How do loan notes work in property development?
Your five-minute guide to developer loan notes
When a property developer wishes to develop a property – say, for example, to create a new residential estate – it has various options to finance the development. One of these options is to issue developer loan notes.
In this article, you’ll learn how loan notes are used and some of the key elements that make them attractive as investment instruments.
What is a developer loan note?
The simplest way to explain a developer loan note is as an IOU. The investor lends the developer money, and the developer agrees to pay it back. The developer will pay a fixed rate of interest while it retains the investor’s capital.
Loan notes can be ‘secured’ or ‘unsecured’. A secured loan note is secured against the property or other assets of the developer, while an unsecured loan note offers no such protection. Therefore, a secured loan note carries lower risk than an unsecured loan note: if the developer defaults on the terms of the loan note, the assets on which a secured loan note is secured act as insurance against some or all of the capital the investor has loaned to the developer.
How loan notes work for the property developer and investor
Breaking down loan notes into a step-by-step process, the following is a simplified guide to how they work:
- The developer takes the decision to offer a loan note, and decides the details of the loan note (e.g. the maximum amount, duration, and interest rate). The developer may need approval from its shareholders to issue the loan.
- The developer instructs lawyers to produce loan note documentation and create the loan note.
- The developer offers the loan note to investors.
- Investors lend money to the developer in exchange for the loan note.
- Investors receive the fixed interest (also known as the ‘coupon’) while they hold the loan note.
- At the end of the loan note term, the developer repays the investor the capital that they loaned to the developer.
First and second charge loan notes
While secured developer loan notes are less risky than unsecured loan notes, not all secured loan notes are created equally: some are riskier than others. One way in which the risk differs between loan notes is if they are ‘first charge’ or ‘second charge’.
A secured developer loan note with first legal charge holds less risk than one with a second legal charge, because if the issuer does default, the first charge investor is first in line to receive repayments. An investor in a second charge loan note only receives their repayment after the first charge investors have received theirs.
Key developer loan note terms
Here are a few key terms used in the world of loan notes:
Issuer: The company that issues the loan note – the borrower
Loan note instrument: The documentation that sets out the terms and conditions relating to the loan note.
Coupon: The interest paid by the issuer to the holder of the loan note. Often, the interest rate is fixed, though it may also be paid as variable. Some loan notes roll up their coupon, and pay the interest when the loan note matures.
Coupon terms: The terms on which the coupon is paid. This will detail whether the coupon is calculated daily, monthly, quarterly, etc. and when it will be paid (e.g. monthly, quarterly, annually, etc.).
Loan note certificate: Like a share certificate, the loan note certificate is evidence of ownership of the loan note. It contains details of the holder and issuer, date of issue, maturity date and interest rate.
Redemption: When the issuer has repaid all interest outstanding and repays the capital loaned to it, the loan note is cancelled.
Convertible: A convertible loan note is one that can be exchanged for shares in the capital of the issuer. The loan note instrument will set out when this exchange is triggered (for example, at the option of the note holder or the issuer), what kind of shares are to be issued, and how the number of shares to be issued are calculated.
Understanding these terms is important: if you invest in a secured convertible loan note, secured with a first legal charge, you will want to know exactly what it is you are investing in.
Should you invest in developer loan notes?
Investing in developer loan notes could help you diversify your portfolio, and benefit from high fixed-interest payments. They can be structured to provide a regular flow of income from a lower cost of entry (some loan notes allow investment from as little as £5,000).
To learn whether you can take advantage of the benefits of investing in developer loan notes, 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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