Is 14.00% p.a. a good risk-adjusted return?

Our first presenter is Joel Christie, Executive Director at Capital Property Funds.

Joel has 19 years of experience in financial services.

He sits on the investment committee, primarily focusing on investor relations.

He's going to explain, is 14% plan them a good risk adjusted return?

Welcome to the presentation, Joe.

Hi, Angelina.

Thank you for the introduction.

Look, is 14 percent a good return?

Particularly what we're going to be talking about is around high yield property income funds.

So also I just snuck in an additional topic here called understanding the capital stack.

Before I kick off the presentation, I just want to show this disclaimer.

Broadly speaking, what we're saying is that this is not personal financial product advice.

nor is it an offer to invest in or subscribe for units in any particular product.

So before I get into what I'm going to cover, the purpose of this presentation really stemmed from some of our investors coming to us saying, you know, good day, Joe, I've got this fantastic fund that I've just invested in, and I'm getting a 14% return.

And often when you look at these funds, a large portion of the return will be dependent upon the commercial outcome of the product.

So it's not actually a 14% return that's guaranteed.

It may be 7% that's paid as an interest payment every month or every quarter.

Then the other 7% is paid at the back end of the project and is dependent upon the commercial outcome of the particular property development that they're investing into.

So often when you explain this to people, they think, oh, OK, I thought I was in a first mortgage position and I thought I was getting a great return.

And sometimes they're taking on more risk than they thought they were taking on or didn't realise they were taking on.

And they're not really getting a great return once they understand their position in the capital stack.

So I just want to explain what those terms mean.

Risk adjusted returns.

you know, what is the capital stack?

And I think it might be a little informative seminar for other people to look at before they decide to invest into a high yield property fund.

So I'll be talking about exactly what is a high yield property fund.

I'll be talking about what we mean when we say what's a risk adjusted return, and then we'll then get into what we call the capital stack.

And before we get into that, we talk about what's the difference between a first mortgage, a second mortgage and equity.

And so then we specifically look at the capital stack and the pricing of the capital stack as it stands in the marketplace today.

And then we'll just talk about some of the little finer differences between debt and equity.

So just to kick things off, what is a high yield property fund?

Now, typically, sometimes they're called private credit or real estate credit funds.

But it's where a borrower is looking for some funding.

Typically it should be debt funding and they offer property as a security and typically it's done on a property development.

So for example, a developer may have an approval for a large land subdivision and they need some funding in order to complete that land subdivision, reach commercial completion of that project and sell the completed stock hopefully for a profit.

So how the funds work is that investors typically would provide the debt funding and in return they get what's called a first mortgage usually, or maybe a second mortgage or some sort of security over the property.

And in return for that, they get a regular interest payment, usually paid monthly or quarterly.

So the income return for a typical high yield property debt fund

is derived from interest payments payable under a loan agreement.

And I'll talk a little bit more about loan agreements later in the presentation.

And typically at the moment for a first mortgage debt fund, you're sort of getting a return of around about 10% per annum, typically paid quarterly or monthly.

And the usual investment term for these type of funds is around about 12 months.

And the typical minimum investment is around about $50,000, although that can vary from fund to fund.

So what is a risk adjusted return?

And to put it simply is that a risk adjusted return simply means that an investment return that adequately reflects the investment risk associated with an investment.

So the higher risk an investment is, an investor should expect a higher rate of return

as compensation for taking on that additional risk.

And then that leads into my next slide about what is a first mortgage.

And a first mortgage simply refers to your ranking in the capital stack.

And if you rank first in the capital stack, you get paid first.

So by way of example, when a property is sold, first mortgage holders are the first to be repaid in full.

So any funds that are available

after first mortgage holders have been repaid in full are then used to repay other participants in the capital stack.

Now, for example, there may be a second mortgage, another participant in the capital stack, and a second mortgage, as the name implies, refers to your ranking in the capital stack.

So if you're a second mortgage holder, you rank second in the capital stack after the first mortgage holders.

