Five Types of Investments That Give Higher Expected Returns
When the Bank of England hiked UK interest rates from 0.5% to 0.75% in August 2018, it was only the second rise in over a decade. The optimism in savers following the increase quickly disappeared as it became clear that it would likely be the only rise for some time.
Recent comments made by the monetary policy committee’s policymaker, Silvana Tenreyro, have hardly helped matters either, as she suggested that interest rates could be cut, especially in the event of a no-deal Brexit. Clearly, this is a fairly poor environment for investors at present, so it is hardly surprising that many individuals are looking for ways to generate higher returns from their money.
It is a commonly held belief that higher expected returns always equate to increased risk, but this really depends on how you define risk. Warren Buffett, the American business magnate, investor, speaker and philanthropist, famously said, “Risk comes from not knowing what you’re doing”, while American soldier, George S. Patton, said, “Take calculated risks. That is quite different from being rash”. Both sentiments appear to point to the importance of making informed choices, as opposed to blindly investing money.
With that in mind, we present five investment opportunities below that have the potential to pay more than 10% annually. With many of the risk factors considered alongside the opportunities, we leave it to you to decide whether something that sounds too good to be true always is.
1. Property Development Finance
Property development finance is funding for developers who either have new building projects or comprehensive conversions, such as converting a warehouse into a residential property. It includes residential, commercial and mixed-use property and, depending on the seniority (the order of repayment in the event of a sale or bankruptcy of the borrower), the interest rate can be anywhere between 7% and 15% per annum for a small- to medium-size developments.
You can generally invest as little as £1,000 in projects that tend to be on a short-term basis, so your cash is not tied up for years. There are many crowdfunding platforms that provide details of the projects available for investment, with details of the estimated loan term and how much interest you can expect to receive. You can also often benefit from the security of a first legal charge, which is essentially a means by which lenders enforce their rights to a property if the borrower becomes insolvent.
Risk Factors: There are several potential risk factors associated with property development finance. The developer might become insolvent or fail to complete the project, which could make securing additional finance impossible. Then there is the possibility of a delay in repayments, which might be brought about because the developer is unable to sell the completed property. The property market is particularly volatile and a sharp fall in property values could make the completed properties worth less than the value of the debt secured against the project.
2. Property Bridging Loan
Property bridging loans are short-term funding options that are used to ‘bridge’ the gap between the need for cash and the time at which long-term finance can be secured. For instance, home-movers might require a bridging loan to complete the purchase of a property before they can sell their existing home. They are also often used to help someone acquire a property at auction, when the time frame to complete is very short.
These types of loans are generally more expensive than development finance, with charges of between 1% and 2% per month or 12% to 24% per year quite common. They are increasingly popular as a short-term investment solution and an attractive means of gaining a return on capital. They are usually offered on terms of between one and 12 months and can be an effective means of achieving rates of return above current interest rates.
Risk Factors: Property bridging loans are designed to be short-term and for large amounts of money, which explains the high rate of returns for lenders. However, bridging loans can end up defaulting because the borrower has underestimated how expensive the interest can be. These types of loans are often used by borrowers who don’t have the best relationship with their bank, so they might have a poor credit history or have gone bankrupt in the past. Used in the right way, bridging loans can be effective, but if used in the wrong way, they can be highly risky for both the lender and the borrower.
3. Invoice Finance
Invoice finance is a means by which businesses borrow money against amounts owed to them by customers. It is particularly effective at improving the cash flow of a business and can help with paying employees and suppliers. The rates you can expect to achieve are typically anywhere between 1% and 4% per 30 days, and advances (the percentage of an invoice the company gets upfront) usually range from 70% to 85%.
Investing in invoice finance effectively means that you purchase the unpaid invoices at a discounted rate. Let’s imagine that a pipe manufacturing company requires invoice discounting of £1,800,000 in order to increase their cash flow liquidity and takes a 2.5% rate per 30 days and an advance of 80%. If the company drawdowns fully with the invoice amount of £1,800,000 on day one, they would receive £1,440,000 in advance and pay a fee of £45,000 to the lender. They would then receive the balance of £360,000, assuming there is no late payment from their customers.
Risk Factors: There are several risks associated with invoice financing. There could be delays in payment or the invoices you have purchased might not be paid at all. The customer might claim that the goods or services provided by the borrower were unsatisfactory and make a reduced payment or refuse payment completely. It requires a leap of faith regarding the invoices you are financing and it is even possible that the invoice presented for funding is not legitimate.
4. SME Finance
In contrast to invoice finance, SME finance is a broader form of funding for small- and medium-sized enterprises. It can be used for filling the funding gap, restructuring the business, boosting cash flow or acquiring stocks and investments. Business loans from banks are often only accepted if the borrower has a sound and long-standing credit history, which can be a challenge for SMEs. Thus, SME finance fills a gap in the marketplace which is essential for the UK’s economy.
The length of the terms of these investments can vary widely, from six months up to 10 years. Interest rates are generally anywhere between 5% and 15% per annum.
Risk Factors: SME finance tends to be for the longer term, so there could be problems with liquidity. Investors should be aware that they might not have access to their capital for some time. There is also the possibility that you could lose your capital as SMEs can be a higher investment risk than larger businesses. Venture capital can potentially deliver impressive returns, but there is a much greater chance of failure than with investments at a later stage.
5. Consumer Lending
Consumer lending provides financing for individual and household consumers. Many of these loans are unsecured, so no collateral or form of guarantee is required from customers. They also tend to be relatively short-term loans compared to business loans or mortgages. Interest rates vary widely, from 3% per annum for personal loans from a bank, through to 0.8% per day and capped at 100% for payday loans. Of course, these terms generally depend on the nature of the borrowing and who is doing the lending.
Many lending platforms have been established in the past couple of years, with some offering personal loans to people. Terms vary from platform to platform, but the duration will often be between three and five years, with higher interest rates being paid the longer you invest your capital.
Risk Factors: This type of investment is completely unsecure. Often there will be no asset-backed security attached to the loan, so there is nothing protecting your investment should the borrower default. The long duration of some of the investments creates illiquidity and raises the possibility that UK interest rates will rise to somewhere near the rates locked into your agreement. You could then be in a situation where you are not getting a greater reward for the significantly increased risk.
Consider Circumstances and Risk Appetite
While all the above investment opportunities give higher expected returns than current UK interest rates, this does not necessarily mean they are better opportunities. The suitability of different types of investments often depends on an investor’s specific situation and risk appetite. What might be a suitable opportunity for one investor could be unsuitable for another.
Above anything else, it is important that people do their best to make informed decisions, so researching the subject and finding out more about each investment opportunity makes sense, irrespective of whether you then choose to invest. Consulting a financial advisor is also recommended in order to obtain the best advice for your specific circumstances. This blog is merely designed to present some types of investments currently available that give higher expected returns. We do not endorse any particular opportunity listed above because, as previously mentioned, the merits of any investment depend on several factors.