I have been doing some research into the crowdfunding of property developments lately. A recent LinkedIn post led me to a thread of propertytribes.com that rekindled my interest, now that some of the (dirty) water has flowed under the highly leveraged bridge. One highly PR focused developer, the poster child of the online development funding scene in 2016 and 2017, had some of their projects come a cropper and investors are nervously waiting for not a return ON capital, but a return OF capital. As I researched further I read story after story from crowdfunding investors many ignorant of the risk and few appeared to know the questions to ask to undertake proper due diligence on their crowdfunding investment.
The last time I wrote on the subject (here) was in 2014 – boy time goes quick. Some of those links no longer exist. Because the virtual space changes so quickly I am not going to provide links, just google for crowdfunding property/real estate developments.
The first thing is there is a difference between investment-based crowdfunding and loan-based crowdfunding.
The latter should be at least, be a loan with a preferred return that is secured by the hard asset that you are loaning on – the land and construction on top. That will always sit in priority behind a development loan from a main lender- if one exists- but should be in front of any equity investors.
The former, an investment based crowdfunding opportunity, is really a plea for hard cash, equity, secured by nothing more than a promise to make a profitable property development and have enough profit left to give you more than you put up.
Whichever one, you should understand property development is highly risky and do your homework. If you have never been involved in a property development, then I just don’t think you can comprehend the risk.
Now some of you out there might like a bit of a flutter. Roulette and racehorses, poker or penny stocks. You could even be one whose risk disposition enjoys getting in early on a pyramid-scheme, being of the mind you will get out with enough cash to purchase a chateau in the Pyrenees before the base inevitably collapses. So for a measly 5k, 10k or even 500k be my speculating guest and play the numbers without doing too much investment analysis – invest widely and shallow or just do it: put everything on green.
But for those of you who like to research where you are putting your hard earned savings and don’t know the developer apart from a slick online presence, here we go.
The questions to ask of the project and the developers behind it when conducting due-diligence on investing in a crowdfunded property development.
- Why are they crowdfunding the project? Yes I know it’s obvious they want to raise money, but why can’t they raise money via lenders or other investors or use their own money? The answer could be purely financial – the developer can raise money cheaper via the crowdfunding platform – i.e. put another way you are receiving a return less than more sophisticated investors would require to invest. For example, even if you are getting a fair and proportional share of the profit, other sophisticated equity investors might also require a preferred payment, like 5% per annum, that is paid as a project expense before the profit is divided up. It might be the hassle factor – it’s simply easier and quicker to obtain financing from a crowdfunding platform than by going through the rigorous due-diligence demands from professional equity investors. The answer could be more worrisome – they have tried the other funding avenues and no one will lend them and/or this project the money! Or worse its their first project and they have no idea where to get funding from!
- Have they any of their own equity in the project? Can they prove it or are they using the crowdfunding to buy them out, before they have even started? Now, skin in the game is often a prerequisite for any venture capitalist – and that’s essentially what you are since every development project, by definition is a new venture (as opposed to say investing in typically the much less risky commercial office building with existing tenants). You want to find out if they have hard cash in this specific project, it’s just one more incentive for them to perform when the going gets really tough. A key point here is ‘specific project’. If you are investing in a commingled fund (multiple projects), in which the developer does have cash, it is much more difficult to see which projects have more of the developer’s self-interest at heart.
- Is the developer experienced? If yes, then that is a positive. Dig deeper. Are they experienced in exactly the type of project they are promoting for funding? Experience developing two lot subdivisions has next to no relevance to developing ten attached terrace homes let alone a thirty unit apartment project. The risk profile and operational nous required is magnified substantially. Converting a large warehouse to smaller tenancies is not the same as building a brand new office development. You don’t really want to be funding a developer who knows not a lot more than yourself.
- But do you trust them? Do enough research so you don’t have even think about that. Trust me, trust is not enough. When the crowdfunding platform provider says they have professionally vetted every deal, then since it is so bulletproof, are they also going to guarantee the return? No of course not.
- Has the developer had any hard knocks? Those who haven’t can often develop an ego and get tunnel vision letting their optimism blind them to the realities of development risk. They think they can control all the risk and are the master of their own destiny. Few can forever. A developer who has been beaten up a few times, and through a recession or two, comprehends risk and reward much better. No developer of any longevity has always only ever had successful projects [feel free to correct me if I wrong if you are the exception!].
- How much does the crowdsourcing platform charge the developer? With technology, you would think it isn’t too much, and they are actually enabling cheaper development finance without changing the risk-return profile. But if it is substantial ask why.
- Is the crowdsourcing platform provider also or has been a traditional property development lender? i.e. have they been doing property development lending for a long time and they have essentially just tech’ed up. If so, that’s a big positive, because they will (should) better appreciate the risk and only take on better projects.