Again, by way of example, when a property is sold, first mortgage holders

are repaid in full, and then there's anything, any funds remaining after the first mortgage holders have been repaid in full, then those funds are used to repay the second mortgage holders.

If there are any of that, there aren't always second mortgage holders in a capital stack, but generally if there were, they sit behind a first mortgage holder.

And then the top end of the capital stack is what we refer to as equity.

And that is another way of saying owners of the property.

And typically the equity holders, because they're sitting right at the top of the capital stack, they take on the most risk.

And when a property is sold, they are generally repaid last from any proceeds remaining after all the participants in the capital stack have been repaid in full.

For example, first mortgage holders and second mortgage holders.

So if you look at that here displayed as a graphic,

you can see that we have a diagram called the capital stack.

And down the bottom of the capital stack are the first mortgage holders.

They're typically taking a lower risk because they're the first to be repaid.

And typically they get a lower return.

And then as you creep up the capital stack a little bit, you can see second mortgage holders.

Sometimes it's called mezzanine debt or junior debt.

And they get a little bit more return because they're taking on more risk

And then at the top of the capital stack, equity participants.

So they're the ones that take on the most risk, but potentially they can enjoy the most return.

Now there's no problem with investing in any portion of the capital stack, but what we want to emphasise is that making sure that you understand where you sit in the capital stack and you're getting an appropriate risk adjusted return.

So you're getting a return that reflects the risk that you're taking.

So if we look at the pricing stack as it stands in the market today, for first mortgage investors, so the ones that get paid first, for a loan to valuation ratio of up to 65%, and what a loan to valuation ratio means is that if a property has been independently valued by a certified and qualified valuer at say $100, and we lend up to 65 cents in that $100, you have a 65% LVR or loan to valuation ratio

And so the indicative return at the moment is between nine to 10 and a half percent.

And then often, or not often, but sometimes somebody may want to borrow more than 65%.

They may want to borrow up to 75%.

Now, typically how we structure our investments, we would provide up to 65 as a first mortgage, and then we provide the additional 10% as a second mortgage.

So you're going to rank second behind first mortgage investors, but you're getting between a 16 to 18%

return per annum.

And I put there per annum, so generally the return for a first mortgage and a second mortgage, because they're debt investments, it's governed by what's called a loan agreement.

So the borrower would sign a loan agreement that would stipulate amongst other things, for example, how long the loan is for, what type of securities is being provided, but also how much interest they must pay each month or each quarter.

So the owners of that, or the investors in that first or second mortgage investment, their return is underpinned by a loan agreement.

And then if we keep going up the capital stack, we come to equity investors.

And so they're typically between 75 to 100%, but they may get returns of up to 30%.

And you'll notice that we haven't got 30% per annum, it just says 30%.

So for example,

If we have a project that we expected, like might be a land subdivision or some sort of similar property development that was going to take, expected to take a year to complete and they would, and if it would complete it within a year, they get a 30% return and that would be per annum.

However, let's say that it rained, the project was in Southeast Queensland and there was a lot of rain for several months and you weren't able to get any works done on that particular property development.

and the project took two years to complete, so you've still made your 30% return, but it's taken you two years to complete that, therefore that equates to a 15% per annum return.

So that's just the risk that you take as an equity holder, is that you've got a 30% return, but if it's annualised, it was 15% per annum.

Whereas if you're a debt holder, you still have been getting your 10% per annum or your 15, 16, 17, 18% per annum return.

The other thing too, that for equity investors is that their investment is governed by what's called a shareholders agreement.

So there's not a loan agreement that stipulates exactly how much they should be paid every month or every quarter.

There'll be a shareholders agreement.

And that would say, if there's a successful commercial outcome,

and we make a profit, then this is, you know, this is your entitlement or share of that profit.

So it's governed by a shareholders agreement, not a loan agreement.

So, you know, I've probably spoken about, you know, what are some of the differences between debt and equity?

And the main difference really, apart from where you sit in the capital stack is what I was talking about before, is that how your underlying investment is secured.

So with debt,

It's secured via a loan agreement, which stipulates a lot of terms of the loan, particularly what interest rate is payable each month.

