The Property Speculator

4 Principles to Consider when Looking for Development Finance

It’s no secret that entering the field of property investment or development costs a huge amount of money. Some people are lucky enough not to need to borrow to purchase their first project, but the vast majority do.

Whether or not you receive funding will probably be the biggest factor in determining the success of your project and/or venture. If you don’t have the available capital to begin, and no one will lend to you, you are unlikely to get very far.

Therefore, finance is very important to the novice and experienced developer alike.

© Copyright Betty Longbottom and licensed for reuse under this Creative Commons Licence

I’ve written on the subject of Property Development Risk before, and to present the subject of obtaining finance it’s necessary to bring it up again. However it’s probably not in the way you expect.

Managing risk is very important in any business venture. If a company exposes themselves to too much risk on a regular basis, sooner or later something will go wrong and the consequences could be substantial. Likewise if risk is avoided at all costs, the venture is unlikely to grow. Risk is to be embraced but in a controlled way. Profit or losses are the wages of risk. There are ways for a property developer to manage risk; however it should be done with a view to your partner.

When I mention a partner, I mean the bank. If you obtain funding, you will literally be going into partnership with the bank. It’s most definitely not like an unsecured loan or even an owner/occupier mortgage. If you are using a substantial chunk of the bank’s money, they will want to know absolutely everything about your venture. This is when it’s important to consider the flip-side of risk management. Your bank is also extremely interested in risk management; therefore everything you do to limit risk, might have the effect of moving the risk in their direction. The bank is in the driving seat, there is a good chance they have put more money into the venture than you have, so they will be working hard to limit their own level of risk. In this situation, if you really need to borrow to realise your plans, you must take on a significant amount of risk.

Visualise the banks as being like a wild animal, they need gentle and convincing coaxing to entertain your plans. If you offer them a deal where they end up shouldering too high a proportion of the risk, they’ll be off before you know it.

So what should you be doing to get the banks to take you seriously?

Don’t use a Limited Company. The whole purpose of a limited company is to control and limit liability on the owner/s. Therefore if you set up your development/investment business as a Ltd company, the bank faces substantial risk because they will be severely hampered in recouping any potential losses if the venture goes wrong. The bank will be much more comfortable if they are lending to an individual rather than a company.

The CV of the Borrower. The person borrowing the money should really have a good idea of what they’re doing. And if it’s your first property development venture and you are considered a novice, it’s an excellent idea to work with someone else who does know what they’re doing. Obviously this is a bit ‘catch-22’, you can’t borrow the cash until you’re experienced, and you can’t gain experience because you can’t get the cash. No one said it was easy; do your homework, plan the project (especially the finances) well, take advice from a building contractor/Building Surveyor/Architect so that it’s less likely you will go far wrong. This is what the banks are looking for.

Don’t take on too big a project before you’ve gained experience. Most successful property developers start their new careers by carrying out very light renovations to properties that just require a bit of updating and tidying. This way the developer gains experience, and begins to accumulate more capital (hopefully). It’s important to learn what works well, and what doesn’t. It makes a big difference to your decisions when it’s your money going into a project.

Don’t expect to borrow heavily against your first project. This point is probably quite an obvious one in the current financial climate; however it’s an important point. There are financial advantages to borrowing against a property development, but fine-tuning the gearing is something to concentrate on when you are experienced and running a larger project/portfolio. Banks are beginning to be slightly more flexible in their lending criteria, however you really should be able to invest at least 25% into a project and also have enough in reserve to cover a part of the early construction phase and contingencies.

It’s important to see the banks point of view when approaching them for finance. They are in a powerful position, and it is vital that the developer/investor convinces the bank they represent a low risk.

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Apr 11th, 2012

3 Principles to Guard Against Property Investment Scams

I have to admit that I feel quite naive today. I was drawn to a post on one of the forums I look at occasionally where a guy had invested money in one of the numerous companies around that promise that you can become a millionaire property investor in 12 months or something like that. The general principle is called something like NMD (No Money Down).

What was supposed to happen, was that the potential investor or developer would find a property which he believed (and had reasonable evidence to suggest) was dramatically undervalued. The man on the forum had found a property he felt was worth around £290,000 and the vendor ended up accepting his offer of £204,000. The company (which I will not mention) then charged him several lots of fees to get the ball rolling. They put him in touch with a mortgage broker who began to fill out the application form for a property worth £290,000. The guy let it slip that he was only buying the property at £204,000. The mortgage broker immediately informed him that he could definitely not obtain a mortgage for a higher value than he was purchasing the property at. This amounts to mortgage fraud and will land you in an awful lot of trouble when the mortgage company find out.

In the end, the guy realised that he had fallen for a scam but not before he had paid out a couple of thousand of pounds in ‘introduction fees’ and the like to the company.

