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Episode 007 | Development Strategies and Development Syndicates

Thursday, 23rd Mar 2017
Categories: Podcast

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Our seventh episode covers what many consider a hugely exciting topic in property investing: development. There are a number of ways to go about developing property, each with its own risks and benefits. Damian and Arin discuss different strategies to become a developer, what to keep in mind when financing your developments and some of the common mistakes. Finally, they also look at less talked about, yet potentially highly rewarding, sophisticated strategies such as development syndicates.

Welcome to episode 7 of our property investing masterclass

For many property investors, property development is a fascinating subject. The potentially huge profits on offer are certainly attractive, however, caution should be taken before diving in head-first. In this weeks’ episode, Damian and Arin talk about this popular topic in detail, and provide some great tips on what aspiring developers should (not) do to undertake a successful project.

Tune in and Learn:

  • 3 different ways to become a developer
  • What do we need to keep in mind about financing for developments?
  • Considerations for develop and sell or develop and hold
  • What is a development syndicate and what are the benefits?

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Podcast Transcription

Arin Di Camillo, Momentum Wealth: Welcome and thanks for joining us for episode seven of the Momentum Wealth podcast series. My name’s Arin Di Camillo, manager of the Property Wealth Consultants. With me is our founder and Managing Director, Damien Collins. Damien, great to have you with us again.

Damian Collins, Momentum Wealth: Good to be here again, Arin.

Arin: Good. Now this is a 10-podcast series all about the fundamentals of property investment. And we say this every week but it’s so much more than just finding the right investment property, isn’t it?

Damien: Yeah. Absolutely. So, I mean finding that investment property is that really critical thing, but as we’ve been saying each week, it’s getting the right strategy for you. Every person is different. So, you can’t really choose the property until you know what your strategy and plan is, and based on your circumstances and your risk tolerance, and many other things. It’s also about getting the finance structuring right, buying that property, but also, getting it well managed and looking to value add to properties whether it be renovation or development to speed up that wealth creation process.

Arin: Sure. And going on to today’s topic, one of the sexier parts of property investment is all about developments. So, we’re going to be talking about finding a development site, managing a development project, funding the development, and then also whether a development syndicate is right for you. As usual, we’ll have our bonus at the end of this podcast. So, stay tuned and we’ll fill you in on the details at the end of the podcast.

For now, why be a property developer?

Damien: Well, that’s a good question, Arin. And look, probably everybody shouldn’t be a developer. There are certainly some great upsides to it. You can certainly speed up your wealth creation process. And for most investors on their own, the development component of it would be, develop to hold. So, maybe get… create that additional equity. So, it really starts to speed up that wealth creation process. So, yeah, that’s a good reason. Also, you could potentially develop to sell as well. Some people might like to do that. But, that’s in the riskier end of the spectrum. You can make a lot of money but it’s not for the traditional investor, they would need to leave that up to professionals.

Arin: So, there are three main ways that we’re going to look at today about developing property. First one is to do it all yourself. Secondly, we can look at appointing a project manager essentially, and the third way is to jump into a syndicate where you’re pooling your funds with other investors to produce a development site. Starting with doing it yourself, we look at the pros and cons. What are some of the positives and negatives of doing it all yourself?

Damien: Well, I guess if you do it all yourself you don’t have to pay someone else to do it. So, that’s probably the biggest positive. But, it does take a lot of time, a lot of skill, a lot of knowledge, a lot of coordination. I mean when you go through a development project and particularly if you haven’t even got the site, I mean doing all that financial analysis feasibility, the planning, research, there’s a heck of a lot to it.

And, if you get something wrong, which I’ve seen novice developers do, then you can quite easily lose a lot of money. So, I’ve seen over the years that people, you know, we do feasibilities all the time in our office, and I’ve seen people pay prices for sites that we know will be actually… they’re in a loss-making position. Particularly on the smaller end of the scale, a lot of people get sold, “Oh, this is great I’m going to be a developer,” but don’t do all the homework and researching you need to do before getting into it. So yeah, I think for most people doing it yourself certainly as a development can be a risky game. It’s a pretty risky proposition.

Arin: So, certainly the risk and the time involved make it very difficult. So, if you go down the path of appointing a Project Manager, what are some of the things we need to look out for there?

