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.
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.
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