Lending as an investment class

I have mentioned in previous posts of mine that there are three types of investments classes that I have chosen to invest in. Equities being one, Property trusts the other and lending as the third. Well sort of 4 classes actually as I do hold a direct resi property investment.

Looking to deploy capital into the market at the moment has been a difficult choice for me. Not many good value property trusts opening up at the moment after a strong run over the last few years. We all now what's going on with Resi. And while I really want to focus on building the equities part of my portfolio, my feeling is equities are priced on the high side at the moment and there could be a better buy in opportunity coming soon.

So that leaves me with the option of further investment in lending. I have looked at a number of options in the lending space such as peer to peer players. The one that I liked and decided to go with is a Australian Unity fund that lends to small to mid size developers for projects as small as a few townhouses to mid size 20-40 unit apartment buildings.

When I first started in this asset class about 2 years ago, I saw it as an option for a small part of our over all portfolio. Say 10-20%. But now I am questioning why restrict it to only 20%. If I have decided it is an investment I am comfortable with. Which makes sense to me and there is no better alternative on the table at the moment, why not use spare capital that is collecting 2.5% in the bank and increase my holding to 30% or even higher.

I guess the conversation I want to have is, I will tell you why I think its a great investment and can anyone give me a counter argument about why its possibly not. This is something I like to do in order to see if I can be given good enough points against a particular investment to make my re consider my position. If not then it reinforces my enthusiasm for a particular investment. Or if my points are so strong and you can not come up with a single counter against it then I would be interested to know that as well.

For the sake of not making this post any longer, I will make another post with the specific details of why I like this particular investment class. Then feel free to pick those points apart and tell me how wrong I am.

 

@Big Al is this distressed single asset type deal? first mortgage or mezz? I am guessing the latter. Ultimately the city is full of lenders of all shapes and sizes from Banks, Superfunds, credit funds, family offices all chasing yield, and with a very good understanding of pricing risk. The question is not whether one can achieve a very high yield in return for taking high risk - the question is, in any deal whether one is adequately compensated for that risk, after you add a retail fund managers clip....they are in the business of putting together deals to clip the ticket - they cant lose, but the investors can and do. My guess is that they are paying up a little (risk+) to get deals as they will then earn a solid fee when they take it to retail (risk++)

 

hey @The Falcon

So the loans are for single asset developments. All are first mortgage. investor return rates average 7.5-8%. Then on top the fund manager charges a fee of between 1-1.5% as there fee. So im assuming the developer is paying approx. 10% interest for the loan. All the assets are on the east coast Sydney, Melb and Brisbane proximity. LVR for most of the deals is max 65%. And for there loans are conditioned on the developer having normally a minimum of 50% presales prior to lending commencement.

A positive for me is this particular manager is a big player who is not just a standard finance provider. They are a property manager and developer themselves. They understand the development world and would be in a position to take over and complete a development if the original developer falls over.

 

So I will list what I see as the positives of this particular asset class and also of this particular manager in this class.

A return of 8% while very attractive in this current investment climate I don't think its that high that I would conclude that the developers borrowing at these rates are high risk. I think with the difficulty in getting bank funding right now there are good quality developers looking at private lenders as the banks wont lend them.

With a 65% lvr prices would have to drop by over 35% before investors first dollar of capital is lost. Considering we have gone through what's already been a large down turn in the property market I would think significant falls in value above 35% are unlikely.

The manager appoints there own surveyor who overseas the projects and they provide updates on each project approx. every 2 months. This gives me further confidence in this manager that they have there finger on the pulse and are not just lending without close monitoring of the projects.

They have been managing this particular fund for coming up to 5 years now without a single loan falling over. While a positive I don't think 5 years is necessarily a long time. I feel if they can get through this period, being one of the biggest property down turns in recent history and not have any or many loans sour, then I would say this asset class and manager in particular are a good long term investment prospect.

 

I suppose it is just a matter of risk & what happens if it does fall over. Low likelihood of being that bad, but high impact if it does happen to play out that way?