Damien: So, a project or Development Manager most likely would get involved from the very beginning, before you’ve even got the site. And so, what they would do in a normal scenario you would expect is to walk you through from feasibility. They would do the planning, reports, checking that it’s… working with external consultants if necessary to make sure it’s a viable site and that you’re actually going to make money on it, be able to do what you want to do. And they’ll basically guide you through the whole process and take you through all the consultants that you need to deal with, appoint the builders, manage the builders.

So, they call it project management. People think oh, it’s managing the on-site part of it but that’s only, you know… it’s part of what you do as a Development Manager. You actually end up managing it from the very beginning, right through to the end of the project. Appointing sales agents, if they’re sales, and handing it over at the end whether it’s a rental as well. So, we have clients that do that. They appoint a Development Manager. They’ve independently got a bit of net worth and they just go about their business or their job and they appoint some professional team to look after that whole journey for them.

Arin: So, looking at a single development for a single investor can be a big proposition. The third way of getting into a development project is through a syndicate.

Damien: Yeah. And look, it’s also… that’s risk mitigation as well. So, for example, let’s say you could afford to do a $10 million development on your own. You’d need about three to three and a half million of capital at least upfront. So, that’s a lot. But it’s also a lot of eggs in one basket. You’re certainly putting all your eggs in there and if that project comes off, well, that’s fantastic. But, if it doesn’t come off, all your assets are tied up in that particular project.

So, what we see more and more is that people are starting to pool their money into syndicates. Generally they are run as unit trusts or companies sometimes, but mainly unit trusts. And so you might put in 100 or 200 or 500 thousand amongst another 20 or 30 or 40 investors and you pool your money together, and now you should get access to better quality sites. You would generally have professional development management in there as well and it means you’re spreading that risk around. You might be able to go into four or five developments rather than just putting all your eggs in one basket.

Arin: Sure thing. Okay. Let’s take a step back for a second. If we’re going to start our own project, DIY or we’re going to appoint a Development Manager, funding the project is very different to a normal residential investment. So, what are some of the things we need to look out for from a financing perspective?

Damien: So, it is very different. And I guess there is traditional residential development – you can borrow 90% or thereabouts, 95%, and you only need a small deposit. The base income on the servicing of whether or not you can afford that loan based on the expected rental income. And so, when we start getting into development that’s where the rules start to change. So, I’ll look at a small-scale development first. So, let’s say you were doing maybe up to three units. Some of the banks think maybe do four, but at three units you can generally fund that as a normal construction loan. So, you can still borrow 80%. You might be able to get into… mortgage insurance territory depending on what the mortgage insurance policies are at that time, but it’s harder. But, you can generally borrow 80% and they’ll assess the expected rental income that you would get. And you’re developing those, generally on the basis that you’re going to hold them as rental properties.

But once you get out of that space, you’re out of the traditional residential area, and you go into anything generally four and above, that’s when you get into the commercial space and they’ve got a whole different way they look at it. They’re not looking at [the fact that] you’re holding it for 30 years, they’re looking at it on the basis, “Right, what’s the exit strategy? How are we going to get our money back? This is a two-year project, or three.” Or whatever that timeframe is.

And so, the equity requires a lot more. They see development as riskier, which it, is and so generally you’ll need 30% to 35% of money that you’re going to have to put into the deal. So, it’s quite a lot of capital and, look, these things all do fluctuate depending on the state of the market, and what the banks are like, and what the lending environment is like. And they also will generally want pre-sales of the project, particularly the more units you have, particularly so, the more they’ll want the pre-sales. And that they’re looking at… well that’s the exit strategy, right?

So, for that development, if they’re building 20 units, “Well, we’re worried about getting your money back, so we want to see pre-sales.” And again, that can range depending on the market cycle. It can be ranged from… I’ve seen it as low as 50% in really strong cycles where the banks are trying to get a lot of money out there in the market and… lending it out. I’ve seen it also the other end of the scale where they want 120% of the debt pre-sold and so that does stall a lot of projects as well. And it makes it hard too, on the small projects particularly, to get pre-sales because you’ve got to spend a lot of marketing money and energy unless you’re in a boom market. If it’s your normal market or even, particularly even in a softer market also, you’ve got to get… it’s harder on the smaller projects to do that.

