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How to make money by investing in residential property development projects
As an asset class, property is vast, varied and full of potential. A particularly popular investment choice, the large array of property opportunities available in the market generally means there’s an opportunity out there to suit every investor, no matter how large, small, long term or regular their investment capacity may be.
In our recent webinar (which is available to watch on-demand here), we spoke on the topic of residential property projects and why, as an investor, you should consider them as part of your investment portfolio.
Being particularly popular, I wanted to take some time today to talk more about one of they key areas within the webinar - how, as an investor, you can make money by investing into residential property development projects.
What are residential property development projects?
Before we go into the detail, it's useful to lay the foundations first, ensuring you understand just what such a project - and the related investment opportunities - are.
Residential development projects are a favourite among investors as they have historically provided strong growth returns through an easy-to-understand structure.
Moreover, an asset backed investment into property - where an investors' share is a visible and tangible asset - often appeals to those investors who want something tangible to invest their money into, as opposed to an investment into an early stage, high growth SME opportunity.
Projects were historically only available to a small number of investors directly; those with a connection to a developer and who were prepared to invest a sizeable amount into a single opportunity. However, the rise of fintech and alternative investment platforms allows everyday investors to access the same deals as institutional investors, building a diversified portfolio of asset backed investments, whilst developers are no longer having to rely on their known networks for finance.
Larger property developers use retained capital and low interest bank debt to fully fund developments, and will have several developments at a time taking place. But small to medium size developers don’t often have the same benefits as the national and international house builders.
Consequently, this type of investment enables smaller and local developers to make their contributions to the housing crisis, whilst providing jobs and homes for local people, benefiting not only the investor and the developer, but the local economy, too.
Choosing between an equity and debt investment
Residential property projects are made up of two types of capital - senior debt (or a loan) and equity investment.
The equity investment will be raised from individual investors in exchange for shares and typically allocated for the purchase of the land. As an equity investor into a project, you wouldn't expect to receive annual payments or income. Instead, you would invest for growth on your investment at the end of the project and presuming that the development runs as planned and costs remain with budget, typically a growth of between 1.2x and 2.0x money is anticipated.
Conversely, the senior debt in the project will be used for the development costs and working capital, funding the execution and delivery of the scheme until the sale of the properties begins to deliver income.
The senior debt will be borrowed at a set rate - or one tracking the index - for example 7% (or at present, the base interest rate of 0.5%, plus 6.5%).
The senior debt provider will charge an annual coupon or interest payment on top of the capital lent to the developer, delivering the senior debt provider annual income as opposed to the growth on investment seen by the equity investors. Senior debt can be provided by banks, but also by property bonds and peer-2-peer (P2P) lenders.
Whilst investors can get involved in property projects via such bonds, it does mean you’re not in control of the opportunities you invest in, unlike equity investors who can essentially pick and choose each element of their portfolio.
What do I need to know as an equity investor?
At GrowthFunders we focus on giving investors the opportunity to invest on an equity basis. Compared to the debt investment, it does bring with it an increased level of risk - but similarly, the potential for return is greater.
I mentioned that equity investors generally target a base return of 1.2x to 2.0x for equity investors. This means the target return is, for example, 1.2x your original invested amount, so a £100,000 investment would deliver a 20% profit, therefore returning £120,000.
Developers will run their site feasibilities, looking at all the influences on potential profit, from the initial purchase price of the land right through to the end sale prices of the properties. Looking at an investment opportunity, you’ll often see a target ‘base case’ return, which is a conservative estimate of the deliverable returns. The documentation will then often detail an upside target return - which is a larger return should circumstances be favourable - as well as a downside return should costs increase.
Equity property investors will often diversify their portfolio with opportunities of varied terms and return targets, meaning that risk is mitigated where possible and the returns are received in different financial years, helping to manage capital gain liabilities from profits.
From an investment perspective, growth is classified within the tax system as a capital gain and therefore subject to capital gains tax. You are entitled to a capital gains tax free allowance of £11,300 in this (2017/18) financial year. Capital gains over and above this would be taxed depending on the nature of the investment and your annual income level. However, with a diversified portfolio of property and EIS/SEIS eligible investments, an astute investor would be able to innovatively mitigate some tax liabilities.
Investing into property for growth: the risks?
Risks come hand-in-hand with investment opportunities of all types, but a savvy investor will look to diversify their portfolio with different levels of risk in their investments.
Investing in residential property developments typically attributes less risk than investing into a high-growth SME, as your property investment is asset backed. You can see the land or property you’re investing into, instead of investing into a business.
Moreover, to ‘lose money’ in a property project, the costs of the project would have to increase significantly at the same time as selling prices and values decreasing rapidly, which although is technically possible, is highly unlikely.
By way of an example, if we assume a £200,000 house on an opportunity consists of equity investors having 25%, debt accounting for 50% and the remaining 25% is the profit from the sale, house prices would have to fall 25% for equity investors to not see a return - but they'd still get their money back.
The housing market would therefore have to see a considerably steep drop in house prices (more than 25%) for investors to lose money and not return what they invested into a project.
To put this into context, in the financial crisis of 2008 - generally seen as one of the worst times financially for many - Halifax recorded an average 16.2% drop in house prices throughout the UK.
How do I start making money from residential property development projects?
The ability to invest into such projects is arguably easier today than it ever has been. Equity crowdfunding platforms allow investors to participate in opportunities in a matter of clicks from the comfort of their own home. There's theoretically no need to speak to the team behind the project - everything is accessible and actionable online.
I say 'theoretically', however, as before you make any financial investment into an opportunity you need to understand every detail in-depth. The expected returns. The opportunity risks. The best case and the worse scenarios. The anticipated length of the development project. The contingency plans if the build doesn't go to plan.
We mentioned this in the webinar, but investing into a property opportunity is about more than looking at the returns and notable risks. To be fully behind your investment, you need to have full confidence in it - and this comes from researching and understanding the opportunity in full.
Can you do this all online? If you're an experienced investor, it's possible. Our documentation for every investment opportunity is in-depth in every respect and all accessible via the pitch details.
As a new investor, however, whilst the documentation is still available, we fully appreciate support is often needed to run through it and understand it in its entirety. Whilst we don't offer financial or investment advice on an investment opportunity, we're always happy to chat to explain any aspect of an opportunity further.
But if you've read the documentation, fully understand the risks and returns and are ready to invest, it's simply a case of pledging your investment - and on GrowthFunders, it's a short and simple process (in fact, Tony recently explained how you actually make a tax efficient investment on the platform step-by-step, and it's an almost identical process for property investments).