 

Hi @Morgs . Thank you for your input. So let’s say a worst case scenario occurs. A developer falls over and doesn’t complete the project. I have met with this particular manager and asked how they would move forward with such a situation. There response was they would continue with the builder to complete the project or engage a new builder to finish the project.

As this particular manager is also a big player in the development game I have no doubt they would be able to achieve this.

But let’s we go an even worse case scenario. They don’t finish the project and put it on the market as an incomplete project. Is an incomplete project going to sell for less than 50% of its completion value. At 50% of its finished value investors have suffered a loss of 15% of there initial capital. This assumes you never received a single months distribution. Say the project fell half way through the investment period you would have already received at least 6-7% back.

So I can’t see how even in such a worse case scenario anymore then 10% of any one loan investment could be lost.

 

Assume its 65% lvr on end value. In your scenario it sells for 50% of end value. You lose 15/65 or 23% of your capital. Before management fees. Part of the issue is that the loss will be permanent. Where a etf can fall 30% but will probably recover over time.

What would the risk be comparable to? Shares? Also dont see it as diversifying risk.

The other question would be how optimistic is the end value?

 

This more sounds like a discussion on your specific lending arrangement with someone you know and trust (ie. your own specific enterprise) rather than lending as an "investment class".

It sounds like you have a good thing going on. But would I recommend people getting into it generally? No way.

 

Hi @Trainee . I’m not following your maths on the loss %. So if you are lending 65 of a 100 value. Now if the 100 value has fallen to 50 and you get a return of capital of 50 you lost 15.

You make a good point in saying the loss is permanent. That I accept. I guess one way I sort of mitigate this is that I invest across 20 loans. This way all 20 would have to fall over with a worst case scenario to suffer a total portfolio loss of like I said early should be no more then 10%.

I don’t know if it’s diversifying risk so much compared to shares. It’s a different type of risk. A drop in share prices should not directly affect this asset class. With the exception that a total market calamity will affect every asset class. I’m assessing he risk of significant loss in this investment without necessarily comparing to risk of any other asset group.

My approach with this is based on the fact that I have what I believe to be a significant wealth base which I hope to continue growing. What I am working towards at the moment is having a number of different asset classes with each class independently producing enough income to support our lifestyle with no working income.

Currently I have achieved this with property trust investments. I’m not far off achieving this with this topics investment class. The last being equities which I’m still a fair bit off achieving this with. While I want to go full tilt into equities in the near future to achieve this I feel prices are a little frothy at the moment. Plus with average yields in equities of say 3% being 50% aus and 50% international. It’s no easy feat to earn enough in just distributions to fund lifestyle.

 

Hey @thatbum , this is not a personal arrangement. The asset class is fairly large and has many players offering slight variations of what I mentioned.

The particular details I’m mentioning are with Australian Unity called the select income fund. It’s available to all retail investors.
At face value this was not an asset class I would have touched. But once i understood the finer details and the way this particular manger manages the risk of such an investment I’m now a convert.

 

If you invest $65, and get back $50, youve lost $15 which is 23% of $65. Percentages make it easier to compare since the return is also in %. This is just math, but I think your 10% loss limit is incorrect, if you say 50% of end valuation is the max loss.

The risks seem to be how good the developer is and how conservative the end valuations are. If there is enough information this to assess risk correctly, it may be a good investment (that is, the return is worth the risk). A second question might be, how do you know if the risk is increasing in the fund (e.g. competition in the market means they take on less proven developers, or they become more aggressive in their end vals?)

This seems to be one of those great when the property market is doing well and catastrophic when things go bad. Which you can say for shares, of course, but a big difference between debt and shares is that you cant dollar cost average into debt. So if X company is $80 and falls to $60 but you have been buying since it was $40 and live off dividends, thats different to debt where you have to invest at $100 and are limited on the upside.

The question is whether it is lower risk or uncorrelated compared to shares that it is worth the limitations.

