# High Risk (of loss) and High Yield



## Investor (21 May 2005)

In The Age newspaper today, a timely warning. The next property downturn (it has started) is the third that I have seen during my career (previously in the banking industry; now as a full time investor). 

*Thousands invest believing wrongly that property is safe, writes Anne Lampe.*

A decade and a half ago, Macquarie Bank high-flyer Bill Moss was called in to help sort through the twisted wreckage of the Estate Mortgage Trust. Along with the Pyramid Building Society, thousands of investors lost their life savings after putting their money into what they thought was rock-solid real estate.

He remembers it as a scary, heartbreaking and sobering experience. Estate Mortgage advertised itself as "better than a bank", offering high-yield securities of 17.5 per cent with an advertising blitz that featured prominent radio personalities.

In the past 12 months, a range of property companies have once again launched huge marketing campaigns, with promises of guaranteed yields of 9 per cent - almost twice that available on term deposits. "One of my great sayings in the property markets is that people forget risk," Moss says.

"Ultimately, when you have a long cycle, people just assume if you buy real estate you will make money; if you develop real estate you will make more money. And people forget that the driving criteria for real estate is supply and demand, and location, location, location. If you do a wrong project, you will lose money."

Moss is the head of Macquarie Bank's banking and property division, and he fears that time has dimmed investors' memories, which have been overtaken by one of the biggest residential property booms in Australian history. He also believes the market conditions now are similar to those he witnessed in the late 1980s.

The property boom has well and truly cooled. *Prices for residential real estate, particularly units, has weakened significantly during this year and auction clearance rates have struggled to get above 50 per cent.* With the long time lags associated with property development, money raised during a boom may evaporate if the development is completed after a significant downturn.

In recent years, money has been pouring into property-based debenture and finance companies offering a range of high-interest securities.

Earlier this year, the Australian Securities and Investments Commission estimated that as much as $1.8 billion had been raised.

*ASIC was concerned enough to issue a blunt warning to would-be investors. "High-yield debentures are typically a risky investment, and there is no guarantee that investors will get their money back," ASIC said.*

Concerned with the aggressive advertising used by some companies, it highlighted the emotive language employed to lure cash.

"These advertisements played on many older people's need for a fixed, secure income, and used words like secure or secured," ASIC's fixed-interest report stated.

At the moment, there are 12 companies advertising for funds. One promoter boasts that he is attracting $10 million a month in new funds, in response to a high-profile $2 million advertising campaign last financial year.

Many of the ads feature laughing retirees, often frolicking with grandchildren and entertaining friends and family. They push the line that the investments are high fixed-interest securities, and talk about investors who can "sleep soundly", who make "sound investments", and invest with "certainty".

One company, Fincorp Investments, reassures potential investors they can earn a 9.75 per cent return per annum and "invest with certainty".

The ad continues: "Prudent investors . . . want a strong measure of security so they can sleep soundly at night."

But Fincorp's executive director, Jeff Organ, confirms that, despite this advertising message, neither the interest payment nor the original investment are guaranteed.

*According to Moss, most investors who are attracted by fixed interest rates of up to 9.95 per cent for first franking notes, and up to 10.25 per cent for unsecured notes, simply don't know exactly what they are investing in.*

If the investment vehicle invests in established buildings that have tenants providing a regular income, then the risk factor is low. But it is the vehicles that invest in development projects that really concern him.

Some sites don't even have development approval, and may have been valued some time last year, during the height of the boom, on a completion basis some time next year.

*"We've been saying for two years that residential real estate prices are going to fall, and particularly that development sites are going to fall," Moss said.*

"And the reason that is easy to predict is that the development site value either gets multiplied up or multiplied down by a movement in the property market. Quite often you get a 10 per cent drop in resale values and the development site might drop 50 per cent.

"So development sites, by their very nature, are risky, particularly when they don't have DAs approved and they don't have pre-sales."

