Just over a year ago, an unusual opportunity arose. A friend asked if I might be up for lending his small property development company some money. I ended up going ahead with it. What happened? What lessons can I learn? I’ll share the former, hoping my readers can help me with the latter.
Who was the borrower?
The loan was to a small private company doing real estate development. Basically they buy buildings in London where they believe they can get planning permission to increase the number of dwellings; they then maximise the planning potential of the buildings, do the work themselves, and sell on the units. They’ve got a few years’ successful track record.
I have known the three principals for over twenty years; one of them is a very close friend of mine, admittedly one who has radically different approaches to FIRE/money/investing.
What were the terms?
I reached agreement as follows:
- the loan to come out of my Ltd company
- 1% arrangement fee, added to the loan, and repayable at the end.
- interest of 1% per month for the first 12 months, and 1.5% per month thereafter
- half the interest to be payable in cash, monthly; the other half to be paid off at the end with the principal.
- all the principal to repaid at the end of the loan
- no fixed term – the timing of repayment to be at the borrower’s discretion
- security: a second charge against one of their properties. This wasn’t documented properly.
The agreement was written up (in not a lot more detail/length than the list above) and signed by both parties.
My thinking here was that I would probably either receive my money back quite fast – within 2-3 months, or around month 12. If within 2-3 months then this was a lot of work for very little return; in this scenario the arrangement fee of 1% would be a material improvement in my IRR – potentially almost doubling the return to 20%+ p.a. If however I was repaid after 12 months then I was looking at an IRR of around 14%. Any later and my IRR would improve up to around 20%, if I got my money back at all.
What happened next?
After the borrower drew down the loan, I found myself almost immediately regretting providing it.
To explain a bit more of my reasoning; part of why I wanted monthly interest payments was to provide a ‘heartbeat’ pulse which I could use to reassure myself the loan was being serviced properly. The contract stipulated the exact dates of the month these payments were due – the same every month.
In fact what happened was all of the first 3-4 payments due needed to be chased. The borrower wasn’t the most organised and they did all the payments manually. At some point I flipped my lid – with my close friend and his boss – and actually at that point they very quickly fixed the situation by setting up a standing order.
Peace then reigned until about month 11. At that point I enquired about when I might get my money back. No plans were imminent. I reminded them that the interest rate was about to spike up to close to 20% – knowing that they regarded 12% as ‘cheap’ money and 20% as ‘expensive’ money – and, sure enough, suddenly they got their skates on.
The next thing I know is that their finance department takes over the operational side and emails me a draft spreadsheet detailing his calculation of the final sum due. I built my own spreadsheet and quickly saw that they were significantly off – due to basic incompetence. I sent them my spreadsheet; they quickly reverted to me accepting my calculations, and I duly received all the money outstanding at the end of month twelve.
All in all I made about £6.5k, gross, on a £50k loan. In effect this loan was borrowed on margin, at a cost of about 2% (i.e. £1k). So I made a profit of about £5.5k pre-tax. As this was in my Ltd company the tax rate will be about 20% and I will retain about £4.5k.
What did it feel like?
For me the enlightening thing about this whole exercise was the emotions it triggered at the time.
Though I never seriously doubted I would get my money back, I found the comparison with equity investing instructive.
When I make equity investments I know I am taking on risk. I know there is a chance – a very real chance in the case of private companies and even with small-caps – that I lose 50%+ of my money.
By contrast, with a loan I run a risk of default. I thought of this risk as a small probability that I lost the vast majority of the loan.
I realised as I contemplated the prospect of loss that by far the biggest downside I faced was the damage it would do to my relationship with three friends. I think there is a very simple and clear strategy I could endorse, based on these learnings, which is: “never lend money to friends/family”.
On the other hand, my ability to judge the risk and manage my exposure was far greater because I knew the borrower well. As well as knowing the three principals well, I know several of the equity investors who have backed the business. I am, separately, a small equity investor myself, so I receive periodic shareholder information. And my ability to make things happen can be done with a WhatsApp message, or over a beer, and didn’t require a formal letter. So in fact the relationship I had with the borrower made this loan a lower risk, more attractive opportunity than some anonymous small company loan on FundingCircle/etc. So there is another strategy I think that makes sense which is: “what’s business is business, and mustn’t interfere with my personal life – i.e. provided I can maintain separation between the two then proceed, with suitable caution”.