Arin: And I guess the other thing to consider is that, for the lenders and the banks, it’s short-term lending and it’s high-risk for them. So, they’re not going to be that eager to throw the money over to investors.

Damien: No, they certainly see it as part of their lending book. Absolutely, yeah, they’ll charge you more interest for it, but they certainly want to get their money back. So, at the end of the day that’s what a bank thinks like. They don’t think about, “Ah, this is a great project.” That’s part of, I guess, their assessment. But they’re looking at risk. “How can we minimize our risk.” They want their money back.

Arin: So, assuring we’re now past… we’ve got our finance in place for our project, we’re now working at our strategy. And we’re looking at whether we build the development to hold, or we build to sell. When would we look at those options?

Damien: Well, that would be a part of your initial strategy as an investor first. So, you’d be saying, “Firstly well, what’s my plan here and am I going to be holding those or selling them?” So, obviously working back from that. If you’re developing to hold, certainly the amount of research you need to do goes up another level because it’s not just about the planning and the feasibility of that particular project and if it’s profitable now. It’s also, “Okay, well, what’s this area going to be like in 10 to 15 years, because I’m not just getting in there, to sell and leave – I’m getting in there to hold for the long term.”

So, you’ve got to be thinking like a developer but also like an investor as well. So, you’ve got to put your investor hat on and be making sure that it’s designed for the market, that it’s going to be rentable, and be there for the long-term. The other thing I think is certainly if you’re selling you can go into some different areas, maybe it doesn’t matter as much that it’s going to be great in 20 years, as it matters as to what is it going to be like in the next two years, and is there going to be demand for that particular product? But, developing to sell is riskier because you’re at the mercy of the market cycle more. If you’re plan is you’ve just got to sell to get out, whereas if you were developing to hold, a little bit less risky because you’re worried about the rental market at the time and not so much about what you’re going to sell it for.

Arin: So, just touching on that point of the researching of the development site before you kick off, basically you’re looking for sites, you’ve got a couple of different options you can go and look at yourself, a do-it-yourself option. You can go and talk with sales agents and see what they’ve got available, or you can go through a buyer’s agent.

Damien: Yeah, and look, again, doing all the research yourself is going to take a lot of time and energy. Understanding a local planning scheme and local council policies, that can be a lot of work in and of itself. And so, you could hire, I guess, a town planning consultant, but that’ll cost you a lot of money especially for each deal. You don’t know whether a deal is going to come off or not. Certainly, you can talk to the sales agent and, you know, when I’m developing and when our team are acquiring sites for our clients and our syndicates, we certainly do talk to the sales agent but at the end of the day, they’re working for the seller, selling a product they want us to buy. So, we get some information from them, but just be always conscious that, you know, they tend to be very bullish. They say, “Well.” We say, “Well, well sort of… if we’re building a two-bedroom apartment, what would we get from it in this area?” And they tend to be a bit on the bullish side. So, we go and do our own research as well, because at the end of the day it’s our neck on the line and client’s neck on the line. So, we want to make sure that, you know, what the market is… the real value in the market.

So look, sales agents are definitely helpful in that process. Obviously, a buyer’s agent is working for you so you’re paying someone to go and find you that property and they’re definitely… they’re working for you. So, they’re legally obligated to work in your best interests and get you… And look, you know, a good buyer’s agent obviously knows that as they are working for you. A sales agent, well, they’ve sold the property. That’s their role. A buyer’s agent, obviously they want to make sure they get you a site that’s feasible because that’s what you’re paying them to do.

Arin: And I guess we’ve said it a fair bit, we will have clients come to us who already own a development site.

Damien: Yeah.

Arin: And so we have to try make feasibilities work. Sometimes they don’t quite stack up, as opposed to starting fresh or we can go… actually take into account the client’s criteria before we go and find a site for them.

Damien: Yeah, exactly. So, we can, you know, basically work to a standard that they can afford, what the long-term goal is and their strategy. You know, development can certainly fit into client strategies, but it’s got to be the right time for them in the right stage of their investment journey.

Arin: Sure. One thing we do see is that investors will come to us with a development site that they’ve bought in an area that they know, it might be their local area, not always a great idea for them though, is it?