 

Sounds a bit skinny for me. As you suggest, at the moment 10% seems to be the rate for this type of thing - was talking with a HNW advisory firm this week who put together a (from memory) $6-8m first mortgage deal recently on a Brisbane unit block for a couple of family office clients and that was the number earned. They seemed pretty happy with that.

My concern though with such a high level of current income do you need it (because you will be taxed heavily) or would a blend of income and capital work ? My feeling is that this type of debt has a moderate to high correlation to both Australian property and the Australian share market. Have you looked at both, or either of International property or Infrastructure as an alternative source of return with lower correlation?

 

Hey @Trainee , you raise some good challenges / counters to my argument.

I have confused myself with the maths on the % loss scenario. But ok let’s say 23% loss on capital in a scenario in which the asset is sold at half of what it was initially valued for. You can minus a few % for the return you have already received as well. Again this number should be reduced by the fact that the capital is split across at least 20 different loans. If a large number of the 20 loans fall over in a worse case scenario situation then yes it would start to hurt.

The end valuation is one area I have considered and see as a risk factor. So I did some homework. They use a number of different independent valuers to value each project. The valuers they use appear to be reputable players in the valuation game.

Could the valuers be fudging the numbers to appease the fund manager. Possible. But I would think considering the market is in a downturn they would have to be cautious with there Val’s. if they did provide a Val that was way off and the loan falls over you would think if there Val missed the mark significantly they could find themselves in hot water.

Would a reputable valuer risk there reputation and possibly being sued by providing Val’s that are way off the mark?

 

BigAl who is the lender and who is the mortgagee?

 

You make a good point @The Falcon . I’m definitely not short on the income front. But I’m a little old school. I see income as a bird in the hand. In saying that I have learned to also value growth since I began my investment journey.
I actually don’t have exposure to international property which I should look into. I like infrastructure and do have exposure through 2 managed funds.

I would really like to put more capital into equities at the moment with a focus on index funds. Though I am following the lead of my advisor our very own @Alex Straker and sitting tight at the moment on the equities front.

But I’m not a fan of sitting on cash. Hence why I am building this part of the portfolio in lending at the moment.

I have also put this investment option to the advisor for his opinion. Though while waiting for his feedback I thought I would start a conversation here to debate the positives and negatives.

 

You're talking about investing in contributory mortgage schemes.

Nothing wrong with that per se, but it should be recognised for what it is - high return, high risk lending.

It certainly can't be compared to an interest bearing account with an ADI like a bank or building society.

 

Cool. To further demonstrate, it is my understanding that you have a large asset base so I make an assumption that you are top tax bracket for at least some of your distribution.

Income return 8%
less tax -3.76%
less inflation -2.00%
Real return 2.24%

Better if you kick it over to a corporate beneficiary. This looks ordinary to me.....cash gives you optionality at least, as does high quality debt which this is not.

The key here is that income and capital are taxed differently - capital at half the rate of income. This is a massive free kick. I'd rather keep some of those birds in the bush!

 

Do u have any plan for or own pipeline for development ?

If so, and assuming your company can obtain partial development funding, then why not
lend your own excess capital (for which yo r chasing yield) as the rest to your own development company
at the yield (8%) you indicated above?

Why lend to strangers whom you have no real understanding about when you can lend to your
own/related development?

 

Hey @Terry_w . The lender would be the manager I guess. Australian unity. The mortgagee is normally the person / entity that holds the asset. Also normally a number of guarantors associated with the or have an interest in the asset.

I would assume a player like Australian unity would make sure all there t’s are crossed and there’s i’s are dotted when it comes to the paperwork and legals before lending out.

 

Thanks @The Falcon. Totally agree with your strategy based on minimising tax. Should have mentioned this asset is held in a company. So corporate tax rate applies. With no capital gain with this investment holding in a company makes sense. Other assets that have a capital gain component I hold in a family trust.

Actually I just recently used the services of our resident structuring expert @Terry_w to review my investment structures.