300,000 reasons property loan notes could be the solution for Britain’s housing crisis
Last year the Government announced new plans to enable over 300,000 people become homeowners by building many more homes. But where is the investment to come from? With banks still reluctant to loan, property loan notes could be one way forward to help end Britain’s housing crisis, says Investor-Square’s founder Ross Kelly.
The Government announced big plans last year to boost the amount of new homes being built. It wants to get over 300,000 people into property ownership in the next few years by building thousands of new homes, as well as boost Build to Rent and end the shame of Britain’s 203,000 empty properties. But these plans will need a radical rethink of how we finance property construction.
While many developers have permission in place, and even land waiting to be built on, new developments are still being delayed because, since 2008, banks have been far more cautious about property construction loans. Although bank lending has improved in the last few years, the heady pre-2008 days of liberal property construction lending now seem very distant; and the era of easily obtaining 100% development finance is long gone. Today, many banks and established lenders offer only around the 60-65% mark, leaving a much bigger gap to fill. The continuing caution of established banks, together with their long decision time and lack of flexibility, means developers are looking for innovative new ways of raising money for key developments.
With a funding gap of at least 35%, where can property developers turn? A new ‘crowdfunded’ style approach is becoming increasingly popular; with private investors stepping into the vacuum created by the banking industry. New ways of funding developments include peer to peer lending, joint ventures, property bonds, and perhaps most attractively of all, loan notes.
Hitting the right notes
Property loan notes offer a win-win, creating extra funding for property constructors to build urgently needed affordable housing and new estates; while helping small investors who would like to get involved in the property market, but have no desire to take on tenants or maintenance costs by buying properties of their own. And, of course, one significant benefit is that for the lender the minimum investment amount is much smaller than when investing directly in property.
Because the loans don’t need to be for significant sums potential lenders can, for example, use a little of their pension pot. It’s a step on the property investment ladder, but without the significant financial outlay needed in buying a property to rent themselves.
Small investors can become a lender surprisingly easily through loan notes. By lending a developer a set sum, that money is used to build much-needed developments, and in return the developer agrees to pay the investor a fixed return over a set period. The lender will usually be given a secured charge on the development as protection, just as if they were a bank.
Developer loan notes are usually tied to specific developments, meaning there is specific named collateral as security. As a development matures, this collateral increases in value. Effectively, the risk for lenders decreases as the developer builds.
At the end of the set term of the loan note investors get their money back, as well as having the predictable fixed income over a set period of time. There are no extra legal fees or stamp duties etc to pay. Most notes are usually considered quite short-term investments, lasting around 2 to 5 years. This short-term model can be very attractive to lenders, offering speedy returns because the loan notes have maturity dates built in. And because the developer will be keen to avoid paying premium rates of interest for any longer than needed, there are incentives for both sides to set a relatively short period before the maturity date on which investors are repaid the capital they effectively loaned the developer.
Ongoing loan notes eat into developers forecast development profits, so it is in their interest to keep them short.
A typical property loan note scheme might be over two years, with an income of 10% per annum (pa) and a deferred option of 12%pa. It could be for as little as a minimum of a £5,000 loan in some cases, to a maximum investment limit of £500,000 or more. Typically, the interest on a loan note ranges between 8% and 15% in the first year.
Not so empty promises
Property loan notes to smaller developers can also help end the ridiculous situation of having 203,000 standing empty properties in the UK. That’s £38bn of housing stock going to waste until it can be renovated, and its promise fulfilled. From stately homes to council terraces, the hundreds of thousands of empty buildings spread across the UK are an obvious target for everyone wanting to increase the number of available homes to buy or rent. Renovations and developments around existing properties offer lower-cost, shorter term project for smaller developers; and for would-be investors the potential of getting a foot on the property market ladder for a lower, shorter term, investment.
The elephant in the off-plan room
Despite all this positive news, the rapid growth in property loan note schemes has created a certain caution amongst some potential investors. And there are three reasons why they might not be every lender’s first choice:
Firstly, lenders are only offered a fixed return for a fixed duration of time. That is of course, part of the attraction for smaller investors, but it does mean lenders won’t benefit from long term capital growth in the properties.
Secondly, for lenders who may need swift access to their capital, loan notes usually cannot be redeemed until the end of their term; which means their money is locked in. However, as part of the key structure of most such investments is their short length, this is not a significant drawback.
The final elephant in the newly constructed room is that, of course, there is no sure guarantee the developer could not default on their interest payments, or the final repayment. But would-be investors must be aware that there are similar financial risks that come with buying to let and many other forms of investment.
By choosing the right developer and ensuring a secured charge on the development, the potential risks can be reduced. Potential investors should always bear in mind the pecking order of potential creditors, ensure their loan note is tied in directly to the construction and they are not at the foot of a long line of investors.
A potential win-win
Back in his 2017 budget the Chancellor stated there was no ‘magic bullet’ to fund the 300,000 homes Britain needs. But property loan notes certainly represent one tool in the UK’s housebuilding armoury. With the well-worn caveats above in mind, loan notes do look to be one highly useful and innovative way to help ease the increasingly critical housing shortage and for investors to enjoy a predictable profit.