Construction 5: Mezzanine Financing, The Whole Story from Top to Bottom

When is buying property not buying property – or “shared” construction schemes.

 

This is a blog about things to avoid!

In my mind, buying property (real estate) puts your name on the title. If your name isn’t on the title you didn’t buy it.

 

I cannot give advice but, I can give guidance in relation to the question "WHY you would want to invest in property?"

 

In that respect – do you ever remember looking up the answer page in a maths text book and then working backwards to the start?

The answer is clearly found in two of my earlier blogs :

 

The WHOLE POINT of investing in property is that you want the power of leverage – you WANT the borrowing.

 

Why? – read the abovementioned blogs for a detailed answer, but as a quick summary …

  • $100,000 invested in cash or shares – when it doubles is worth $200,000
  • $100,000 used as a 20% deposit in a $500,000 property – when it doubles is worth $600,000 – how?
  • $500,000 doubles to $1,000,000, then sell and pay back the $400,000 loan
 

Now back to the blog : when is buying property not buying property?

 

In my mind, buying property (real estate) puts your name on the title. If your name isn’t on the title you didn’t buy it.

 

At times of high interest in real estate (such as we are in now) all the “schemes” of the past come back to haunt the market.

 

They present as low risk because you are “sharing” with others. They are sold as an easy entry to property without the risk of borrowing. Nothing could be further from the truth.

 

Mezzanine financing (in real estate) is when a developer uses a “property advisor” to raise money from private investors.

To use a fictitious example -  DEV Property Group raises $1,200,000 from private investors. You might only have to put in $10,000. You are promised a return on your money at very attractive rates – say 20%. You are given an official document called a Convertible Note. It promises that if the developer can’t pay you the interest you can convert to shares in the company.

DEV Property Group puts $200,000 of the capital aside to “pay the interest” – that in itself is a warning bell. Dev Property Group now takes the remaining $1,000,000 and uses it as “deposit” on a loan with a Bank. They might be able to borrow up to $9,000,000 to develop a piece of real estate. DEV Property Group has the loan and is on the title, the Bank holds the mortgage.

If and when it turns to tears – and eventually some of these do turn to tears – DEV Property Group goes into receivership. The bank sells the property for a loss (it isn’t completed). You are left holding a convertible note in a company that is bankrupt. Your $10,000 “loan” ranks behind the bank and other secured creditors. It is usually small investors who thought it was a low risk way into property who discover they get NOTHING back. It is the highest risk of all.

 

Similar to mezzanine financing is when a “financial advisor” encourages you to buy into either “listed” or “unlisted” property trusts. Once again pooled funds are handed over with “pieces of paper” given in return. In some cases these “pieces of paper” have restrictions on when you can sell and who you can sell to. You will probably be given a glossy brochure showing some of the “property” the trust may or may not invest in. The property trust may or may not borrow – giving some similarities to the previous example.

What is your investment worth?

It is here that words from my stockbroker uncle are emblazoned into my brain. He said “Unlisted property trusts are valued by the trust itself and can only be bought and sold through “advisors” – DO NOT – invest in it”.

 

The owner of a house is an unreliable source of its value – it’s called a vested interest. A listed property trust can be bought and sold every day on the stock market – at least its value is determined by “the market”. This then is no different to buying shares. There is absolutely nothing wrong with that – BUT – you are simply buying shares – you don’t have the title – so you are not buying property.

 

To go back to start – if you wish to buy property – the whole point is to borrow. The whole point is to take advantage of the power of leverage.

 

If borrowing isn’t for you that’s ok BUT, that simply means that property isn’t for you.

 

The only way that you should buy property, is to borrow and put your name on the title.

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Alan Heath Mortgage Choice Brisbane CBD

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