How to compare risk and return and invest better

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?

I'm any form of property investing can be confusing at present. Depending on which media headlines you read it's either good news, bad news or something in-between.

Many of our subscribers are turning their attention to property development to boost their wealth independently of organic property market returns.

But this presents its own challenges.

As property data technologists we're pretty good at using algorithmic research to guide our decisions and that includes which property development projects to sponsor on behalf of our thousands of subscribers.

Today I want to introduce two basic investing concepts that might make your life a lot easier when deciding between competing (property development) crowdfunding opportunities in the market namely,

CAPITAL STACK >> where in the financial structure of a project your capital would be used and,

DEVELOPMENT RISK STAGE >> where in the development process your funds would be deployed.

Each have their own levels of risk and expected returns.
When you examine both you can quickly decide if the returns offered are in line with general market expectations (or..like our returns..better)

WHY IS THIS IMPORTANT?

In my previous email last week I mentioned how I had sponsored an off-market crowdfunding opportunity offering a 47% return.

Prospective investors assumed it to be a "very high risk" project given the returns offered were comparatively high.

As it happens the risks were quite normal given where in the capital stack and development process my investors were participating. The returns though were indeed comparatively very high.

So next time you see an advert offering property development returns of 10%...15%...30%, make sure you understand where in the risk spectrum the offer sits.So let's see how you can do this....

The Capital Stack?"

The capital stack is made up of of debt and equity.

My investors were offered an EQUITY investment which means they would have expected returns between 10-20% due to a pure equity investment being on the higher end of the risk spectrum.(The actual return was 42%)

See results

Equity: 10-20%

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 the asset is sold or they sell their interest in the asset.

Preferred Equity: 6-12%

These investors generally get paid a fixed return before the remaining profits are paid to the developer and other lower ranked investors in the capital stack.

“Hotspotcentral targets returns of 10-15% for it's preferred equity investors, generally 5% above industry averages".

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.

Some property developers prefer 'no bank debt" in their capital stack. This avoids the deep scrutiny and due diligence typically undertaken by the banks. Hotspotcentral prefer to sponsor projects with some senior debt in the capital stack so that there is an additional layer of independent project scrutiny and oversight.

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 your money will be used..

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 right 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, delay from contractors can make or break a projects profitability and the investors returns.

Settlement - are the end buyers of the finished properties able to settle on time at the contracted price so that profit expectations are achieved?

The appropriate ASIC prescribed project offer documents should disclose all the relevant risks including those above associated with the development process.

My investors made an equity investment at the very beginning of this project after the DA was obtained and they were tied to the project results on an equal basis with the developer (joint venture).

In contrast....

I'm currently negotiating a 15% fixed return in a project that is already quite far in the development process PLUS...

It's a preferred equity investment... so investors profits are paid first before the developer and other investors are paid.

Construction is about to start... with DA..BA...bank Funding...Pre-Sales etc in place...

Comparative returns elsewhere would average around 8-10% for similar levels of risk based on the capital stack.

If you have $20k or or more in your SMSF or other "lazy equity" you wish to put to work, then join the priority waiting list and be the first to know when our next crowdfunded property development offer is ready.

So far we have 110 out of 200 places available before we close the waiting list. Existing investors will get priority allocation.


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