Professional Service tailored to your financial needs.
Private Debt Is a Bridge; Not a Life-Support Machine
Expensive short-term private debt must lead to a defined, profitable exit.
One might also say it is … an expensive, short taxi ride to the airport is justified—but only when the flight is booked and the destination is clear…
How high-cost private debt impacts your investment
Higher interest rates and fees associated with private mortgage debt can hit a property investment three ways:
● Loan servicing obligation increases stress on cash flow with monthly servicing.
● Higher cost of debt can erode the equity in the security property, especially if capitalised and prepaid, making the debt more difficult to refinance at the end of the usually 12-month loan term.
● Reduces the financial return from the security property where it is an investment property vis-à-vis fixed rental return. An investment property’s financial viability is limited by its net rental income.
Private mortgage debt can be an excellent tool to accelerate commencement of a profitable project when compared with the extended haemorrhaging of holding costs and delayed realisation of project profit due to months of inactivity while the applicant for finance is made to jump through hoops and is put through a series of wringers by the big banks—picture the hand-cranked clothes wringers atop your great-grandmother’s washing machine!
Borrowers who don’t qualify for traditional bank finance often turn to private mortgage debt; the risk is that they dig themselves into a deeper hole than they are in already.
Unless there is a clear and defined exit, private mortgage debt can be a trap from which the only escape could be a forced mortgagee sale.
But that does not have to be the case. If private mortgage debt is utilised correctly in the circumstances, it can be a way to “bank” an “un-bankable” project, whether it is a construction-for-sale project, a refurbishment and re-letting project, or a wealth-creating land subdivision.
Borrow for purpose.
Price the risk.
Protect the equity.
Identify the exit before drawing the money.
The essential exit strategies
The essential criteria, however, must include a defined way out, whether by way of:
a. On-sale
On-sale of the completed project for a profit; or
b. Refinance
Refinance with a tier-1 or tier-2 commercial investment loan at a lower rate of interest once the refurbishment works have been completed and new lease agreements secure higher rental incomes, which both add value to the property.
In the case of a, private mortgage debt is the bridge to the end profit; in the case of b, it is an expensive taxi ride to the airport.
Private mortgage debt should really only be utilised to fund a value-creating milestone; that is, a transaction to a genuine profitable sale or feasible and sustainable investment refinance. Ideal circumstances include a comfortable level of pre-sales and/or Agreements-for-Lease, both of which provide certainty as to final outcome.
When to avoid expensive private debt
Expensive private mortgage debt should be avoided where, for example:
● income does not adequately meet the higher interest costs;
● capitalised, prepaid interest erodes equity in the security property such that a refinance is no longer possible due to an excessively high lender exposure or loan-to-value ratio;
● there is a serious likelihood of unmitigated market risk at the end of the project—that is, the target sales price required to clear the debt cannot be achieved; or
● the strategy is to wait and see what happens and hope that values recover.
A proposed or anticipated refinance is not an exit unless the future income, valuation and LVR genuinely support it; likewise, conforming pre-sales provide the comforting proverbial bird in the hand.
A caveat on the preceding paragraph: a project’s practical completion is no guarantee of debt repayment. A project must be properly completed, comply with approvals and consents, and be free of defects so that sales, leasing or refinancing can discharge the private mortgage debt as quickly as possible.
LINK Commercial Mortgages specialises in commercial-industrial property investment finance as well as development and construction finance across all four tiers of the credit market.
Should you require expert guidance and assistance with investment finance or project finance, get in touch to find out more about senior debt, mezzanine funding and equity assistance that may be available.