- Is this crowdsourcing platform successful? I mean regardless of project risk, what is the risk to your money if the platform goes bankrupt? There should be nothing, bar a small interruption to project communications. And if the platform owners and the developer are one and the same, is this clearly disclosed? If there are only one developer’s projects advertised on the platform, then they might as well be one and the same. Or is the developer using the pretense of a third party or respectable intermediary to entice you to part with your money?
- Many sites show the investment success of past projects online, all those pretty pictures makes a great testimonial to encourage you to dip into your pocket. But there are a few things to consider. One, just because lots of projects are fully subscribed, doesnt mean the project will be a success. They are there intending to convince you to join the herd: lots of people have invested and so should you. Ignore those, they don’t tell you anything about project success or if the return on your investment is appropriate for the risk of the project. Two, for the projects that have closed – and investors have been paid out – identify the ones that are actually property developments (as opposed to existing assets) and had terms similar to the project you are thinking about participating in. A project wanting finance before consents have been issued is riskier than one where a consent has already been issued. A conversion of a heritage building has a different risk profile to a ground-up development. A commercial building with a tenant signed up is less risky than one where the developer has yet to locate tenants. Three, ask the provider to tell you about any projects that were not successful – good luck at getting that info though from an artificial intelligence-powered chatbot!
- Talking about talking, does the investment specify regular communication reports, so you can see project progress? They should, and the report should tell the whole story. I would expect to know how my investment is performing along the way. For main banks lending on construction it is called a monthly drawdown report, timed not-surprisingly before the bank will release funds to pay the big bills like construction in progress. Or put another way it’s like half-yearly report season in the stock market. Unfortunately, you might not have any secondary market to sell your shares if things are going poorly, but at least you can psychologically and financially prepare for a loss, or attempt to make some noise to rectify the situation.
- Where do development management fees sit? Yes, the developer makes their money based on the profit of the project, but typically they will also want a preferred expense to pay them for managing the project. It could be called project management, project administration or a development fee. And if it’s in the expenses it gets paid out, before the profit is split. So after the final wash-up, even if the project makes you the investor no money, the developer may have had a decent feed along the way. Whilst it would be good that the developer only gets paid out of profit, it is a legitimate expense and should be shown. Just make sure it’s not an exorbitant cost for this type of project and reflects the actual cost of people’s time doing the work, and not another profit center that effectively dilutes your potential return.
- What other related party costs? This is where sophisticated lenders take a very hard look at a developer’s financial feasibility. And so should you. You want to know exactly how many fingers the developer has in the development expense pie. Every additional profit center could dilute your project profit especially if costs ‘escalate’ during the project. For example, is the land being provided at cost, or is it based on a higher (or even pumped up) valuation? The developer might be making all their money on this one element alone, and who cares what the final project profit is. Fair enough if longer than a year has passed between buying the land and putting it into this crowdfunding investment. But just be aware. A huge jump in land valuation, in a short period of time, without any added value being applied to the site (like consents) should be challenged. Even with consents, make sure the land is worth the higher amount – ask for and read a professional valuation/appraisal. Other examples to watch out for: is the developer also the builder, and taking profit there? What about the sales agent, does this developer sell inhouse? Or a key supplier to the construction? Developer’s partner the ‘interior designer’? Brother, the engineer? Or is there a ‘finance arrangement fee’, paid to none other than the developer? There are plenty of places to hide developer profit centers. If everything is disclosed and you accept they are a fair rate, then fine.
- Fixed contracts. Following on from the point above, even if they are a fair rate, and you are happy with the developer clipping the ticket in multiple line items are the costs capped? Fixed fee agreements and contracts as much as possible are a must. But in the construction of private development projects, I hasten to say there is really no such thing as a fixed price. And if the developer IS the builder, then they are probably quite amicable to construction variations! (If you don’t know what a variation – or change order – is, then please reconsider investing anything into a property development!).
- Is there a bank loan for construction/total development costs on the project? If so what are all the terms and conditions? Specifically, when does the loan have to be paid back? What is the Loan to Value ratio? And who is the lender, what is their track record in property developments? Are they are related party to the developer? Do they get a cut of the profits? And is there a second lender on the project, perhaps a layer of crowdfunded debt? Or high-interest mezzanine funding – which itself adds further risk. And make sure you know if profit will be shared with lenders before you get your cut.
- What security do you have (and this varies by country, learn more here)? Is your investment secured by mortgage a registered charge, a pledge or a lien. What about quasi-security like bonds and personal guarantees? Has or will the contractor put up a cash bond – they can become life savers if the contractor goes bust (doesn’t happen you say!).
- Can you see the detailed feasibility? And I mean detailed. Now if you haven’t been involved in property development it might not make much sense. Sure if may show a glowingly high 30% Return on Cost at the bottom, which translates to a whopping big return on equity, if there is debt leverage in play. But you won’t know what is missing or even what is realistic. Is there a line item for contingency? Do the professional fees equate to a percentage of construction costs commensurate with this type of project? To understand you really need someone who has been there before to look over it. Believe me that’s what the main bank lender will be doing. You could take the approach that if the lender has ok’ed the development then it will be fine. And there is some truth to that. But if the lender is only lending a low Loan-To-Value ration, say 40 or 50% of the total cost with full security and a personal guarantee that has some teeth to it (i.e. there are personal assets to go after, that aren’t also within a personal guarantee for another loan) then they may not have done a lot of due diligence. At that low rate of leverage, barring a global financial pandemic, they will almost always get out fine as they are first in line to be paid back.
