A common piece of advice that is given to property investors by mortgage brokers, at least knowledgeable brokers, is to keep securities for each loan seperate, ie) avoid cross-collaterisation at all costs.
So what is cross-collaterisation and why is it so bad? Cross Collaterisation is the combining of one mortgage registered against two or more security properties. This is the preferred structure for banks when dealing with clients with multiple properties because a) it is a simpler than arranging multiple loans and b) because this structure allows the banks maximum control over future dealings with the client. Point b) is exactly the reason that this structure should be avoided whenever possible by property investors and developers. The control that banks have can have a big impact if the borrower either finds themselves in financial trouble, are actively looking to grow their portfolio, or even trying to sell. The global financial crisis has exposed the dangers of poor loan structuring and we have seen countless cases of people having serious trouble extracting themselves from situations due to their having all assets tied in with the same facility. I recall the example of Mick, a formerly successful business owner who had several properties, both residential and commercial, as well as boats, fast cars and a large amount of business assets. Mick had a very simple loan structure, with just two loans with two seperate banks covering all of his property and business assets. this structure kept the banks happy and enabled him to access slightly lower rates. The problems started during the global financial crisis when Mick’s business took a turn for the worse and simultaneously the property market went backwards in locations that Mick owned properties. Mick suddenly found himself with a very high LVR on all properties, a struggling business not producing sufficient income to meet all of his commitments, and as if this was not enough, two banks and a landlord breathing down his neck. Because of his loan structure any moves he made had to be ok’d by the bank, including refinance of any of the properties, sale of assets or releasing securities. To make things worse, Mick was put into credit management (a bank’s way of describing their internal debt collectors) by one of his lenders which means his ability to negotiate solutions with them was greatly diminished. If Mick’s loans were structured differently, he could have potentially sold down assets and used the proceeds in the most efficient manner, but because his assets were tied up, he effectively lost control of his business.
Another example of an interesting case we have come accross is Kevin, who is a very successful property investor and has buiilt an impressive portfolio consisting of several residential and commercial properties. Kevin was able to build this portfolio through a mixture of good market knowledge, savvy negotiation skills, a high income job with a resources company and, it has to be said, some luck with market movements. Kevin’s problem was that he wanted to retire early, which is something someone of his net worth should easily be able to do, were it not for Kevin’s one big mistake. Being from the old school of investing, Kevin believed in establishing a relationship with his bank and letting them handle all of his dealings, so his portfolio was crossed into one facility. Kevin’s plan for retirement was to purchase a large high income commercial property and live off its substantial positive cashflow. To achieve this, he needed to use the equity in one of his existing properties. Unfortunately due to the global financial crisis, his bank had become increasingly conservative and they now saw his considerable borrowings as a risk. So even though he was geared extremely lowly (well under 50%) and his servicing was very strong by any standards, they would neither allow further borrowings, or release any of his properties as security. As a result Kevin is still working 70 hours a week.
My last example of the evils of cross-collaterising concerns a pair of developers I will name Anthony and John. These guys had been successful developers for over 15 years with an impressive track record of residential developments. They developed only around their local area, which was an up-market suburbs in a major city. Anthony and John’s strategy was to hold on to a couple of units in each development they completed and maintained some debt. Once again, their mistake in debt structuring did not surface until the “GFC”, which caused their bank to shy away from property development financing and also resulted in a dip in their local residential market. Upon an annual review, their bank decided they wanted them to take their business away, for no other reason than that they were property developers. This was a bad time for Anthony and John as they were ready to begin their latest development which was mostly pre-sold and contained a healthy profit margin. Unfortunately, the dip in the market had also meant that their LVR on existing debt was too high to refinance to another bank and they were stuck with a situation where their bank would only accept a full pay out. We had to provide a very expensive short term solution with mezzanine facility in order to extract them from this situation.
Structure matters. These examples show how bad structuring can hurt you regardless of whether or not your investments are performing well. Anyone looking to be active in property investing or in development should consider the importance of their loan structure and weigh this up against the pricing they recieve for their debt.