The other thing I found very frustrating was that the work/energy required to monitor those first few payments felt very disproportionate to the return I was making. With hindsight, I think I was over-reacting a bit here. I think my logic for wanting a standing order set up was correct. But the actual time spend managing the relationship didn’t in truth amount to more than a day or two of my time, over the whole term of the loan, and I think this effort was appropriately rewarded with the return I made on the money.
My other reflection on the incident is that when I provided the loan I was consciously looking to rotate some of my equity exposure out of equities and into other asset classes; in late 2016 with equities at seemingly record highs I didn’t expect to see a further 12%+ return over the next 12 months. Having got my 12%+ return from my loan, how did equities do? In fact even better – most markets were up by more over the same period. Doh.
What’s next?
I’m replaying this incident in my mind because the same borrower has now returned and asked for the same deal, again. I’ve asked myself if this is sensible, and concluded it is. My cost of funds has risen slightly but I have the personal balance sheet capacity to make the loan, stock markets are near all-time highs so don’t feel likely to offer me a 12%+ return over the next 12 months, and I think the next time round the loan would go a little bit more smoothly – e.g. I would push for a standing order to be set up on day 1. Against that, maybe I dodged a bullet last time, and will find myself facing difficulties getting repaid next time around?
If an opportunity presents itself I will look to negotiate a slightly different deal; I will ask for a minimum repayment of 25-50% of the loan after 12 months; this would have the effect on providing a more substantial signal of the borrower’s means/intent to honour the agreement, as well as capping my downside closer to the level that I’m familiar with from investing in equities.
I’d love to know reader’s reactions/thoughts – do you think I’ve been sensible here? Is there a better loan structure for me and the borrower? Would you take this opportunity if it presented it? Should I look for more?
FIRE v London 
This is just like playing double or quits at the casino. Usually you win, a small amount, but eventually you get wiped out. Same will happen here. If you did this 20 times (or even 10), one of those would not work out because of a black swan event (particularly given their incompetence, which surely extends to other parts of their business) and you would lose your principal.
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Unless the developer has a sizeable slug of equity in it, I think there’s a risk in providing development finance that you could be taking an equity-type risk for something closer to debt returns. Should the London property market fall substantially or there be problems with planning, utilities or similar your loan could easily be wiped out. I’d look for a greater premium to the expected returns of listed equities than most developers would be willing to give, and would also want a debenture over the share capital and controls over what they were paying themselves, and extensive due diligence.
I realise that some of these concerns are reduced in your case as you know the individuals and have a shareholding in the company. But I would be wary of getting involved in development funding myself, with an unconnected third party.
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I am going through a similar situation currently, although mine started back in 2012 and was for a much larger sum. I am ballooning the interest until the end (this suited me from a taxation perspective). Won’t go into too much detail here.
I agree totally with all of your points about by knowing the people it reduces credit risk, but also introduces a lot of other potential difficulties should the relationship become strained due to non performance. Luckily I’m a heartless automaton! But I totally agree – these types of deals are a lot more personal and emotionally involved than trading options or equities on an exchange somewhere.
I’d recommend getting as much security and ongoing repayment built into the structure as you can, as well as some sort of finite end date if you can manage it (I don’t have this in as in part it suited me at the time, but I do somewhat regret it now that I actually want to close things out – it means I’m going to have a much tougher time of it). I really liked your idea of the ramping up of interest payments to incentivise repayment.
I’ll let you know in 12-18 months whether or not it was a good idea for me or not… I like the idea of it being diversified away from equities and property where most of my other assets are, but when I look at equity returns since 2009 I sometimes think that might have been a much less stressful path… maybe if the current market wobble turns into a 50% decline (I don’t think that will be the case!) then I may well see much more value in the diversification!
Good luck with it, which ever way you decide to go! From the sounds of things, in relation to the rest of your assets the amounts are fairly trivial, so it’s probably not going to cause you any serious damage even if it does all go a bit south!
