I talk a lot about how to be a property developer with little to no money of your own in the deal. There are lots of different ways to achieve that goal, and spoiler alert - I'm not going to go racing off down that particular rabbit hole in this article!
Obviously, though, if you're not using money of your own, then you need to be using "Other People's Money - often referred to as OPM.
And let's get real here - nobody, whether a lending institution or a private individual, is going to hand you large wads of cash unless you give them some sort of security in return.
There are different ways to secure borrowed money. It ranges from the biggest, thickest, most indestructible cuddly blanket on the market right through to a threadbare rag. It's important to understand which security you need to offer in your situation. I'll focus on the most common ways these different types of security are used, and please note that your lawyer should always be part of your process.
Mortgage
If you've ever had anything to do with property before, then it's highly likely you've also come across a mortgage.
Most of us start out buying a house to live in. We beaver away, limit how much smashed avocado on toast we eat, save up the deposit and costs - and borrow the rest from a lending institution.
That lending institution is definitely keen on massively warm and fluffy security blankets, and so takes a first mortgage over the property.
Welcome to the wonderful world of home ownership and potentially 25-30 years of paying off a mortgage, along with paying the lender a LOT of interest over that time. Or am I the only one who looks at mortgage calculators and wants to be sick when I see how much interest ends up in the lender's pockets?
But did you know it's not just financial institutions who will lend you money based on a first mortgage? In fact, you can secure any type of loan with a first mortgage, if there's not one in place over the property already.
You can even get creative and secure a private loan for one development project, by offering a first mortgage over another, unencumbered property!
Bottom line is that a first mortgage is the most secure option out there for a lender, and so is generally only offered in low risk situations. That's why they rarely offer funds equivalent to more than 80% of the property's value without extra security (eg Lender's Mortgage Insurance).
There's a second level of mortgage, coincidentally called a 2nd mortgage, which is another instrument that is regularly used to secure lending for property development. It's mostly used to bump up the LVR of your borrowings.
As an example, you might have a lender who will secure 70% of the property's value with a first mortgage, then a second lender will secure another 10%. Typically the interest rates for the 2nd mortgage are higher. Why?
It all comes down to priority. The main security of a mortgage is that it gives the lender the ability to sell the property in order to repay the debt. When the property is sold, then the 1st mortgage is paid out first, and the 2nd mortgage is paid out second. I bet you didn't see that coming (just kidding - of course you did!).
What this means, though, is that the second mortgage position is a little riskier than the first. That's why the interest rate will be higher.
Caveat
A caveat can also be used as security for private money, but it works in a different way. Essentially, it "locks" the title, making sure the property can't be sold or refinanced.
Usually, a caveat is used together with a loan agreement, in situations where there is already a first and potentially second mortgage in place. This puts the lender in a much riskier position, as the mortgagors will get first grab at the funds if the deal falls over and the property is sold.
One problem you need to consider with a caveat is that if you're planning to refinance further into the project, having a caveat on the title will definitely cause you some problems. For instance, when you get your Development Approval, you might be intending to refinance into construction financing.
For that reason, it can be worthwhile to use a registerable caveat. Definitely one for legal advice, but essentially all the paperwork to lodge a caveat is drawn up and signed, but not actually lodged. The lender, however, can immediately lodge it if there's any whiff of trouble. This gives you the freedom you need to refinance if that's part of your strategy, but can still be used to protect the lender if things are going wrong.
Personal Guarantee
Personal Guarantees are common in the area of private finance, when you already have more traditional lending for the first and perhaps second mortgage, but still need equity to pay a deposit or fund the process of getting a Development Approval.
In effect, you guarantee the lender's funds from your own personal assets. The reason a lender likes to have this is because the risk of the property being sold and not returning enough capital to pay out the first mortgage, second mortgage and also the private lender is high. So they want to know they can get paid back their capital from another source.
And although private lenders have been using them for a while, they're becoming much more common in the realm of standard mortgages too. If you're using an entity for a property development purchase, you've most likely signed a director's guarantee, which is very similar, as it allows the lender to liquefy your personal assets as a director if selling the property results in a shortfall.
Unsecured
Now we're into threadbare rag territory! The word "unsecured" says it all really - there's no specific security offered. Having said that, in the world of property development that's not always true.
It depends on how your deal and your finance are structured. There are instances where the security you're offering is the deal itself.
Let me explain. You've brought in a private lender to get a deal underway, but then you fall under a bus and you're out of the picture. Depending on the paperwork, the lender can then "take over" the deal and see it through, keeping all the profit at completion. It's an unusual scenario, but if the deal is a good one, it can be a lot more secure than the name "unsecured" makes it sound!
Be warned though - there are predatory lenders who specialise in this type of deal, who have been known to apply the thumbscrews at any opportunity in the hope of squeezing you out of the deal. They then take it over and bank all the profits themselves. I know I've said it before, but here it is again - LAWYER!!
The other thing to keep in mind, along with how appropriate each type of security is for your financial needs, is that risk equals return. As the security blanket gets thinner and thinner, the lender is going to expect higher returns. After all, they need to run their heater more to keep warm - a threadbare rag just doesn't cut it!
And remember, finance is a hugely important part of every property development deal, so make sure you speak with your team of professionals, particularly your lawyer, to make certain you fully understand which security is most appropriate, and what exactly you're agreeing to do when you sign off on any finance paperwork.