Damien: No, and Arin, often they haven’t done feasibilities. And I guess the other problem is [that] they actually don’t know how to do them because there are just so many different things that go into a feasibility and a financial feasibility analysis of a project. I mean certainly at the top you’ve got to take into account the market. It’s all very well to say, “Oh, you can build 20 apartments here.” But if there’s no demand for apartments that makes it a moot point. So, you know, there’s a lot to do and I find a lot of people, ‘do-it-yourselfers’ don’t do all the proper research and feasibility analysis and don’t understand all the costs that go into it, you know. Some of the councils have developer contributions and people go, “Oh, I didn’t know that.” And, you know, they’ve hit for $400,000 that they didn’t even take into account.

Arin: Blows them out of the water.

Damien: Absolutely.

Arin: Just on that point, some of the disaster stories… what are some of the clangers that you’ve seen with development stories over the years?

Damien: Buying sites without doing that proper feasibility, and going, “Well, someone else has bought one for $800,000 around the corner so that must be the market rate. So, I’ll pay that. I’m sure I’ll make money.” But particularly at that lower end, you’re getting a lot of people who aren’t necessarily understanding feasibilities and they’re buying them and, you know, when you go through the numbers you find clients sometimes are shocked to find that, “Well, if I develop this, actually I won’t make any money.” So, then they’re left with often an old property, in a pretty average condition that they’re going to have to sit on for 5 or 10 years before it’s even worth thinking about developing.

So, I’ve seen that. I’ve certainly seen people… builders go broke partway through developments. Again, proper risk management in doing the due diligence on the builder upfront, making sure that they’re viable. And because once a builder goes broke partway through, it can be a disaster because the next builder coming in to finish off the job is going to charge a heck of a lot more than it would otherwise cost.

And then, I’ve seen people again develop the wrong product. One of the big ones I remember is, I had a development of my own many years ago and it was in an established – you know, upper-middle class to upper class sort of suburb – so you had to build a premium product. And, a competitor came in and built something on a smaller scale but down the road, but it was the cheapest one, you know. He got the cheapest builder and that build it was great for maybe a first home buyer product out in the outer suburbs, but not for an inner-city location and that project, they couldn’t sell it, they couldn’t get the product away.

Arin: Just completely missed the market.

Damien: And then eventually the buyer that ended up buying the house that was still there and ended up having to gut it and start again. So, yeah, there’s a lot that goes into it and if you get it right, you can certainly be very profitable. But if you get it wrong you can lose a lot of money.

Arin: Now, you touched before on the complexity of doing the feasibility study and how it goes from people not doing them at all to varying levels of depth with the feasibility. What are we looking for the feasibility study to tell us?

Damien: Well, feasibility is financial feasibility but there’s also feasibility of the project, because you’re going to put the numbers down. The numbers are a really important part. So, you’re starting off with, “What will I sell these for?” And I always tell people, “You start off at the top.” Not, “Well, this is my land. This is my building. I’ll sell them for that plus 15%.” It doesn’t work that way. The market works what’s it really worth and then you’ve got to work back, okay. “Well, okay it’s going to cost me this, this is what I can sell them for. And then I’ve got to work back. What’s it going to cost me to build?”

And then taking [into] account all the consultants costs, the interest costs, other holding costs you might have, there is a whole raft of things that go into that. Taking all that out and selling agent fees if you’re selling, all that sort of stuff. Then you’re left with what you should pay for the land. And that’s something I often see people get wrong, is they go the other way. “Well, the land is [worth] $1 million, I can build it for $3 million. Okay, well, I need to sell it, or I’ll sell it for $5 million.” Well, the world doesn’t work that way.

Always start, “What can I sell them for?” And the last number that goes in should be, “Well, this is what I can pay for the land, or the site.” And that’s how you should do it.

Arin: Yeah, sure. Okay. So, say we’ve got past that point. We’ve got our site, we’ve secured the site we’re going to build on. Do we then just go straight to a builder to start the design process or what would be the approach here?

Damien: Generally, not. And the reason being is that builders in-house really are…  they own the designs and the copyright. So, I’ve done it both ways. So, I’ve gone to builders direct in my youth, when I was a bit younger. And, look, for a basic product like a single house, they’re great. But, when you’re starting to get to this sort of stuff, you don’t get a competitive pricing, that’s because the builders own the design and the copyright. And so, you get a price from them and you say, “I want to get another price.” Well, you can’t because it’s their plans, they own the copyright and they get you in and say, “Oh, we’ll do it.” They do it at a loss leader proposition. They say, “We’ll do them cheap and we’ll only charge, you know, a certain amount just to get the plans and the trouble is you’ll end up paying for it one way the other. The builders have to make money. Fair enough, it’s their business.