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I’ve always wavered between thinking these sort of investments are risky verses where do I sign up? Although a little bit more work and chasing than a normal investment, it sounds like all has continued to work out well for you.
But……London property is not looking great at the moment, people are holding off buying waiting for the big drop or at least for inflation to erode the prices while the brexit negotiations are being screwed up royally.
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I would look at it from an arms length perspective. If you didn’t know the borrower, weren’t mates with the developers, and couldn’t make it rain with a simple WhatsApp message would you be satisfied?
If yes then incorporate your learnings into the next deal (you have something they want, so the power is yours), providing you believe that Brexit and/or landlord tax changes and/or the mooted British first/foreigner sloppy seconds won’t kneecap the London property market during your timescales.
If no then count your blessings and cash in your chips.
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I have made loans like this, and I have concluded they’re not really with the time and potential stress.
The crux of the problem is that when things go wrong, you don’t have the same enforceability that a larger lender has. Loans come with a lot more back office than equity does. Will you want to spend countless hours chasing money, or assets should it come to the worst (you mention the security wasn’t documented properly). It’ll be even harder if they’re good friends.
It’s also worth considering why they are happy to take your money. Is it just easier and less paperwork than the other options? Are they really not able to get a better rate elsewhere?
If you’re also an equity holder, a longer term solution may be to work to help them find cheap and scalable lender.
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At 12% you were getting the same return as many property backed p2p loans, but was the extra work of DIY worth the £500 arrangement fee? I have nearly £100k in p2p, but I’ve not got more than £900 with any one borrower (and I’m reducing that to £500 now), so I rely on diversity, not due diligence, and while I’m niggled if a loan goes bad, I’m not annoyed, as I would be with a £50k one.
Knowing the borrower might increase your certainty it will be repaid, but the social consequences of failure would put me off. A few years I considered lending friends with CC debt the money to pay it off, but decided that anyone in CC debt probably wasn’t wise, and I didn’t want to damage my friendship (or wider social circle if people had to take sides).
Lending 5 digit sums to people smacks of being a businessman, and I’m happy being an investor.
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Just my 2p on securing your personal loan (from the risk-averse view of a banking lawyer!):
Would strongly recommend securing your loan and making sure the second charge is properly documented (i.e. the charge must be executed and witnessed as an English law deed, and registered at Companies House and the Land Registry within 21 calendar days). It’s also worth checking beforehand the existing mortgage provider permits second-ranking security and/or requires notice of any second-ranking security.
Additionally, you could consider having the loan paid into a segregated account and have an agreement drawn up to control withdrawals and deposits, and you take a charge over that bank account (the charge document must be executed and witnessed as an English law deed as well, and registered at Companies House within 21 calendar days). The account bank would have to agree to the charge, however.
Getting security documents properly drawn up and executed is a faff and getting a solicitor to do the legwork may not be an expense you and your friend are willing to take on – so consider whether it’s a priority for you to have effective security. If not, then your risk profile is that of an unsecured lender (you’d be entirely reliant on the health of the company, the effectiveness of their business plan and goodwill to see interest payments and repayment of principle). You’d still have contractual rights under the loan agreement that can be enforced in court, but assuming you’re looking to lend only £50k, the amount may not be worth the time and effort to litigate for repayment.
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Hi,
Thanks very much for another fascinating post.
Would you consider writing down your thoughts about tax efficient investments (VCT, EIS) for a post in the future? I assume, based on their omission, that this is not a focus area for you, and would be interested to understand your rationale.
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Mark. Thank you very much for the suggestion. I love suggestions!
I do actually have quite a lot to say about this topic. Omitted for other reasons. I will try to remedy.
Thanks for your support.
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Interesting post! Sort of similar to my fiddling about with crowd-sourced mini bonds for learnings, though you’re getting far better terms/rates.
Some random thoughts:
I sort of agree with @Andy. Someday the market will turn and unless you’re certain your friends are as good as the likes of say Pidgeley at Berkeley Group, do you want to risk them / you being exposed to a potential total loss?