Moss claims that from a prudent investment perspective, lenders should be very careful financing a development site that is unzoned or not approved for development.

"When the market is trending down, you naturally know that land values and development sites will trend down much quicker than the market."

*Moss estimates that in Sydney, site values have come down by between 30 and 40 per cent from their boom highs. That means that people who bought sites two years ago, at the height of the market, paid a premium for them, in many cases because they thought the market would rise.*

"Site values have dropped and the scary thing is that a lot of the funds today that are out there have been working the valuations in the information memorandum on the basis that they will lend 70 per cent or 66 per cent of project value."

In one case it is 85 per cent.

There is no provision for unlisted property trusts or property companies to disclose a change in values.

"In many cases I am sure the dividends are still being paid by the new deposits being taken," Moss says.

ASIC has turned the spotlight on the industry and has observed that some investment vehicles have revalued their pool of assets, doubling or even tripling the value of property purchased just months earlier. In a number of cases, the only apparent reason for the revaluation was that they had gained development approval.

The corporate regulator then insisted that promoters include in their prospectuses more details of the projects underpinning the securities.

One site - at Millar Road, Chester Hill - which is owned by Australian Capital Reserve, was purchased in June 2002 for $13.3 million. Its most recent valuation was December 2002, when it carried a $30 million value. There is a first mortgage on the property and a loan balance of $25.5 million, substantially more than the $13.3 million purchase price.

The information memorandum says the property is to be completed by the end of next month. ACR director Samuel Pogson says the master plan was endorsed by Bankstown City Council, that construction of roads will take a few months and the project is behind the June completion deadline.

But, he adds, the company is in negotiations to sell the site and hopes to exchange by the deadline. The site, he says, was purchased at "a very good price" based on its value at the time in December 2002.

Peter Phippen, chief valuer at Abbotts Valuers, which carries out most of ACR's valuations, acknowledges that some of his valuations were done up to two years ago, when the market for residential development projects was stronger.

"We don't predict the future but we have to take into consideration the present market, and the valuation of a development site assumes that the potential development is there on that day."

Phippen agrees that quite often properties sell for prices substantially less than the estimated value, based on the potential at the time.

"A valuation is good on the day it is prepared and if the market goes up or down later, and if we had to do a revaluation, it would change," Phippen says.

"And in the last 12 months, most times we have had to review things, they have come down."

But equally, Phippen says, development sites receive approvals allowing for a greater number of units on the site than initially allowed for because architects and planners have been able to negotiate with councils to get substantially more. In such cases the value goes up.

But investors have no way of checking if the valuation reflects current market conditions.

If the valuation was done at the peak of the boom and the market has since retreated, it may bear no relationship to what the site would fetch in the current market.

Unlike listed property trusts, where regulation is strong - boards must hold annual meetings, report to the stock exchange and circulate all available information to shareholders or unit holders - the unlisted privately run development vehicles have no such safeguards.


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## Investor (21 May 2005)

Also in The Age today:

High risk on the high-rise
By Anne Lampe
May 21, 2005

Property finance companies, often described as mezzanine finance companies, take investors' money at one rate of interest and relend it to developers at a higher rate.

In its report on the industry, ASIC says: "In many cases, the debenture issuers that ASIC examined, lent money to property developers on a capitalised interest or pre-paid interest basis.

"In these circumstances, there is no flow back of cash from the developer to the debenture issuer until the development is completed. In the meantime, investors in these debentures are paid only from the cash raised from other investors.

"This is high-risk finance that can be sustained only if the development is completed successfully."

Any profits made on the developments go not to the investors who are exposed to risk, but to the developers.

It's a sweet deal for the developers. Normally, banks would impose stringent lending requirements, constant valuations and demand security and personal guarantees from directors.

But with this type of financing, the small investors take all the risk and often remain in the dark.