So, the process I’ve learned over time is that we… go to independently design. And again, it’s horses for courses. We use a number of designers and a designer on a duplex, two-unit project might very well be completely different to a designer we might use on a 40 or 60 apartment complex in an established upper-class, higher income suburb.

So, choosing the right designer for the project and that way you can competitively tender it. Put it out to the builders that you… again do your due diligence on them, but at least you get a competitive pricing and you own the rights to the plans.

Arin: Sure. Now, you mentioned our development team and the things that we do. There seems to be a cast of thousands in our development team with the town planners, and building specialists, construction managers heading up the works. The process is quite complex from going into the design phase. I mean even back before that securing a site, design phase, getting approvals, working with councils, there is a lot to working through that process, isn’t there?

Damien: Oh, absolutely. Yeah, I mean we’ve got, you know, as you say, we’ve got experts in town planning and in construction management, managing the builders and understanding, you know, how things are built, and it is a very highly specialised area. And, you know, to do it, again, to do it yourself, I don’t know how you’d be able to do that on your own because there is so much knowledge and expertise you need in so many fields. It’s… And even… you know, we manage the project, we still use external designers, external builders, obviously and the other, you know, you need engineers and other consultants as well. So, it’s really understanding everything that goes into the process at the right stage. If you get the timeframe wrong and you go to the one consultant before you’re meant to go another, that can put back your project months and months. So there’s…

Arin: And any delay costs money.

Damien: Time is money in development, particularly if you’re selling because you’re not getting any income from it. So, certainly [it is] really important to have that expertise.

Arin: So, you talked about an independent designer for it. Once we’ve secured the design, what are the things we’re looking at when we’re choosing a builder? What are some of the standouts that we need to be aware of in the builder selection process?

Damien: So again, choosing horses for courses, the right builder. So, if a builder… I’d want to know… and what the due diligence we go through is, “Has this builder done a product of similar type before and of similar quality?” Again, so if you’re, you know, doing something in a lower socioeconomic area, then the builder that you choose might be different to someone in the… maybe the upper end of town. It’s got to be the right builder for the right project, but importantly making sure that they’re financially viable. Now that’s a really important part of it.

So, we’ve got a whole due diligence process that we go through, asking for their financial statements. And we also go on site, talking to subcontractors, “How are you guys going with that builder? Are you getting paid on time?” Little things like that you can get. And we pull credit reports and other things.

Arin:
Great on the ground info, though.

Damien: So, that’s the canary in the coal mine, if things are going a bit astray. And certainly, checking the quality of their work references as a whole. There’s a whole checklist that we go through in checking the builders. But, ultimately, it’s got to be the right builder for the project. So, we’ve already checked them out before we even get the of price the job because we don’t want to, you know, have builders who aren’t going to get the job in the end. So we don’t want to waste their time. So, that’s just the due diligence they go through to get on our panel.

Arin: Yep, right. Okay. So that covers the builders. Going back a step to development syndicates, what’s the basic structure of a development syndicate? What does it look like?

Damien: So, in simple terms, so let’s say you were… Keep it simple, say it’s a $20 million development and you needed say 30% equity as you often would do, you’re probably going to raise… let’s keep it at $6 million just to keep it simple. So, rather than one person fronting it with a check for $6 million there might be 20 people who put in $300,000 each and it could be all sorts of variances. Some put in $50, some put in $500. But then you own effectively that share of that particular project. So, if it is a $6 million-dollar development and you put in $600,000, you own 10%.

And, when the profits and the capital come back, you get 10% of that. So, it’s pooling money and giving you access to better projects than you could do on your own. And also, that risk mitigation as well, spreading your risk, you know, rather than putting $6 million into one, if you had that money. Rather than putting $6 million all into one project, you might split up 12 lots of $500,000, so you’ve got a lot of different projects. And so if one happens to go badly or [it’s] a bad time in the market and, you know, markets can change, things can happen. That way you’ve… you know, you haven’t put it all on black effectively at the roulette table, which is what it is. If you’re putting all your eggs in one basket you could be taking that risk.

