How does Fixed Rate Income work?
Generally fixed rate income is usually derived from an interest bearing promissory note underpinning an investment.
In simple terms there will be a lender (investor) lending capital to a borrower, which can be an individual or legal entity, for which the borrower is prepared to pay an agreed interest rate (yield) for the use of the capital.
The interest is paid for the agreed term of the loan (investment) usually in pre-agreed regular intervals (payment schedule).
The capital may be secured or not depending on the terms of the agreement between the parties involved and is returned in full to the lender (investor) at the end of the agreed term.
These key principles apply to banks, building societies and any other company or institution income bearing products.
Fixed Rate Bonds
The most common type of interest bearing vehicles are deposit accounts where the fixed rate bond may pay interest of 1-3% but the bank or building society may lend the same capital at 7-18%.
This deposit based type of account is backed by the Bank and the Financial Services Compensation Scheme (FSCS) will cover the risks. However any financial product/investment that is dependent on ‘performance’ such as stocks and shares and property based investments are rarely covered by the FSCS.
In this article we consider whether Property Loan Notes should be considered for income provision as part of an Investment Portfolio so these are not covered by the FSCS.
Reader, please note, neither this type of product nor this website are designed for the average ‘retail’ investor. We are seeking Sophisticated Investors as defined by the FCA and you can read more about the definitions here.
How does a Property Loan Note Generate Income?
In simple terms the same principles mentioned above still apply.
The lender (investor) loans (invests) capital with the borrower (developer) and the developer agrees to pay a rate of interest (yield) to the lender (investor).
The developer will use the borrowed capital and repay it at the end of the agreed term.
Property Loan Notes in Detail
Once a potential property development project has been identified planning permission is applied for. Once planning approval has been obtained in writing funding is usually sought and Loan Notes are made available.
Loan Notes are not widely advertised and are available through specialist brokers.
Once the capital is received in the developers bank account interest is paid as agreed in the Loan Note T&Cs.
Reader note that the Loan Note may be ‘development’ specific or open ended and the capital used on other projects.
At around the same time a limited company will be set up usually using the name of the property development. This company holds the assets and any liabilities ring-fencing them protecting the lenders (Investors) and borrowers (Developers) interests as much as is practical.
Special Purpose Vehicles
This type of limited company is called a Special Purpose Vehicle (SPV) and is invariably a temporary holding measure until the next stage. The land or relevant property is bought using the borrowed capital and often registered to the SPV.
Once detailed planning permission has been granted the development may be sold on there and then to a large investment institution. The SPV property borrowing may also be refinanced and be retained by the developer to be used as rental property for example. In this case the SPV may be closed once all lenders (investors) have been repaid and the assets transferred across the Developer.
Either way it is at this stage the loaned capital is usually returned to the lender (Investor) dependent on the Loan Note terms. Some Loan Notes allow you to continue investing and may pay bonuses for doing so.