Investing in wholesale property development funds can seem like an attractive opportunity. These funds promise returns that are generally higher than term deposit rates, making them attractive to investors seeking better yields. However, it is crucial to understand that these returns are often low compared to the substantial risks they carry. Investors must be aware of the unique challenges and potential pitfalls associated with these investments.
As an insolvency firm, we’ve seen first hand the pitfalls that can arise. Here’s what you need to know before diving into wholesale property development funds.
The current landscape of wholesale investor funds
Wholesale investor funds can take various forms, but two models are particularly common in the current environment:
Model 1: Fund offering fixed rate of return in this model, wholesale investors pool their money into a single fund managed by the developer. This fund offers a fixed rate of return to investors and lends money to various property developments. The developer oversees the allocation of funds to specific projects, aiming to generate returns to meet the promised interest rate.
Model 2: Project-based financing with preference shares in the project-based financing model, investors may invest directly in one or more specific development projects. They receive a ‘preference share’ offering a fixed rate of return or repayment upon the completion of the development.
While the structure may vary, they all generally share the same set of problems:
Subordinate claims
- Issue: These funds often do not have a first-ranking claim over the real estate they are lending against, meaning that other professional lenders will be advancing funds with superior security.
- Impact: In the event that the development fails, money from the sale of the development will first go to those other lenders. As a result, wholesale investors may recover little to none of their initial investment.
Limited visibility
- Issue: Wholesale investors have very limited visibility into the value of the underlying assets, the trading performance of the main development business, or the level of priority debt.
- Impact: This lack of transparency makes it difficult for investors to assess the true risk and potential return of their investment. Without clear insights, investors are essentially operating in the dark. There is often no way for an investor to know the exact security held, and the level of priority debt owed. The company may be in default of their agreements with other lenders, and being charged default interest without any knowledge of the wholesale investors.
Lack of independent governance
- Issue: These funds often have no independent governance and are operated by the developer, who has no incentive to enforce the rights of the wholesale investors.
- Impact: This can lead to conflicts of interest where the developer prioritizes their own interests over those of the investors. The lack of oversight increases the risk of mismanagement and potential fraud.
Weak covenants
- Issue: While most professional lenders will include various acts of default, including debt covenants in their loan documents, these wholesale funds generally have very weak covenants and no one to enforce them.
- Impact: Without strong covenants and enforcement mechanisms, there is little to protect investors if the developer defaults on the loan. This significantly increases the risk of financial loss.
Conclusion
The returns offered by these funds are generally disproportionate to the risks they present. While they may allure investors with the perceived security of real estate investments, they are essentially the latest iteration of high-risk property developer finance, similar to what was previously offered by entities like South Canterbury Finance, Hanover Finance, and Bridgecorp.
Article written by Peter Drennan
peter@waterstone.co.nz
