How to quarantine property profits in uncertain times

Michael Fuller

April 15, 2020

Here's a property development investing tip that might prevent you throwing money out the window...

It's called QUARANTINED profits.

This article is for those investors who are about the uncertainty in the market but also want to continue building their capital independently of the broader property market...with a higher degree of safety.

'Quarantined profits' is a POWERFUL yet little understood mechanism that ensure investors protect their capital and returns by securing first right to the profits in a property development project. In recessionary times, it's not only an opportunity to make money but also a key mechanism for protecting your investment against a massive slow down in the property market. 

Development profits are only theoretical​

Most of us agree that property development can be a very lucrative. Even a way to build wealth independently of the property market. And in these times that might not be a bad thing.
You acquire a good site in a top location, get the council approvals, some pre-sales, secure construction funding, build and sell the finished stock and make a decent profit, not so?

"If only it were that easy", I hear you saying.

Sure, it's a pretty simple formula. But like all formula's ...there can be gotcha's along the way. Gotcha's that make the estimated profit and the actual final profit quite different. Remember, property development profits are purely an estimate until the final tally at the end of the project.

Profits can be reduced if estimates sales prices are not achieved, if the project takes a long time to sell bank debt costs mount up or if building costs shoot through the roof. There are a lot more examples but you get the idea.

So here's the big question: How can you isolate/quarantine your capital and returns from a drop in profits? Most property development investments are joint ventures in nature. That means the investor shares both the profits and the losses. They may also be liable for some of the bank debt.

How to 'quarantine' my profits and returns?

Let's say you invested $100,000 into the second stage of our current Buddina Beachfront Investor-Developer Offer (it might be closed when you read this but it makes for a good illustration). 

The offer is a fixed dividend of 40% paid on the sale of approximately 40 of these beachfront luxury units. 

As you can see from the profit scenario's below, the investors get paid before the Developer. The estimated profit in this project - and these numbers are backed up by a valuers report (income) and QS report (costs) - is $25million.

In scenario 4 below where sales prices drop by 30%, investors would still get their capital and 40% return because there would be $4m left in the profit pool that is quarantined for the investors. In this project, the most owed to investors would be $3.8m.

Quarantined Profit? How?

Investors are offered a preference share or preference unit in the trust/company that undertakes the development. Proceeds from sales are then distributed as a profit first to the preference unit holder and then the common unit holder who is the developer in this example. Its a right created under the Corporations Act 2001 which sees the investor sitting ahead of the Developer when profits are distributed.

Why is quarantining profits so important?

You might wonder why the Developer in this project, or any other, is prepared to sit last in the profit share queue after spending a few years securing an excellent beachfront site and taking the project from 'cradle to grave' over a number of years? A process requiring a great deal of expertise, money, time and various consultant contacts to achieve.

If it was a 50/50 joint venture then the Developer would be sharing $25m if all went according to plan. That means his profit share would reduce from $21.2m (that $25m less $3.8m) to half of $25m or $12.5m. If the Developer is happy to put his hand up for all the bank debt and doing all the work and, more importantly, is confident about the project; then why share the total profits equally?

So for the Developer, they get to keep most of the profit. For the investor, they get protection against a loss of capital and returns in the event of a drop in sales prices and/or an increase in costs. 

Development profits are only theoretical

The reality is the property market did well in some sectors during the GFC and this will be the same during the next recession. It all comes down to where you invest, who is buying the end product (are they immune to a economic recession) and the structure of the investment.