Mortgage companies will not take kindly to potential purchasers attempting to manipulate figures in order to swindle them out of money. In the case of the company above, the plan is to mortgage the property at the absolute top end of what it might be worth, but to purchase at significantly less. This means that the purchaser ends up with a lump sum of surplus cash over and above the purchase price. The mortgagor (the party that is borrowing the money) will still be repaying the whole sum through the monthly payments; however the mortgage company will be excessively financially exposed to risk. No one could realistically expect a bank to take on all the risk in someone else’s property venture. Mortgages are subject to conditions that ensure the bank minimises its risk as much as possible. They are not charities, and they will not allow a prospective property entrepreneur to indulge in attempting to build a property business without facing risk. If banks were to leave themselves open to such risk on a regular basis, they wouldn’t be in business for long.

© Copyright Gordon Brown and licensed for reuse under this Creative Commons Licence

My point in this article is that I always (rightly or wrongly) assume that everyone involved in the property field is a professional and unquestionably honest. That’s why organisations such as The Royal Institute of Chartered Surveyors, the Law Society and The National Association of Estate Agents exist. They ensure that their members adhere to high minimum standards of practice. I’m not saying for a minute that all private companies offering a service that doesn’t fall into the professional categories above will rip you off. However, the old expression “if it seems too good to be true, then it probably is” will serve to remind you to be on your guard. It wasn’t until I read the forum post mentioned above that I looked round the web and saw far too many similar companies doing the same as the one above. They just want to sell expensive property investment courses to aspiring (but naive) entrepreneurs. It makes me sad to think that the profession that I take very seriously might be associated with these shysters.

Please, remember these principles:

Property sale values are recorded within the process of purchase and registered with the Land Registry. You will not get away with obtaining a mortgage for more than the property is bought for unless it’s one of those fabled 110% mortgages.
You really should not have to go to seminars to learn about property development and investment. All you need to do is study this website (!), do your homework properly and enter the field carefully. If you go to a seminar, there is an extremely good chance that they will try to sell you something.
If it were really possible to purchase a property legally without using any of your own money, everyone would be doing it. Property is expensive, this serves a purpose by (in economics terms) making ‘barriers to enter’ the field. If everyone could buy property without using their own money, can you imagine what property values would do? The hard fact of it is, purchasing property requires capital. It’s what makes the whole process work properly; The bank wants to minimise risk so that they stay in business, and the property entrepreneur should be embracing a small amount of risk because this is what produces the return for him.

Jun 1st, 2011

Borrowing to fund a property development

Financial leverage is basically the practice of using borrowed money to supplement equity (non-borrowed money). In the field of private property development and investment, this is often done at a ratio of between around 20%-50% equity, the remainder being borrowed in the form of a mortgage.

The term ‘gearing’ is closely related to this subject. Gearing is the particular ratio of debt to equity. The proportion of debt is expressed as a percentage of the equity. So if a property is geared at a ratio of 65%, this means that the amount of capital borrowed to purchase the property is 65% of the total investment. In the world of finance, if a particular company is geared at 65%, then it would be regarded as high risk. However, private property investors might have to borrow up to 3 times the equity level. This would not be regarded as risky in the same way as corporations, but you should always acknowledge the risk factor in any investment. The return on your investment is the payback for accepting this risk.

A certain amount of financial leverage is not only (for the majority of people) inevitable, but it is also desirable. This is because of 2 reasons:

It enables a speculator to increase his holding several times over. It makes more financial sense to place 25% of your total investment into each of 4 properties, rather than placing 100% of it into a single one. This enables investment diversification (which helps minimise risk) and maximises potential future returns.
Purchasing a property using 100% equity is the most expensive way to run a development or investment company. This is because tax is payable on a company’s NET profits. If the vast majority of your return is regarded on paper as profit then you must pay tax on it. Mortgage repayments are regarded as liabilities and will subsequently reduce tax liabilities.

Property is quite unique as an investment as it enables speculators to borrow higher levels against the property value. This is because it offers a tangible investment. Even if the property remains unoccupied or unsold for an extended period of time, the lender will always have (at the very least) the land value to guard against the loss of their capital. Even if the building upon the land is destroyed somehow, the land will always have some value. Most other investments do not offer this.

An example of why financial gearing increases returns is as follows:

An investor purchases a property at a price of £100,000. Equity is £35,000, and £65,000 is borrowed.

Investment capital £100,000

Less loan £65,000

Property owners equity £35,000

Rent for initial 5 years £8,000 per annum

Less loan interest £5,200 per annum

Net income to property owner £2,800 per annum

Return on Property Investor’s equity £2,800 ÷£35,000 = 8%

So the property investor achieves a return of 8% per year for the first 5 years. However it is in the subsequent years where the advantages of leverage become clearer.