Arin: So, there’s… you talk about risk mitigation, about investing in a syndicate, but also the ability to get hold of better projects. There [are] a lot of benefits really to developing in a syndicate.

Damien: Oh, absolutely. Yeah, absolutely. So, certainly since… for my personal circumstances I just do it through syndicates now. It’s just, “Why would I need to go and do one on my own?” And, you know, when there [are] great syndicates out there and obviously we’ve been doing them for a while ourselves in our team and so yeah, I’ve been putting my money into our syndicates because they’re great projects and it spreads the risk around for me as well.

Arin: Yeah, sure thing. So, with development syndicates, what sort of timeframes and returns can investors expect with a typical development syndicate?

Damien: Yeah. So, if it’s an apartment project, you’re probably looking at around two and a half to three years, around that sort of range because the syndicates have got to find the site, go through all the planning approval process etc. That’s… generally we’re talking 2 and a half to 3 years, land subdivisions can be up to 10 years, 7 to 10 years, that’s a long-term horizon. But generally, the apartment ones are a couple of years [in terms of] timeframe.

Arin: So, if I’m an investor looking at investing in a syndicate, what are some of the things I should be asking? What do I need to check out before I jump in?

Damien: Well, certainly they should prove these are financial products, so they need to be under a financial services license. So, make sure that they are because they are pooled money. I’d be certainly checking out… they should have an information memorandum, or if it’s for wholesale investors, if it’s for retail, or anyone, it would be a product disclosure statement. So, making sure that they’ve got that, that they have covered off… certainly they would give you financial feasibility and all that sort of stuff in there, you would expect.

And certainly, making sure that they’ve got a good track record. That they’ve got the expertise in-house to do it and manage the project, particularly when the boom is on.
When things are going, people come out the woodwork and suddenly they’re development experts. And well, I’d want to know how long they’ve been doing it for, [their] track record. What’s their background? Who [are] the people behind it? Checking out the company and the team that are doing it because that’s… they’re managing your money and your project for you, so you would certainly want to be checking them out for sure.

Arin: So, syndicates sound great, but not necessarily for everyone.

Damien: No, I’ll just go back to the returns. Sorry, I missed that part. Look, the returns you’d expect, this is 15 to 20% per annum would be… So, if it was a three-year project you’d be certainly expecting 45% to 55%, thereabouts. And again, that sounds like… you think, “Gee, oh well, I might only get 2% or 3% in the bank. That sounds good but there is risk that comes with that.” So, you know, projects can make 80%, 100%… I’ve been involved with a… you know, you’ve doubled your money in two and a half years. But also you can get products where you don’t get much more than your money back.

And a really bad scenario, which… – I’ve never been involved in one of those – but sometimes you don’t even get all your money back. So, you’ve just got to understand it does involve risk and that’s why the returns are higher. It’s not something you’d put, you know… It’s for the investor who’s already got some properties and has got some, you know, ability and willingness to take a bit of a risk. If you need the money back guaranteed at two years and six months, you shouldn’t go in because they can, you know, particularly in a soft market, the last bit can sometimes take you a little bit of extra time. So, the returns are strong, but people have to understand that there is risk involved.

Arin: Sure. Okay. Look that’s all we’ve got time for this week. Thanks very much again, Damien, for giving us your time and insights.

Damien: Pleasure.

Arin: An experienced developer that you are, so it’s handy to have you in the chair. Before we go, this weeks’ bonus, as I said at the start, will include a summary of today’s discussion. It’ll also have an article on rezoning and what effect rezoning has on a potential development. So, go to www.momentumwealth.com.au/podcasts and check out all the material there for you.

Now we’re fast approaching the end of our 10-part series. In our final episode, episode 10, we’re going to do something a little bit different and invite you, the viewers, to pose any questions you might have. It can be on anything about the fundamentals of property investing, or any questions that you want me to fire at Damien. So, send your questions into questions@momentumwealth.com.au and we look forward to answering those in our tenth episode.

So, we hope you’ll join us next week. We’re covering commercial property next week, so, it’s a big topic to cover. We’re going to look at different types of commercial investments, commercial syndicates, and also who is suitable for investing in commercial property. So, a big episode. Thanks, again, for tuning in. I hope you enjoyed the podcast and we look forward to your company next week.