What's a fair return for the risk when investing in a property development project?
Thinking of investing in a property development project as a money partner but don't know what a fair return is relative to the risks?
Property development can be a great way to build equity beyond the more passive approach to property investing. What if you do not want to rely on the uncertain forces of the property market to deliver capital gains?
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 rely on algorithmic research to guide our decisions and that includes which property development projects to back 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 >> the capital stack refers to the total capital needed to take a development from concept to completion. This capital can be derived from a number of sources and comprises of both equity and debt. More about this below.
DEVELOPMENT STAGE >> typically as a development advances towards completion the risks diminish. For example, investing in a project prior to a development approval being obtained from council is riskier than investing when construction has started.
As an investor you need to decide where in the development lifecycle and where in the capital stack you are comfortable sitting.
The Capital Stack
The capital stack is made up of of debt and equity.
Debt implies there is some form of security such as 1st mortgage attached to your investment. If the project collapses then you sit first in line if there is any capital left after the site is sold for example.
Equity investments generally mean there is no security but the returns are generally higher to compensate for the additional risk.
Equity investors 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.
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.
Development Risk Stage
Now that you know where in the capital stack you are 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).
I hope you can now see that your returns expectations really depend on which stage you are investing in and what form of capital you are providing.
On a final note, these returns do change depending on the market conditions at the time of the investment but not hugely. If you are being offered unusually high returns then it's advisable to ask all the right questions starting with why is the developer able to offer higher returns.
Are they simply 'giving' away more than others?
Nope. No developer does this.
Is the project so much riskier than other competing alternatives that the higher returns are justified? Is the developer not potentially putting the project at necessary risk by offering too much?