investment. Economic shocks may cause property values to fall, and make selling properties at the expected values more difficult.
By considering the scheme’s expected value at completion and investing with a good buffer to this, the investor helps to protect themselves from market risks. A detailed analysis of the scheme and local residential market should help to ensure that you invest in only the best development sites.
In addition, an investor should conduct annual appraisals to ensure that the project is on target and that the market has not changed markedly from previous expectations. Many developer loan notes allow sales at one-year anniversaries, and if the market has taken an unexpected turn south, then these annual selling periods could help to protect your investment from future market risks.
4. Senior lender risk
If the developer has secured lending from a senior lender, and the senior lender demands repayment (for example, if the developer defaults on interest payments), then the developer may be forced to accelerate sales and not achieve the expected profits.
Before investing, you should ensure that you also examine existing lending agreements and the relationship between the senior lender and developer. Where the developer has worked with the senior lender previously, this is evidence of a track record of a good working relationship.
5. Liquidity risk
If you should want to withdraw your capital early and the developer is unable to repay your capital, you may have to wait until they are able to repay. This is similar to the late repayment risk discussed above. This is why we always recommend investing only with developers who have a good track record of identifying the best development sites and delivering schemes on time.
In summary
The risks of investing in developer loan notes are not so different from those of investing in off-plan property. By taking action to mitigate these risks, you can maximise the potential of their investment while sleeping soundly at night. The main strategy to mitigate risk is to undertake comprehensive research and ensure that you invest with developers that have a good track record of selecting and developing profitable sites, and which have also consistently paid interest and capital repayments on time.
To learn more about the benefits and risks of investing in developer loan notes, and how they may enhance your investment portfolio returns, contact one of the team at Gladfish at +44 (0) 207 923 6100. We’re looking forward to speaking to you, and think you’ll be as excited about the loan note market as we are.
All right, now we’ll get into the fun stuff guys. So the risks of developer loan notes and I think the interesting thing is that this is the risks whenever you buy, you know, off-plan property or any of these sorts of things. So that they don’t, I mean obviously the asset, the underlying asset is the same. So the risks are generally the same as when you’re buying, you know, off-plan property and that looked, so I’ll run through them. So the first is the developer risk. Obviously you’re buying through a developer. Now that developer could be, you know, top tier, middle tier, bottom feeder, and I don’t mean bottom feeder, that’s probably the wrong word to say. But there are a lot of developers out there that really… They are going to value their return first over you. They don’t really care about their reputation, you know
And so generally I’ll say don’t invest with those guys. You know, stay right away from. This is too risky an investment to go with those sort of people. And they may offer higher rates. They may even have a track record, you know even that you start to look into it a bit deeper and you sort of wonder. So you got to be really careful about the developer that you choose. Now what I tend to do, I don’t touch the bottom. The middle I go for, the top tier lenders generally they’re going to get their own funding through senior debt, through joint ventures with pension funds and you know, that sort of thing. So they’re not really going to be offering you this stuff. So really it’s the two aspects you’ve got. Stay away from the bottle. Okay. You know, unless you’re prepared to operate a high-risk strategy, which means you got to put a lot of time into researching them. Just stay away.
Don’t even bother. The developer risk is all about the developer going bust, the development on keeping their commitments, the development on paying. And you’ll see a link to a lot of these sort of things because they are very much… Times are good. Generally, you’ll get your money back. Yeah. And if they…so that they can be good times and they’re developing some stuff up the development or the developer can, you know, have problems with planning. So you know, the other side is the late repayment side of things. So the developer is more about the development going bust. I’m not committed keeping the commitment, you know, something seriously going wrong with the development. The late repayment is more about the fact that there’s a lot of things that go on. You know, you’ve eventually got three stages. Okay. You got the lends stage, you’ve got the build stage and the sales and marketing stage.
And really that sort of, you know, if any of those stuff up, if any of the planning takes longer than it should, because obviously if they’ve bought the land and if used finance and they may have used your finance and all of a sudden plenty takes another 18 months, it’s the cost of keeping that finance for 18 months, which may turn that property or that development into a no go, in which case your money has already invested in there, your money’s at risk. Okay. So generally there’s a lot of things that can go on. You know, there’s the sale, the sales side, so at the end of the day, they may have planned to sell two a month for the entire bill program and actually they’re six months in. They haven’t sold any.
