Know, Like and Trust – don’t let it distract prudent investing …
With recent defaults in property development, now would be a good time for investors to draw lessons and refresh their notes around due diligence.
When I read stories of investors impacted by default, a recurring theme is often one of surprise. Surprise that the developer was known, liked and trusted. Perhaps a family business which had operated for many years with the owners apparently demonstrating trust, credibility and expertise – particularly in their local area. They might have talked well, were friendly and appeared professional.
I caution investors to avoid associating “likeability” with “investability”. They are two different concepts and the former should not necessarily be seen as enabling the latter. If you found both did exist, the next logical step might be to consider investing in a specific deal. At that point investors should move into full deal-DD mode. More on DD later but the key message here is that passive investors should, at the outset, treat the three concepts of likeability, investability and deal-DD as separate things. Linking the three could result in negative outcomes for the investor.
Human brains are hard-wired to buy from people they know, like and trust (KLT). The psychologist Robert Cialdini, author of the seminal book Influence said we are more inclined to be influenced by people we like and trust. If we like someone we are more likely to do what they ask.
Zig Ziglar wrote, “If people like you they’ll listen to you, but if they trust you they’ll do business with you.”
Seth Godin stated, “People do not buy goods & services. They buy relations, stories & magic.”
Established businesses know the power of creating KLT – it’s often deeply embedded into their marketing tactics. As consumers, we become sold because human instinct kicks in.
We can all relate to this. We stay loyal to our hairdresser, car mechanic, dentist, optician, conveyancer etc. They may not necessarily be the best choice but at least we know and trust them. With such examples there would probably be limited downside in making the wrong choice. When it comes to investing, however, there’s less logic in needing to KLT someone. Moreover, there is usually greater downside in making the wrong decision.
Diversification is one obvious consideration. Any investment portfolio should be diversified across various asset classes and providers to mitigate risks. Staying loyal to a provider because of KLT reduces the benefits of diversification. In the property-backed loans space, a provider can mean a property developer, a promoter or a P2P platform.
The second reason to be mindful of KLT in influencing your investment decisions is related to “Behavioural Finance”. This is a fascinating branch of economics which explores how and why investors make decisions. In theory, we should all make investment decisions based on rational considerations around risk and return. Behavioural Finance reminds us that, in reality, we are not rational and that results in biases and errors.
There are several strands of behavioural finance but three are relevant to this topic: 1) Confirmation Bias, 2) Narrative Fallacy and 3) Framing Bias.
- Confirmation Bias is the tendency of people to pay close attention to information that confirms their belief and ignore information that contradicts it. If a developer, borrower or promoter interacted in a likeable or trustworthy way, that would create a powerful impression. Thereafter, an investor might be pre-disposed to favouring an investment opportunity and ignore red flags, instead focusing on evidence that supported their initial positive impression.
- Narrative Fallacy. One of the limits in our ability to evaluate information objectively is what’s called the narrative fallacy. We love stories and we tend to let our preference for a good story cloud the facts and our ability to make rational decisions. This might result in being drawn towards a sub-optimal outcome. We’re all hard-wired to love stories. Wealth Managers had taken advantage of the narrative fallacy for years, convincing clients to invest in a stock or fund by telling them a great story about the company or the fund manager. Remember Neil Woodford? Stories for marketing are rife across different business sectors, property development included.
- Framing Bias occurs when people make a decision based on the way the information is presented, as opposed to just the facts themselves. The same facts presented in two different ways can lead to people making different judgments or decisions.
How an investment is “framed” can cause investors to change their conclusions about whether the investment is good or bad. We should always remember that any developer or promoter looking to raise capital is really undertaking a sales campaign. As such, an opportunity will be presented in the best light. As investors, being the “buyer”, it’s our responsibility to uncover – or test – any negative aspects of the opportunity. Just like we would for any other buying process.
So investors should at least be aware of KLT which, given the biases mentioned above, could result in making inadvertent errors in your investment decisions. Always remember, it’s your money for your future. Invest with YOUR objectives in mind. The seller’s objectives won’t be the same as yours.
The above provides a starting point for investors to separate KLT from the investment decision-making process. Below, we’ll discuss the next stage: the evaluation (DD) of a typical passive investment opportunity in a property / development deal.
Readers can also download a free interactive DD checklist to help evaluate property-backed deals. The checklist can be downloaded from www.InvestLikeAPro.co.uk.
Security and Valuation
The first step is to evaluate the quality of any security you’re getting. That means knowing the seniority of it. In descending order of seniority and ranking, security ranges from First fixed charge (on a specified property), Second fixed charge (mezzanine), Debenture over an entity that owns a property, Personal Guarantees from the borrower through to unsecured debt, and finally equity. Effectively (and generally), if you are below the Second fixed charge ranking, you’ll usually find that your security backing is very light – particularly if there are senior lenders above you who will take priority in a repayment.
The other aspect of evaluating the security is the quality of the property that defines it. The quicker this property is “sellable” (buyer demand) will equate to how liquid it is. A highly liquid property like a vanilla 3-bed house in a popular location is considered to be strong security. Examples of less liquid properties include undeveloped land, a half-finished site, unaffordably priced properties, properties that might struggle to refinance, or even a completed (but large-scale) block of flats that might take a while to sell.
Apart from the quality of the security, one must also look at its quantity. This brings up the loan-to-value (LTV). There are different versions of LTV but the common lending limits for established lenders is a day-one LTV (70%) or Loan-to-Costs (70%) and Loan-to-GDV of 65%. Take care to ensure the “V” used in the LTV can be verified using a reliable and recent RICS valuation that you have also sense-checked .
A word of caution here. First charge security is not automatically failsafe. If anyone tells you first charge deals cannot go wrong, they probably don’t understand lending. One must also consider the various other factors such as LTVs, liquidity, exit strategy, profitability and cashflow of the project. Also, stress-test scenarios, as described below.
Assess how realistic or viable is Plan-A for the exit strategy. Might there be exits B, C or D? If so how realistic and viable are they? Can all the end-units be easily absorbed upon sale? Are they attractively priced and affordable for the target market? Assess exit timeframes and safety of exits.
If the exit will be a refinance, how viable is that? Will lenders have appetite to refinance this scheme or the finished units? If so, will the lender’s loan advance (assuming an LTV) cover existing investor capital plus interest?
Who are you dealing with? Assess the borrower’s track record – both duration and relevance – and their ability to execute to plan.
Get under the hood of the deal. Look at the project profitability. Cross-check the expected GDV, costs and timeframes independently. Conduct stress tests and sensitivity analysis to understand how the deal might look in less favourable times – eg assuming a market drop and/or cost escalation, with the latter being highly problematic for developers right now.
Risk v Return
Compare other deals in the market. Are you being paid a fair return for the risk profile you’re taking on? For example, on a stand-alone basis, a promised return of 8% pa sounds attractive compared to the return on cash in the bank. But if that opportunity provides a junior form of security, a fair return would be more like 15-20% pa.
Despite recent defaults, Secured Loans is an attractive asset class providing good returns with asset-backed security. Along with equities and property, secured loans remain an important part of my own portfolio, helping to generate consistent long term returns to outperform inflation.
To maintain this consistency and mitigate risks, one needs to be careful on selecting loans. That involves identifying biases and separating those from deal-specific DD which must be done without being influenced by KLT.