- On the feasibility. If you only manage to look at two items, let it be these. Sale price and construction costs. The former is quite easy to analyze even for a layperson. Are the sales prices realistic in today’s market? Look at your local online listing engine, compare this project to the competition – adjust for size and location and see if it stacks up. Better, ask for the professional valuation or appraisal for the project. And if there is none, that’s a red flag on its own. If there is, then don’t rely on just the summary. Look inside at the valuer’s assessment of the competition in the body of the report. I will let you know a little tip for free (yes another one!), most developments only ever get out of the ground, because the developer is setting the market. That is their prices will be ahead of where the market currently is. The developer is hoping their project will attract the market setting price! I am OK with that, as long as it is not an outrageous escalation.
- And construction costs. Unless you are a quantity surveyor or professional cost estimator you are not going to know if the costs are reasonable. But that’s when you would expect to see a report from a professional quantity surveyor or cost estimator included in your crowdfunding investment due-diligence pack. Not there – hmmmm. Don’t rely on a builders price on its own without a professional signing off that the cost looks right. But at least it’s better than a developers estimate.
- Pre-sales, does the project already have pre-sales? – that is sales or pre-leasing commitment before you have handed over your investment. That de-risks the revenue side of the equation, somewhat. It can backfire though because then you have a capped revenue, that can’t rise with the market and if construction costs rise. This is a common situation with property developments that contribute to their downfall. I could go on, but no need, here is something I wrote earlier on the pre-sale dilemma. Although, make sure any pre-sales are legit – look at the sale contracts and discount any that are with related parties – like family, pets, or deceased relatives!
- Schedule? Only a professional expert can tell, but is there sufficient float to allow for realistic timelines? Delays cost money, especially if there is debt leveraged against the development. And delays happen all the time. But the best know how to set expectations and depressurize the development by setting a realistic schedule, that allows for some of the unknowns. Of course this always eats into the return, hence why so many schedules are so ridiculously tight. Remember, you are most concerned with the return you receive at the end of the project. What is said at the beginning is always only a guideline (and expect it to be optimistic).
Now about 17 points ago you may have said to yourself, is this degree of investigation worth your time? Only you can answer that, and it ties directly into your risk appetite and the sum you intend to invest. Look if its 5k or 10k maybe you can gloss of most of it and focus on the developer’s success record and whether you buy into everything they promote to you online. Certainly, developers want to provide as little information as possible, and presumably, crowdfunding platforms want to interact with investors as little as possible – to keep their human costs down. But if you are ready to part with a sum that you can’t afford to lose, then understand this: it is a risky business and you are supplying venture capital to a speculative activity. Property development is not the same as property investment. Not only might you not receive a return as great as you think but it is also very easy to have all your contribution wiped out. And unlike the share market, you cannot exit until 100% of the dust has settled. From what I have read, many crowdfunding investors don’t really differentiate development projects from an already income-producing investment (an office building for example). But development is much riskier and regardless of disclaimers on the crowdfunding website and some flash videos with people driving flasher cars, unless you have been in the business, you simply can’t comprehend the risk your cash is about to endure.
However, let’s say you manage to get ticks on everything above. Even after all of that, property development is still behest to the mighty market. Flat or falling sale prices combined with rising construction costs, planning ‘delays’ and optimism bias are part and parcel of the development game. Margins can be wiped out in no time. Although also understand (otherwise, no one would get involved in the development business), in an escalating real estate market margins can be amplified – can your equity investment take advantage of that or has a cap been placed on your return?
So ask yourself this, does your pending online investment still sound fun? Is it still worth you following the crowd? If so, I hope you get the return promised, but please do not moan if it goes pear-shaped. You have been well and truly warned.
Andrew Crosby
P.S.
Now in this blurred world of social media versus professional media, my opinion versus my employer(s), salary versus side-hustle, middle of the business day versus 11pm on a Sunday evening, it can all get a bit confusing. So, here is my value proposition, and both complement and benefit each other.
- If you have a development site that you would like to sell some or all of, to develop yourselves, or to build houses then Universal Homes www.universal.co.nz might be able to help. We focus on delivering value-for-money homes in the ‘relatively affordable’ range, like the 1300 home westhills.co.nz or the 600 plus homes we have built at Hobsonville Point, or the thousands of others around Auckland over the last 60 years.
- If you want to learn more about real estate / property development and a continuous improvement approach, with books and courses in development management to maximize profit and decrease risk then visit www.developmentprofit.com
- Message me on LinkedIn at any time linkedin.com/in/ajcrosby. Gee I will even help you analyze your next project if you like.