If things don't go well, if the property market softens and construction is delayed, if residential sales are soft, or prices fall or the developer is unable to complete the project or repay the loan or fails to receive development approval, the risk factor can reach dangerous levels. Most of the companies are paying investors between 6 and 9.95 per cent, depending on the length of the loan.

Unsecured notes attract a half a percentage point premium to debentures or first ranking notes to compensate for higher risk. Often there is a penalty for early withdrawal of funds.

*You don't have to look far to see the warning signals. In recent weeks, listed property developers have issued profit warnings as market conditions deteriorate.*

Given that unsecured investors stand last in line, there is no recourse if available assets are sold and used to satisfy first mortgagees.

*John Wakefield, the managing director of property market researcher Commercial Property Monitors, said the median price of home units sold at auction in Sydney during April dropped by 9 per cent and in March it was 4 per cent. He expects to see a 10-15 per cent price decline in the home unit market in Sydney this year.*

"The underlying worth of a development site is its development potential," Wakefield said. "The intrinsic value that is put on pure land value is its best and highest use and there is a certain assumption that there is a linear progression that goes upwards and onwards. And that is the problem here."

*He says the market has been hit by oversupply, scandal involving off-the-plan purchases with deposit bonds and a dramatic drop in the level of borrowing by purchasers of investment properties.*

While 9.5 per cent looks attractive, there are plenty of other assets, like listed property trusts, that have slightly lower returns but much less risk.

"The argument would be that I think you would need a higher return than 9.5 per cent to justify taking the higher risk."

In response to ASIC's requests, promoters were required to identify any related party developments and more information on investment risks and revaluations.

Fincorp's latest information memorandum details almost $7 million in loans to companies associated with Clinton Krecichwost, the company's managing director, at zero interest.

Jeff Organ, the Fincorp executive director, says that on a consolidated basis, all loan entities are netted out and no loans to related parties of Krecichwost will remain.

Australian Capital Reserve's documents show that a Waterloo development valued at $48.25 million in May 2003 was revalued 11 months later at $120 million. ACR director Samuel Pogson says: "Approval for the Waterloo development has not yet been obtained but we believe it to be in the not too far distant future."

ACR, he says, has more than $30 million in the bank and has never missed a payment to investors since its inception in 1999.

Having forced promoters to provide more information to investors, ASIC feels it cannot do much more. It is up to investors to read the prospectus, evaluate the information and make an informed decision about the risks.

But most property experts who read the prospectuses are left asking more questions than are answered.


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## DTM (21 May 2005)

Great articles Investor.  I'm finding out a lot of information thanks to all your posts.  

I'm sure that I speak on behalf of a lot of people here when I say that your sharing of your knowledge is greatly appreciated and valued.

Thanks again.


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## tech/a (22 May 2005)

Investor.

As both an Investor and Developer (Smaller Subdivisions and Apartments) this is a sobering warning to those who are not "In the Trenches".

The expectation that every developement is going to be a winner and occupancy rates and return on $$s invested is a given----- is fraught with dangers.

Placing all your savings as a retiree into an area you know little about ----- other than the colored brouchures and video---is plain crazy.

*If you cant CONTROL it DONT DO IT!!*


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## Investor (22 May 2005)

DTM said:
			
		

> ....Thanks..




No problem. Wait till I have warmed up, then I might post at a faster pace


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## Aden_1 (25 May 2005)

I fell victum to property


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## tech/a (25 May 2005)

*ADEN*

I'd be interested in your story and what youd do/have done differently.


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## moses (31 May 2007)

de ja vue


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## tech/a (31 May 2007)

2 yrs later and the dreaded Housing downturn is STILL happening.

Got a call from a mate yesterday.

"Kathy's, house went for auction on Saturday. Agent valued it at High $300ks,so we expected around that. 20 mins prior to Auction a CASH buyer offered $405K----Although Agent was really keen for Kath to take it she proceeded to Auction."

"What did it go for?"

*$507,000*

Yep Its tough!


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