Probably would also be better to do 3-4 smaller loans (or same size, given hassle factor) across 3-4 different properties, with separate security on each? Still exposed to market risk, but at least reduces the risk of a blow-up at any particular property… (they discover it’s being built over a WW2 bomb site or whatnot! 😉 )
Ideally 3-4 separate companies as you know, but probably impossible — unless what you’re learning here can scale up and it can be a mini-side business?
I guess that’s the big question: Why can you provide this loan and commercial lenders can/are not? Is your friend doing you a favour? Or are you taking on hidden (or not so hidden! 😉 ) risk for an incremental 3-4% over commercial terms?
I’d also be concerned that you may damage the relationship just by doing 2-3 loans and then saying you don’t want to do any more. Even if nothing goes wrong!
“What’s changed mate, so you don’t trust me anymore?” or some fancy version of that.
We all break the friends & family rule I suspect now and then; it is there for a reason. 🙂
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Hi FvL,
Apologies for the silence recently, but a fascinating read. It all comes down to how large this is against your overall portfolio. If it is just play money then why not have some fun, although be wary with friends and money….
I think for me I would consider doing something like this, but for now it is a little higher risk than I want to take – ISA/Pension/Pay down mortgage are my priorities for now!
Cheers,
FiL
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I’ve done this quite a bit. A few quick thoughts…
If your charge isn’t properly documented, you don’t have a charge – it’s an unsecured loan. The facility agreement and charge should be drawn up by a specialist solicitor (borrower pays). Second changes can be messy so it’s even more important to do it properly. I’d also want a personal guarantee from one or more of the company’s directors.
This is all important psychologically as well as allowing you to actually enforce. If the arrangement is seen as informal, repaying you won’t be a priority if things take a turn for the worse – all other creditors will be higher in the mental queue than you.
Chasing up interest payments isn’t a big deal, but I’ve found that getting immediately and insistently on top of the first payment means that subsequent ones arrive on time. You could always write into the agreement that a standing order must be set up and evidence provided.
You didn’t have a set end date, and were relying on the increasing interest rate to motivate repayment. This seems risky, because as long as they make the monthly portions of the interest payments there’s no obvious event of default at any point, which makes it harder to enforce. If the loan drags on for 24 months, your LTV is steadily increasing the whole time leaving you more exposed. How would you go about getting your money back if this happened (perhaps coupled with a drop in the value of the underlying asset) and you started getting twitchy about your level of exposure?
As there wasn’t an end date, I assume there wasn’t a clearly defined exit in place either. For a development loan I’d want at least one exit that could be credibly achieved before the loan period – preferably two (usually sale and refinance). In this case it sounds like the strategy depends on some element of planning gain, so I’d also want to know what the plan would be if planning wasn’t granted.
In short, I’d treat a loan to friends just like a loan to someone you didn’t know. The lack of ambiguity is better for both parties, and less likely to affect the friendship because the borrower won’t be expecting indulgence that you won’t want to grant.
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I think you got it right first off – never lend money to friends/family. Particularly if it goes wrong, you’re risking losing a friendship. It’s almost impossible to make a distinction between your emotional and your logical faculties – would you really put that many ‘eggs in one basket’ if you were making any other financial decision? Plus, you have to consider that the loan might go wrong for reasons entirely unrelated to your friend’s business acumen, e.g. 50% fall in property values. If, in spite of this, you are tempted to go ahead, I’d suggest a repayment loan (not interest only); I’m not sure any other lenders would go for an interest-only arrangement!
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[…] other news, I have temporarily extended my margin loan to make a couple of property-related loans outside my ‘invested portfolio’. This leaves my margin LTV at just over 25%, up from […]
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“stock markets are near all-time highs so don’t feel likely to offer me a 12%+ return over the next 12 months”
Based on your admitted past track record of predictions, seems like we are locked in for 20% returns in 2018 😀
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[…] Will your relationship with the founder/business change? If you don’t have much of a relationship, then be careful; it is more rewarding/fulfilling when you know the management well. But if you do know the management well, make sure that an investment isn’t going to sour the relationship. In my experience though, equity is much ‘cleaner’ and lower impact on relationships than debt – which is why a lot of wise people say they will never lend to a friend. […]
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