Reviewed rent for next 5 year term £10,000 per annum

Less loan interest £5,200 per annum

Net income to property owner £4,800 per annum

Return on Property Investor’s equity £4,800÷£35,000 = 13.71%

Subsequent terms will reflect even greater returns in comparison to the level of equity placed into the investment. This investment would be a 65% gearing.

It is highly unlikely that an investment of only £35,000 could produce a return of 13.71% and more if invested in stocks. Prior to the recession, Hedge Fund Managers spoke of producing returns of up to 40% per annum. However, a minimum investment is required (far in excess of our example value of £35,000) and the investment risk would be regarded as far higher than that of property. Many hedge funds have gone out of business post recession, taking their invested capital with them. Remember though, property is a tangible investment and it is difficult to foresee a situation where it would ever be worthless.

Nov 28th, 2010

Property Tax

The following post is NOT intended to be comprehensive financial guide, nor is it a definitive guide for calculating your tax liability on any income received from investments. This post is based upon tax avoidance, NOT tax evasion. For accurate advice regarding tax liabilities, I highly recommend you consult a Chartered Accountant or Tax Accountant and refer to the relevant website of the appropriate tax authority for the region you live in.

When considering the best approach for your venture into property investment, it is important to differentiate between different ways of structuring the finance. This will help prevent you paying more tax than you need to. It must be stressed that evading your tax liability is a criminal offence; and if HMRC/IRS suspect that you have attempted to do this, you can expect a thorough investigation that might continue for up to several years.

That said, these agencies are actually very approachable and have a cooperative attitude. This is simply so that taxpayers do not pay more tax than they are required to. It makes good business sense to me.

In the UK and the US, tax is payable on a company’s NET profit. This means that all the company expenditure that it must pay throughout the tax year, are not included in the final taxable amount. This does not mean however that a company can purchase anything just to lower their tax liability. Some items are regarded as Fixed Assets (these are normally items that do not depreciate immediately, items such as IT equipment or motor vehicles).

In the UK, if a private individual has a supplementary income or is self-employed, they must compile a self-assessment tax form. This works in a fairly similar way, in that net profit is taxed and most expenditure is not.

The reason these basic principles have been explained, is because investment property provides an income that will contribute towards your taxable amount. No one wants to pay more tax than they should, and your individual circumstances will affect how you structure your property financial gearing.

If you regularly pay income tax at the higher rate, it makes sense to run your property venture as a limited company. This is because any profit/income that is collected on an annual basis will be liable to corporation tax which is charged at a much lower rate than the higher personal tax rate. Starting a limited company is very straightforward and will cost somewhere around £80-£100. This method however, will be subject to a bit of administration. You will be required to submit a Company Return (specifying shareholders and capital) and a Corporation tax return every year. These obligations are not difficult to carry out but you will probably be subject to a fine if you miss due-by dates.

The interest payments on an investment property mortgage qualify as company expenditure; this means that they serve to reduce the company annual profit, and therefore the amount of tax payable. Many professional property investors structure their mortgage to only pay-off the interest on a month-to-month basis. Obviously the only way you will ever clear the balance of this mortgage is by finding the capital from another source, or to sell the property and pay it off. This method works fine if it is only ever the capital value of the property you are interested in. As we’ve been reminded in the last few years, property values can fall as well as increase but a capital loss is not particularly likely if you hold it for 20-30 years. The property is then sold; the mortgage paid off, tax paid and the remainder is yours (or the company’s). If you have a repayment mortgage that pays off the capital as well as the interest, the monthly payments will be more expensive but there will eventually be a time where the property is mortgage free. At this point, the rent payments then count as all-profit. This makes the books look much healthier but remember you pay tax on the net profit. So if the property is completely mortgage free, you will be paying the maximum amount of tax.

Another point to make regarding companies is that if you are the director of a property investment company, you cannot take money out of the company without paying income tax on it. Your private financial matters are entirely separate from the company’s. Your property company can pay you a salary, but this is taxable like all personal income.

If you currently pay income tax at the lower rate, it might be better to run your venture on a personal level. When selling, if the property is not your ‘primary and principle residence’, you will be subject to paying Capital Gains Tax. This is calculated at a certain rate (currently 18%) on the NET gain of the asset. This means that if you purchased a property in December 2000 for £80,000 and you sold it in December 2010 for £120,000 your net gain would be £40,000; you would be liable to pay around 18% of £40,000. The actual calculation is slightly more involved than this though, as individuals have an annual exempt amount will can also be factored in (this is currently £10,100). For information on Capital Gains Tax and relief, follow this link to the HMRC website.

You might be covered by ‘Entrepreneurs Relief’. There are certain criteria that must be met, but it applies to the disposal of business assets if you are a sole-trader or are a partner in a trading business. There is a lifetime limit currently, of £2 million. This should be investigated fully if you believe you fit the criteria. For information on Entrepreneurs Relief, refer to the HMRC website by following this link.

Oct 25th, 2010