Pocket Land have a simple business model. They purchase land and construct affordable housing which they then sell. In so doing the group makes around a 10% profit margin pre-tax. Pocket fund these projects using debt.
Key features of the bond:
Term
4 Years
Security
Unsecured
Interest rate
7.5%
Interest payments
Quarterly
Type
Bullet (principal repaid at end of term)
Minimum issue
£1,250,000
Maximum issue
£2,500,000
Given the urgent need for affordable housing in London Pocket have forged an interesting partnership with the GLA. Indeed the GLA have extended them a 10 year loan, initially amounting to £21.7m but now increased to £26.4m. This loan is used to purchase land. The construction of houses is funded using a £30m facility from Lloyds bank. Both of these debts are secured against the assets of the company – both the land they own and the houses they build.
There are two critically important points to understand about this instrument. Firstly it is un-secured. And secondly it is subordinate to a very large pile of senior debt. It is worth exploring further to understand just what this would mean to the investor.
The Pocket capital structure is complex with a number of different entities. The mini-bond is being issued at the level of a company – Pocket Living Ltd - that has no significant assets. Meanwhile the GLA and Lloyds debt sits at the level of a company – Pocket Living LLP - that own land and buildings. As such, if any thing goes wrong, the GLA and Lloyds bank will have their secured debt investment returned before the mini-bond holder. Effectively the entity that the mini-bond has a claim over has no assets to offset any loss. Meanwhile the senior debt is secured and at the level of the subsidiary company that holds the assets of the group. No detail is given on the interest costs of these instruments but they carry significantly lower risk than the mini-bond enjoying both seniority and the security of the companies assets. On top of this the senior debt pile is large: £26.4m to the GLA and a £30m facility with Lloyds bank which ‘The Business’ section of the prospectus suggests they are negotiating to extend to £50m. In any worst case scenario all of that debt would have a claim over the companies assets before anything was left for mini-bond creditors.
Together this makes the bond risky. To consider how risky an investor needs to consider what needs to happen for things to go wrong and also what ‘wrong’ would look like in terms of the return they would make on their investment.
Property development involves a combination of two risks: execution risk and timing risk. Effectively the risk relates to the possibility that the company cannot sell the houses for more than the cost of making them. This could either be because there is an unforeseen cost associated with the construction project, or because prices take a dive some time after the land has been bought and construction has begun. Everyone will have their own view on the risk of sale prices falling so it does not warrant comment but it is worth noting that this is a 4 year bond and the current house price bull run is no longer young by any historic standards. On top of that rising costs of construction and land are encouraging Pocket to taken on more complex and larger projects. They explain that they are “now looking at broadening our product range, taking on larger sites and entering into more diverse partnerships”. Whilst there is almost certainly a sound logic to using scale to mitigate increasing costs this undoubtedly means an increase in execution risk.
The Pocket mini-bond will be serviced using the ‘un-restricted’ cash amounts broken out in the financials. These amount to between 5% and 10% of annual revenues depending on the year. If the assumption of a 10% pre-tax profit margin is wrong this ‘un-restricted’ cash could come under threat quite quickly. Clearly it would not take much for a cost over-run or drop in sale prices to make that risk a reality. And that risk is present for 4 years. On top of that the absence of any security, and the sub-ordination to the majority of the debt explored above, means that if things go wrong it would likely result in a return of zero to the mini-bond holder.
As something of an aside Crowdcube recently introduced a Probability of Default (POD) calculation by Moody’s Analytics to help prospective investors assess risk. Whilst any attempt to quantify risk should be welcomed I would emphasise that the calculation only measures the risk of default within 12 months of the last financial accounts. Clearly when appraising an investment with a minimum time horizon of 4 years this is only moderately useful. But whatever the caveats it is academic in this instance because the Pocket Mini-bond has n/a listed against its POD. We have contacted Crowdcube to try to find out why this bond is not rated, but we have yet to receive an answer.
So whilst affordable housing might be a very appealing investment this instrument offers a limited return of 7.5% in the context of a real risk that it could return zero.
In fact it is also striking to note how easy it is to find instruments that offer a similar exposure but at more attractive terms. In the last BondWatch column David Stevenson reviewed a mini bond issued by LMSL secured against a specific London property asset. Admittedly the LTV was a punchy 87% but at least it offered security. And there was the lure of a more generous interest rate of 10%.
Meanwhile a review of current offerings reveal that the latest LendInvest deal of the week is an 8% 1 year bond secured against London property at a 69.8% LTV and the site lists a range of similar yielding secured instruments. So it would seem to me that if you do not see any risk to property valuations on a 1 year, or even a 4 year view, then there are better ways to get exposure. Effectively this Pocket mini-bond is asking you to take equity like risk with the promise of only a 7.5% return. That certainly would not fit into my retirement portfolio!