So the cash that is expecting to come in from that hasn’t come in. But also now we’re starting to get to the point where they’re having a discount to get them sold and that means less profit. So do their numbers still work? So there’s a lot of the, you know, the sales risks. So basically the sales risks, the planning risks, there’s a whole range of other, costs overruns. For instance, you might find like with Grenfell, all of a sudden people were building stuff. All of a sudden the rules changed. So the cladding had to be different. So a lot of developers, who are halfway through cladding, all of a sudden had to go, I have to rip this down. We have to put new stuff in, added costs, the labour market, all of a sudden if prices wages go up.
So, once the Brexit vote happen and all the cheap labour went back and said, you know, we’re out of here, we’re not taking that risk, all of a sudden now the price of labour went up. So there’s a whole range of things can go wrong over that period of the bill program, which you generally, that’s why the developer is asking you for money to help them build or fund that period.
All right, so the other one is, the third one is. So we have developed a risk, the labour payment miss, then you’ve got, okay, the market risk. Now the market risk is quite interesting because the market, the market goes in cycles. Okay. And generally, when times are really good, you’re not going to have a problem. But when times are starting to get a bit shaky or when they’re dropping, that’s when things can really be hard. And that’s where effectively the market’s dropping, the values are dropping, they’re getting less money, they’re making fewer sales, and it’s a double whammy. So it can really affect your investment.
The fourth risk is the senior lender risk. Now most people don’t even think about this, all right? But the bottom line is generally they will take your money upfront, then they’ll go to a senior debt lender. Okay. And that could be a bank that’s, you know, let’s say a high street bank. That high street bank, in their terms and conditions, will send in, say a, you know, they’ll send in a surveyor every says a month or every stage or whatever it is. And they have a say in what happens. So maybe you know what, this is not being built to this spec. We need this spec, we need that. And so they have a lot of sway in what happens with that development and that can affect the outcome.
Now obviously, professional developers will have this covered, they’ll have good relationships, but especially if things start going wrong and say in the proposal they put that they were going to sell two a month and now they’re six months behind the development may, sorry, the lender may well say, you need to get rid or shift six units now. Or what may happen is prices may drop and the lender says, no, they are to be sold for that price, not for less price. Then all of a sudden now they can’t do that price, which restricts the level of sales. And then eventually we’re heading towards, eventually, that property falls over, the bank comes in and repossess it and resells it off, you know, at a wholesale price. And guess where your money is? It’s gone. So it’s another risk.
The other, the final risk is liquidity risk. All right, which you know for me is, look, this is not a liquid investment necessarily. So they may say, you know any and all going, well you can take your money out after 12 months, but if they don’t have that cash to be able to give back to you, for instance, they may not have sold those two units a month or whatever it is. Then all of a sudden now what becomes, a 12 month investment becomes an 18 months, become two years, becomes three and then the key to that is if you, let’s say for instances some people they may have put this money in for 12 months knowing in 18 months they need it to complete another property. It may be a knock-on effect. You don’t get that money back there. So, therefore, you can’t complete it on your money there or your property there.
And so that falls over. So now you got a double whammy of lost. Not only has this been delayed and potentially lost, but also this one lost as well. So you’ve got to consider all those near five main risks. Okay. A lot of them can be overcome by due diligence, but I’ll be honest with you, a lot of them can be disguised because you know, there’s so much detail that you’re not going to be privy to, you know, planning and you know, designed specs and labor market changes and all these sorts of things that go along, which you’re not really going to know what’s going on there necessarily. So they are risks. You got to be aware of those risks. But what I would certainly do is be asking lots of questions about these risks.
All right guys, any questions you’ve got to jump on the Facebook group. You know, just speak to the team and get really clear on this. It is a great opportunity. There are lots of ways, you know, and we’ve got a huge experience in these developer loan notes. And so, you know, we know generally what are the best ones to go for, which are the ones that to avoid, what’s the sort of things that need to, you know, sound warning alarms, you know? And so jump on the Facebook groups, speak to us and we’ll chat real soon. All right guys to see you, bye.
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