When it comes to developing or investing in property, if you've spent some time educating yourself, then you've probably heard that you should ALWAYS avoid cross-collateralizing your loans.
While in theory that sounds great, most of us live in the real world. Rainbow unicorns farting perfume sound awesome too, and we'd all love one as a pet, but our usual reality options are a cat or a dog.
Does cross-collateralization deserve its bad reputation when it comes to funding for property developments? Are there times when it's a good thing to do? Or are the experienced Property Investors and Developers right?
So What is Cross-Collateralization?
Let's start by being clear what I mean when I'm talking about cross-collateralizing your loans. Essentially, it means that you have multiple loans with one financial institution. Cross-collateralisation in property development finance involves using multiple properties as security for one or more loans.
This can be set up in a number of different ways. The most common version is where you have one large loan facility, with two or more properties used as collateral. Sometimes they're held in separate loan accounts, with one for each property to make bookkeeping easier, but it's still one facility with multiple properties as collateral.
What about if you have loans for multiple properties with one financial institution, but they're all separate loans with one property as collateral for each one? Think you've escaped cross-collateralization?
Wrong! If you delve into the extremely fine print of your mortgage documents, you will inevitably find an "All Monies Clause". This nasty little sleeper clause basically means that in the event something goes wrong, the bank has the ability to sell ANY property you have mortgaged to them - not necessarily the one with the problem.
And guess what - they're not going to choose the half-built property development that's causing issues. They'll choose your family home, or that nice townhouse which has had massive capital growth and is currently cashflow positive. In other words, they'll sell the property you would rather keep. This highlights the importance of understanding risk in property development finance structures.
The Real World
Okay, so now you know best practice in terms of limiting risk is to finance each investment property or property development with a different bank so it can stand alone, and avoid cross-collateralization.
And here's where reality kicks in - when you're starting out, that can be really hard. Maybe you're in the fortunate position of having plenty of equity and serviceability and financial institutions are desperate to give you money hand over fist for property development projects.
But most of us aren't in that situation early in our Property Developer careers. Which means that sometimes, pooling the available equity from a couple of properties rather than trying to keep them separate may be the difference between funding the project yourself and needing to find a money partner. Using equity across multiple properties is a common approach in early-stage property development funding.
So even though cross-collateralization isn't the preferred option, if you're using it to fund a property development where the end game is to sell all the new properties you've created, then it may be a good strategy to use, knowing it's only short-term.
Tax Minimisation vs Asset Protection
I've already mentioned that your needs starting out can be different to later in your Property Developer journey, and the constant juggle between minimising your tax obligations and protecting your assets is one thing that changes substantially as you progress.
Early on, chances are you're not going to be in a position to hold the properties you develop, and so your focus is understandably going to be on minimising tax.
Once you reach the point of being able to hold some properties, asset protection rapidly starts to become important. That tipping point is different for everyone, but once you reach it, the risk of cross-collateralizing loans starts to increase rapidly. At the very least you need to make sure the properties you're holding are financed separately to any projects in progress.
If you're interested in learning how development finance works, our free 7 Step Development FORMULA course explains key concepts like funding structures, risk management and feasibility in simple terms.
Now let's answer the question, is cross-collateralization friend or foe for funding property development?
While the answer is generally foe, in reality there are times, particularly early on in your journey, when it can actually be your friend. So while it's mostly a good idea to avoid it if you can, if using it is the difference between doing a development deal or not, then sit down and think seriously about the risks involved, and whether they're at an acceptable level or not. Because sometimes you might just find cross-collateralization is very definitely your friend for financing property development.
And as always…talk to your trusted advisors, they’ll know your situation best and can provide additional advice to ensure you don’t become unstuck!
The bottom line….I still want a rainbow unicorn!
While in theory that sounds great, most of us live in the real world. Rainbow unicorns farting perfume sound awesome too, and we'd all love one as a pet, but our usual reality options are a cat or a dog.
Does cross-collateralization deserve its bad reputation when it comes to funding for property developments? Are there times when it's a good thing to do? Or are the experienced Property Investors and Developers right?
So What is Cross-Collateralization?
Let's start by being clear what I mean when I'm talking about cross-collateralizing your loans. Essentially, it means that you have multiple loans with one financial institution. Cross-collateralisation in property development finance involves using multiple properties as security for one or more loans.
This can be set up in a number of different ways. The most common version is where you have one large loan facility, with two or more properties used as collateral. Sometimes they're held in separate loan accounts, with one for each property to make bookkeeping easier, but it's still one facility with multiple properties as collateral.
What about if you have loans for multiple properties with one financial institution, but they're all separate loans with one property as collateral for each one? Think you've escaped cross-collateralization?
Wrong! If you delve into the extremely fine print of your mortgage documents, you will inevitably find an "All Monies Clause". This nasty little sleeper clause basically means that in the event something goes wrong, the bank has the ability to sell ANY property you have mortgaged to them - not necessarily the one with the problem.
And guess what - they're not going to choose the half-built property development that's causing issues. They'll choose your family home, or that nice townhouse which has had massive capital growth and is currently cashflow positive. In other words, they'll sell the property you would rather keep. This highlights the importance of understanding risk in property development finance structures.
The Real World
Okay, so now you know best practice in terms of limiting risk is to finance each investment property or property development with a different bank so it can stand alone, and avoid cross-collateralization.
And here's where reality kicks in - when you're starting out, that can be really hard. Maybe you're in the fortunate position of having plenty of equity and serviceability and financial institutions are desperate to give you money hand over fist for property development projects.
But most of us aren't in that situation early in our Property Developer careers. Which means that sometimes, pooling the available equity from a couple of properties rather than trying to keep them separate may be the difference between funding the project yourself and needing to find a money partner. Using equity across multiple properties is a common approach in early-stage property development funding.
So even though cross-collateralization isn't the preferred option, if you're using it to fund a property development where the end game is to sell all the new properties you've created, then it may be a good strategy to use, knowing it's only short-term.
Tax Minimisation vs Asset Protection
I've already mentioned that your needs starting out can be different to later in your Property Developer journey, and the constant juggle between minimising your tax obligations and protecting your assets is one thing that changes substantially as you progress.
Early on, chances are you're not going to be in a position to hold the properties you develop, and so your focus is understandably going to be on minimising tax.
Once you reach the point of being able to hold some properties, asset protection rapidly starts to become important. That tipping point is different for everyone, but once you reach it, the risk of cross-collateralizing loans starts to increase rapidly. At the very least you need to make sure the properties you're holding are financed separately to any projects in progress.
If you're interested in learning how development finance works, our free 7 Step Development FORMULA course explains key concepts like funding structures, risk management and feasibility in simple terms.
Now let's answer the question, is cross-collateralization friend or foe for funding property development?
While the answer is generally foe, in reality there are times, particularly early on in your journey, when it can actually be your friend. So while it's mostly a good idea to avoid it if you can, if using it is the difference between doing a development deal or not, then sit down and think seriously about the risks involved, and whether they're at an acceptable level or not. Because sometimes you might just find cross-collateralization is very definitely your friend for financing property development.
And as always…talk to your trusted advisors, they’ll know your situation best and can provide additional advice to ensure you don’t become unstuck!
The bottom line….I still want a rainbow unicorn!