And that translates to investors because that loan agreement determines how much interest or how much return is paid to our investors each month.

This means that the income return paid to debt providers is clearly defined, but your equity returns are generally dependent upon

the commercial outcome of the project.

And I just want to take a little bit of time to talk about that because often we'll have some investors coming to us saying, as I mentioned at the beginning of the presentation, I'm getting a 14% return.

And I said, oh, that's terrific.

And then if you look at the loan agreement, or sorry, the investment agreement, is that 7% will be guaranteed or paid as an interest payment.

So they're getting a 7% return paid every month or every quarter.

But the other 7%

is paid at the back end of the project and is dependent upon the commercial outcome of the project.

So what you're having there is you're investing in a product that's starting to look a little bit like debt and a little bit like equity.

So you're starting to creep up that capital stack.

So it, you know, and then you start to ask yourself, well, gee, I'm getting equity style returns here, but I'm not actually, and I'm sitting higher up the capital stack, but I'm not getting a great return.

I'm getting a 14% return.

Should it be closer to 30% return or somewhere between a second mortgage and equity?

The other thing too is I've seen investment product where it's promising a 14% return.

And if you look at the document, you'll see that there's a first mortgage to a large bank.

So you know then you're no longer in a first mortgage position, you're in a second mortgage position and a large portion of your return

has an equity like flavour about it because it's dependent upon the commercial outcome of the project.

So you're starting to have a sort of a quasi equity style debt product and you're not getting a very good rate of return.

And as we said at the beginning of the presentation, there's nothing wrong with investing in equity or any part of the capital stack.

But the big thing we're looking to emphasise is just making sure that you're getting an appropriate risk adjusted return.

Yeah, so going over some of the things that we, you know, some further differences between debt and equity is something I spoke about earlier, that equity is usually secured by a shareholders agreement and a shareholders agreement will not generally not define the monthly interest payment, whereas debt typically is secured by a loan agreement, which clearly will stipulate what the regular interest payment is going to be.

So just to summarize, as I said, you know, there's nothing wrong with investing in equity style products or second mortgages or first mortgages, but just making sure that you're getting an appropriate return for the risk that you're taking and being aware of where you are sitting in the capital stack.

Cause sometimes some investors don't want to be sitting in a subordinated position or high up in the capital stack.

And so, but they want that, they want that higher return.

So just making, but they're not prepared, you know, they're not happy with the risk.

So making sure that they take a bit of time just to examine the particular offer document, understanding where they sit in that capital stack, and then making sure that they're getting an appropriate return for the risk that they're taking.

So thank you for that, Angelina.

Thanks, Joel.

Do you have time for a question?

Absolutely.

I'm wondering, is there anything else investors should look for when investing into some of these high-yield property funds?

Look, we've covered a lot in that particular presentation and it's a really good question, Angelina.

So I'm going to do a quick summary.

You want to know where you sit in the capital stack, making sure that you understand the type of return that's being derived.

Is it equity-like or is it proper debt-style return?

And look, the last thing we really like to look at is, are there any related party conflicts?

And by that, what I mean is, you know, is the person that's borrowing the money, are they clearly separated?

But is there a clear separation between the lender and the borrower?

So often the lender will be lending to related, not often, but sorry, sometimes the lender will be lending to a related borrowing party.

Now, the reason why I raised that issue, it's all fine when everything goes smoothly.

But if I've lent money to a third party borrower, and that particular project needs to be remedied, as in we need to enforce our security, then we can clearly enforce that security and act in the best interests of our investors.

However, if that project was money that we'd lent to ourselves, we're sort of conflicted.

Do we act in the best interest of our investors or do we act in the best interest of ourselves?

So for example, we could have our own particular project.

We want our investors to invest in that and we're gonna go off and run and do the development.

So again, there's nothing wrong with related party lending, but people should clearly understand who they're lending to.

So who is the lender and who is the borrower?

and is there a relationship between the borrower and the lender or are they bona fide third-party parties?

Thanks Joel.

Thank you Angelina, enjoy the rest of the day.