Lending to property developers: how safe is it?

Biggest observation is transparency among all parties subject to how commission structure is set up.

The devil is in that detail subject to any exits and other particulars with other points Lorna being on the money.

Best advise for any investor wanting a slice of this know what you're buying no matter what other parties say.

Mezz funding works extremely well. Its senior Debt that we cant get here in Cornwall Seems the world ends once you get out of the M25

If you want a better understanding of where lending money to property developers gets you, take a look at the share price of HBOS then Lloyds Banking Group.

Bank lending after the last depression in property prices (1990 to 1997) was 70/30 (based on total project costs -- land + construction costs). This base was established because house prices never dropped by more than 30% (I believe the actual decline was 27%, but don't quote me on that) in the post 1990 period. It seemed like a reasonable standard. As the market heated up, and the banks became more greedy, the financing banks were prepared to loan went up to 85%, 90% and in some cases 100%. These were very high amounts, but even then, in the worst case scenario the banks exposure was 30%, and likely to be much less. We haven't seen house prices decline by anywhere near that amount.. So far the banks have not seen house prices in the UK fall by even a fraction of that amount. Property development and housing are not areas of risk for the banks.

Where the problem comes in is that the banks have all become dysfunctional. Regulations were relaxed, worldwide, for banks over the past 15 years. Where at one time banks had to have equity that was at least 10% of the loans they had outstanding, and could not lend more than 10% of their equity to a single customer, these requirements virtually disappeared. Banks became geniuses at risk management - there was no need to have more than 1% - 2% equity to loans, and banks bragged about how good they were and their amazing risk management skills. It does not take a great mathematician to know that no one is that good. However, what this permitted was for the banks to strip the assets out of the banks, taking that home as bonuses, or dividends. To compound the problem, banks became totally reliant on short-term financing. When I studied banking, one of the key elements was balancing long-term loans against long-term finance, and the same for short-term, plus you held a reserve for funds that depositors would want on a daily basis. It appears that this is no longer taught at university. Things have changed so much that when I found some of my old books on banking, I just threw them away. Compounding this, the banks are dysfunctional and not lending to home owners.

If you combine the above items, all it takes is a butterfly down in Brazil, flapping its wings (chaos theory) and the banking system would collapse.

Why did we save the banks? They are still dysfunctional three years after they were bailed out. They do not appear to be "suitable for purpose". If they had been allowed to collapse, we would have a new system evolving by now, one that was not dysfunctional. We would probably be looking at the prospects of growth emerging. Instead we are probably looking at stagflation, with very little prospect of growth for the next five to seven years, and a period of very rampant inflation somewhere in that period.

I guess we have our politicians to thank for this. If you fill up the trough, pigs will go and stuff themselves.

Charles. Just to add to your points. The 70/30 rule really only applies to straight resi investment as houses don't tend to drop by >30%. However, in resi development you have to factor in the land, which I've seen drop by 90% in some cases. Commercial properties again can drop exponentially you only need to lose a tenant (e.g. woolworths). As a rough rule 70/30 works but only when you tie in repayment capacity. During the boom I saw Buy to letters getting 85% LTV loans a level where the rent barely covered interest and would never repay, really LTV should have been 60% max. This has been the fundamental issue with lending during the boom LTV became king, with repayment capacity ignored.

PS there are good development opportunites out there but they are otunumbered by the bad so be careful. Even if the numbers stack up you still have to worry about whether the contractor/subcontractors will be around to finish it. Most of the uncompleted schemes i know are due to the contractor going pop not the developer (though they unfortunately followed).

You can also buy bank Tier1 and Tier2 debt at around 12% (Tier1 is 9-10%, but carries a tax credit and tax free inside ISA etc wrapper).. My guess is bank debt is a tad safer than mezannie debt of developers...

Or you can buy shares in investment companies that buy bundles of mezzanine and other corporate debt. Thus getting a spread of assets to compensate for the risk inherent in high yield debt.

Greenwich Loan Income Fund is an AIM quoted investor in US syndicated loans that yields nearly 10%. Intermediate Capital Group is a main market quoted provider of mezzanine finance, currently yielding 7% forecast to rise to 10% by 2014. There are plenty of other specialist lenders out there suitable for the average investor with less than £250,000 a pop to play with.

Or, still on the theme of non bank finance, there is Private Equity e.g. on the main market, Private Equity Investor PLC. There are also Venture Capital Trusts, Enterprise Investment Schemes...

http://www.hmrc.gov.uk/eis/

http://www.hmrc.gov.uk/manuals/vcmmanual/index.htm

For the curious, I hold shares In GLIF, ICP and PEQ.

I would not want to take the top-side risk for 12% without a profit share.

I don't think I've yet seen a High Street which had a Woolworths shop in it which hasn't had the blank space filled by other shops. The difference is that the new shops are smaller.

High Street is doomed by the small size of the available spaces and the high business rates. The majority are now full of charity shops, pound shops, bookies and slot machine arcades. Suburban arcades serving local needs like hairdressing, take-aways and florists are doing better. Local Shopping REIT looks good for yield. Article in this weeks IC.

Maverick, say you had a small woolworths at £100kpa on a 6% yield (£1.6m) funded 70% by the Bank (£1.12m) and someone else put in 10% mezanine (£160k). Said shop is now let to a phoenix (woolwroths Lite) or as a couple of smaller units. My guess is your rent is only £80k now and your yeild is say 10%. Therefore bank LTV now 140% and mezzanine has gone forever. Thats the problem with invetsment property.