How CFOs Can Increase Profits up to 8% p.a. With This Simple Trick

Many businesses throw off regular weekly, monthly or quarterly cashflow. Sometimes this is often well in excess of the firm's liabilities for the corresponding period. Typical examples of this would include a commercial property company but this could apply to any company, including manufacturers and tech businesses.

However, when the company receives this cash on a granular level (for example on a monthly basis), often the amounts involved are too small to reinvest in any meaningful way. It may take up to 2-3 years of cash generation to be able to make another meaningful investment (plant/machinery, corporate acquisition etc) with that cash (usually then combined with borrowing).

So what do companies do with that cashflow at present? Leave it in the bank and earn nothing? Otherwise, they can return it to shareholders as dividends but only usually a few times per year, and not every shareholder wants dividends. So CFOs - I have a solution for you: Property Development Lending.

I was introduced to this neat trick by another family office investor, who regularly co-invests in development loans with our families. In fact he prefers development lending to bridge lending, which is against the grain amongst most investors in private real estate debt. This seemed really unusual, but then it dawned on me... he viewed development lending like investing in a property bridge loan, but in instalments.

He was using the cash his businesses threw off to fund the development drawdowns, which otherwise would have sat idle in the bank. And it's not hard to see why he used that strategy.

The table below shows how a ￡1.4m loan, made at 8% over 12 months in regular instalments can generate an 8.5% IRR and a cash return on commitment of almost 5%.

However, Fig 1 above doesn't take into account a likely sales tail of up to 3 months, as in practice completed property developments need a few months to sell after completion (nor interest earned on interest retentions either). When a full 3 months of further interest is added in the "sales tail", the total cash return on commitment of that year's cashflow rises to just under 7%. This total return would grow in excess of 8% if the sales element of the facility is a few months longer.

Per Fig. 2 above, some family office real estate private debt investors invest cashflow from other businesses into development loans like the one above in Bristol

So what about the downsides? Development lending is not without risk, so you need an operational lending partner that knows how to underwrite loans. That means your origination and underwriting partner:

• Understanding the borrower and their experience; and
• Understanding the likely time and costs to complete (including a juicy buffer for contingency); and
• Confidence in the market value of the finished product (GDV).
• Knowing the likely sales velocity. For example a large high-value house may take longer to sell than a multi-unit scheme of apartments targeted at the lower end of the market because there are more buyers for the latter than the former. That will have a bearing on the length of the loan term.

However, so long as you are not lending more than 70% of the GDV (including interest and fees) then you should be ok, so long as your loan originator deals with the key points listed above. This should give you sufficient buffer if the market turns or there is a cost overrun on the project that the lenders have to fund (this is generally dealt with by way of a cost overrun guarantee provided by the directors of the developer).

Are there any other complications? Potentially, yes - if your company is subject to a loan agreement secured against the company's assets by way of a debenture or legal charge, you may be required to seek your lender's consent before lending the company's money. There may need to be a reasonable arbitrage between the company's cost of borrowing and the level of return it may want to receive from lending activities, otherwise the company may be better off paying down debt instead.

From a regulatory standpoint, companies lending against property development carried out by an incorporated developer is not regulated currently in the UK. If lending to an individual developer in their personal name, there are regulatory issues that arise if the developer plans to reside at the property on completion. All UK lending entities currently need to do is register with the FCA under their MLRO scheme and register with the Information Commissioner's Office, both of which are simple processes and do not have significant costs.

Alternative methods of investing in property development debt exist if direct lending does not suit (please contact the author for more information).

You may be wondering why I'm telling company CFOs and Finance Directors (as well as large commercial property investors) this secret? The main reason is that UK SME residential developers lack funding options at all levels and in the UK we have a housing crisis of historic proportions. Today's SME developers are the volume house builders of tomorrow.

We at Avamore are passionate about getting Britain building and providing more people more homes. Whether your company wants to collaborate with us and co-invest with our families or not, we are keen to spread the message of opportunity that exists in development lending and seeing more homes built.

Michael Dean is Co-founder of Avamore Capital and is an experienced finance professional and property investor. To discuss any aspects of this article please email [email protected]

Please note this article is for information purposes only and the author provides no warranty for any of its contents, nor accepts no liability for any loss arising from reliance on any of the aspects of the content of the article