Obviously, though, if you're not using money of your own, then you need to be using "Other People's Money - often referred to as OPM.
And let's get real here - nobody, whether a lending institution or a private individual, is going to hand you large wads of cash unless you give them some sort of security in return.
There are different ways to secure borrowed money. It ranges from the biggest, thickest, most indestructible cuddly blanket on the market right through to a threadbare rag. It's important to understand which security you need to offer in your situation. I'll focus on the most common ways these different types of security are used, and please note that your lawyer should always be part of your process.
Mortgage
If you've ever had anything to do with property before, then it's highly likely you've also come across a mortgage.
Most of us start out buying a house to live in. We beaver away, limit how much smashed avocado on toast we eat, save up the deposit and costs - and borrow the rest from a lending institution.
That lending institution is definitely keen on massively warm and fluffy security blankets, and so takes a first mortgage over the property.
Welcome to the wonderful world of home ownership and potentially 25-30 years of paying off a mortgage, along with paying the lender a LOT of interest over that time. Or am I the only one who looks at mortgage calculators and wants to be sick when I see how much interest ends up in the lender's pockets?
But did you know it's not just financial institutions who will lend you money based on a first mortgage? In fact, you can secure any type of loan with a first mortgage, if there's not one in place over the property already.
You can even get creative and secure a private loan for one development project, by offering a first mortgage over another, unencumbered property!
Bottom line is that a first mortgage is the most secure option out there for a lender, and so is generally only offered in low risk situations. That's why they rarely offer funds equivalent to more than 80% of the property's value without extra security (eg Lender's Mortgage Insurance).
There's a second level of mortgage, coincidentally called a 2nd mortgage, which is another instrument that is regularly used to secure lending for property development. It's mostly used to bump up the LVR of your borrowings.
As an example, you might have a lender who will secure 70% of the property's value with a first mortgage, then a second lender will secure another 10%. Typically the interest rates for the 2nd mortgage are higher. Why?
It all comes down to priority. The main security of a mortgage is that it gives the lender the ability to sell the property in order to repay the debt. When the property is sold, then the 1st mortgage is paid out first, and the 2nd mortgage is paid out second. I bet you didn't see that coming (just kidding - of course you did!).
What this means, though, is that the second mortgage position is a little riskier than the first. That's why the interest rate will be higher.
Caveat
A caveat can also be used as security for private money, but it works in a different way. Essentially, it "locks" the title, making sure the property can't be sold or refinanced.
Usually, a caveat is used together with a loan agreement, in situations where there is already a first and potentially second mortgage in place. This puts the lender in a much riskier position, as the mortgagors will get first grab at the funds if the deal falls over and the property is sold.
One problem you need to consider with a caveat is that if you're planning to refinance further into the project, having a caveat on the title will definitely cause you some problems. For instance, when you get your Development Approval, you might be intending to refinance into construction financing.
For that reason, it can be worthwhile to use a registerable caveat. Definitely one for legal advice, but essentially all the paperwork to lodge a caveat is drawn up and signed, but not actually lodged. The lender, however, can immediately lodge it if there's any whiff of trouble. This gives you the freedom you need to refinance if that's part of your strategy, but can still be used to protect the lender if things are going wrong.
Personal Guarantee
Personal Guarantees are common in the area of private finance, when you already have more traditional lending for the first and perhaps second mortgage, but still need equity to pay a deposit or fund the process of getting a Development Approval.
In effect, you guarantee the lender's funds from your own personal assets. The reason a lender likes to have this is because the risk of the property being sold and not returning enough capital to pay out the first mortgage, second mortgage and also the private lender is high. So they want to know they can get paid back their capital from another source.And although private lenders have been using them for a while, they're becoming much more common in the realm of standard mortgages too. If you're using an entity for a property development purchase, you've most likely signed a director's guarantee, which is very similar, as it allows the lender to liquefy your personal assets as a director if selling the property results in a shortfall.
Unsecured
Now we're into threadbare rag territory! The word "unsecured" says it all really - there's no specific security offered. Having said that, in the world of property development that's not always true.
It depends on how your deal and your finance are structured. There are instances where the security you're offering is the deal itself.
Let me explain. You've brought in a private lender to get a deal underway, but then you fall under a bus and you're out of the picture. Depending on the paperwork, the lender can then "take over" the deal and see it through, keeping all the profit at completion. It's an unusual scenario, but if the deal is a good one, it can be a lot more secure than the name "unsecured" makes it sound!
Be warned though - there are predatory lenders who specialise in this type of deal, who have been known to apply the thumbscrews at any opportunity in the hope of squeezing you out of the deal. They then take it over and bank all the profits themselves. I know I've said it before, but here it is again - LAWYER!!
The other thing to keep in mind, along with how appropriate each type of security is for your financial needs, is that risk equals return. As the security blanket gets thinner and thinner, the lender is going to expect higher returns. After all, they need to run their heater more to keep warm - a threadbare rag just doesn't cut it!
And remember, finance is a hugely important part of every property development deal, so make sure you speak with your team of professionals, particularly your lawyer, to make certain you fully understand which security is most appropriate, and what exactly you're agreeing to do when you sign off on any finance paperwork.
