Saturday, December 4, 2010

Queued Soft Loans vs traditional loans. - Math

Natural Finance uses queued soft loans as principle financing instrument.  Presented here are details of the financial advantages of queued soft loans.  Secured queued soft loans are similar to open interest only mortgages in that interest and depreciation are paid each month.  General (or unscured) QSLs have no fixed payment amounts or dates, but rather controlled payments based on cashflow.

Consider a multi-unit residential property investment that cost $1M to buy, and generates $100K/yr in profits.  If seeking to finance the entire amount, a shrewd banker might calculate that the applicant entrepreneur would say yes to 10% interest only mortgage,  on the basis that he may earn a maintenance/management salary, and would gain if the property value increased.  At a 10% mortgage interest, the venture would pay $1M over 10 years to the banker, and would still owe 1M at the end of 10 years.

As a General QSL at 10% interest, after 10 years, over 337K is repaid even if no new investors buy out existing 10% loans. This online spreadsheet clarifies the loan dynamics on a yearly basis

The main advantage of natural finance queued soft loans is that interest rates charged is brought down by new investors buying out existing ones.  In our example, after 1 or 2 years of operating with 100k in operating profits, many investors would consider lending to the project at 8% attractive.  Even our initial shrewd banker who had the power to insist on the initial 10% would be entirely content to reinvest at 8%, after both operational soundness is established as well as demonstrated competitive investor interest.  Under natural finance, if there is $1M in the world content to invest in your project at 8%, then the natural/average interest cost will fall to 8%. After 5 to 10 years, after substantial equity has been built up, the natural finance rate can drop to 6% or less.

A traditional interest only mortgage at 7.63% interest, where any surpluses after interest costs are used to pay down principal on the mortgage achieves the same 10 year paydown rate as a 10% QSL.  As shown on sheet 2.  This means that 10% natural finance loans are equivalent to 7.63% traditional mortgage both for the enterprise, and  for total investor repayments over 10 years. Note that if an investor is repaid within 5 years, he will have earned substantially more interest under the natural finance option than under the mortgage option.  The first $323K of investment is repaid in 5 years organically, but substantially more can be repaid if new investors come in.

A further advantage of natural finance loans is the tax advantages to the enterprise.  By repaying principal earlier (retiring the head-of-queue loans that are repaid), natural finance allows higher interest to accrue (tax deduction) even when it is not paid immediately.

Secured QSLs are almost equivalent to interest only open mortgages when there is no depreciation on the secured asset (such as real estate mortgages).  The differences are in fact advantages.  First, the obligation instead of the right to pay the mortgage down under specific surplus conditions means additional security to the lender (who always retains the option of reinvesting any repaid amounts).  Second, and most importantly, the fact that natural financed corporations are independently comptrolled means that expensive government loan registration services are not necessary, and that all enterprise contractual obligations and loan covenants, such as insurance requirements, are monitored and enforced.  Thus a theoretical risk free loan, is made practically risk free and cost free.

The cash flow of secured QSLs is identical to the interest only mortgage model shown on sheet 2.

The primary consideration in setting interest rates on real estate is the loan-to-value ratio.  It is generally considered completely safe to lend $500K on an insured property worth $1M to anyone, because it is generally certain that the proceeds from foreclosure would exceed the costs.  Because of this, when loan to value is 50% or less, the very lowest financing interest are available almost regardless of the credit quality of the applicant.  We will use 5% as this risk-free interest rate.

A hybrid of secured and unsecured QSL natural financing is shown on sheet 3.  A 50% loan to value secured QSL of 500k @5% is used, and the remaining 500k loan is through general unsecured QSLs. @10%.  Natural finance insists (exceptions are outside this context) that surpluses are used to pay all general QSLs ahead of secured QSLs.  This hybrid model generates 503K of equity over the first 10 years, and all of those investors who chose unsecured QSLs are repaid in full.

Unsecured QSL investors can never be diluted by future security issuances.  All future QSLs will have lower payment priority than their QSL.  Natural Finance encourages Capped QSLs which provide further certainty to investors.  For example, the first $200k principal in queue position is guaranteed to be repaid with full interest or with $400k (double the principal value) if lifetime cumulative operating surpluses of the venture either exceed the amount owing or $400k.  Secured QSLs have payment priority for monthly interest payments and to be paid off if secured collateral is sold.  Because unsecured QSLs use simple interest instead of compound interest, and as shown by the linked spreadsheet, that a 10% QSL rate is equivalent to the enterprise in the long term (10 years) to a 7.6% compound rate,  investors that are bought out or paid off early (first few years), make a much higher return on what turns out to be a short term loan.

Natural finance provides higher returns to investors and less risk, and provides lower financing costs to enterprise.  It is therefore naturally superior to traditional finance options.

1 comment:

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