A complete stranger approaches you with a great investment opportunity.
“If you give this guy I know £100, you’ll get £108 back in a year – guaranteed.”
8% return you think. Not bad in a world where the bank will only give you a 0.25% return. But the stranger has omitted a couple of key pieces of information.
First of all, he gets paid 10% by the “guy he knows” for finding your money. So, after his slice, your £100 is only £90. He also has to pay a middleman, the guy who first mentioned the idea to him. Good news is that he is only looking for 5%, but that’s another fiver off the investment, so you are down at £85.
Then the guy with the original investment idea. He is pleased with himself for conceiving the plan and takes a slice of the action, another 10% as reward his initiative. So, £100 is now £75.
So, where are we after all that? Well, for your £100 to deliver a 8% profit, it has to work that bit harder. In fact, it has to deliver a £33 (£108-£75) profit, a modest return of 44%.
In a world of low base rates, an 8% guaranteed return sounds lovely. Maybe a bit stretchy, but, you know, not impossible. How do you feel about a return of 44%? To help you consider that fully, betting heads in a coin toss offers you a potential 50% winning outcome.
Or, to put this level of return in a property context, a quick look at Yahoo Finance this morning tells me that Persimmon, a UK national housebuilder, makes a return on capital of 29%. The industry average is 13%.
One of the long term consequences of the 2008 financial crash has been a significant tightening of credit. Pre-2008, property developers could secure very high leverage to support their development ambitions. Post 2008, finance has become far more constrained and many mainstream lenders are either “out” of property lending, or will only provide finance on very restrictive terms. So, if you now want finance for property development, and are short of personal cash or equity, you have to find other ways of funding a project.
One of those ways is fractional ownership. So, very simply, a project costs £1,000 to build. You find 10 people to give you £100 and you’ve got the money together. So, let me start by saying that, as a concept, I actually quite like fractional ownership. I think it is a clever piece of problem resolution. But, and there’s always a but, it genuinely has to come with health warnings.
The first warning is that property really is not a risk free environment. Most property projects start with a development appraisal, a forecast of what the development will cost to build. Once you start on site, you soon realise that there is a world of difference between numbers on a page and a development site. Most projects go well, but most will also encounter hitches. Whether that is problems in the ground, difficulty in connecting to services, rising construction costs, project over-runs, bad weather, botched construction, global pandemic….personal experience tells me that many things can, and often do go wrong.
Secondly, experience counts. Have you done this before? How many times? Have any of your projects failed? How did you address that failure? And thirdly, tell me about your financial strength. If the project over-runs, or you encounter difficulties that add to costs, do you have the financial strength to cover the additional costs?
So, professionally, I have now seen a number of fractional ownership projects across a number of different development sites. I have seen the fractional ownership model applied to student flats, build to rent flats, nursing homes, hotels and car parks. I may be unlucky, but not one of them has worked. Why is that?
Well, there are a few observations I’d make to start with:-
1. Who is recommending the project to you?
Remember that guy offering you the 8% return? How would you have felt if he had explained the commission structure? There is nothing wrong with any sales based business, but the nice guy in the suit telling you that you will get 8% return guaranteed and the potential of substantial capital growth is probably not a development expert and is probably being paid a commission to secure your investment. So, you might start by asking (a) how well do you know this developer and (b) how much are you being paid to recommend this project? And, reflecting back on where we started, if you stump up £100, how much actually funds the project and how much is extracted in commissions?
2. Who is building this project?
The internet has, literally, the goods on everyone, and, best of all, it never forgets. So are you dealing with an experienced developer with a long track record of delivery? Is their business profitable? Building tower blocks is entirely different from building a two-storey row of townhouses, so it has to be relevant experience.
3. Who is providing the guarantee?
A guarantee is defined as a promise that something will be done or will happen, especially a written promise by a company. A guarantee is also only empty words if it is not backed up by money in a bank account. The simple question to ask is this – if I don’t get my guaranteed return, who do I complain to, and how likely are they to satisfy my requirements?
4. And if it all goes pop, what then?
If you buy a house from Persimmon, and they fail to deliver that house on time and to budget, your recourse is against a national housebuilder who is subject to various regulatory requirements. If you buy a flat in a fractional project, there is a high chance your recourse is against a special purpose company set up specifically to deliver that project.
There are added complexities to consider including ground rents, service charge, tenant management, property refurbishments, council tax etc etc. But stripping it all back to basics, the key takeaways are:-
1. Nothing in life is, or can be, guaranteed.
So, unless someone is depositing your guaranteed return in a bank account, and telling you that you and only you can touch that money if the guarantee is not fulfilled, treat any such promises with scepticism. Similarly, any promise made about capital growth needs to be taken with a pinch of salt. The property market is complex. It offers no guarantees of exponential annual capital growth.
2. Do your diligence.
Diligence into the guy doing the sales pitch, the project, the developer, the contractor. If you can’t be bothered doing that, pay someone to do it for you. And, before anyone complains about paying fees, are you really going to make a case for giving a complete stranger a substantial deposit on a property simply because he promised you a guaranteed return and seemed nice, but won’t pay an advisor a fee for protecting your interests because advisors are greedy and grasping?
3. Understand that it is a risk.
There’s absolutely no reason to be risk averse. But, at a very basic level, understand that an 8% return at a time when base rates are beneath 1% is exceptional and therefore comes with increased risk. There is absolutely no problem in investing £100k on a higher risk, higher return investment if you can afford to lose £100k. The problems arise when you can’t.
4. And, if it all goes wrong, organise.
If you are 1 out of 100 with a complaint, you are quite easy to ignore. If you are part of a group of 90, you are a significant force. Websites like this one, are a useful vehicle for helping you get organised, and getting you connected to people who can help. You should expect to pay for such support.
There is much, much more to be said about my trip through the world of fractional investment, but let me go back to where we started. You meet a guy who you don’t even know and believe him when he says that, if you give him £100, you’ll get £108 back in a year. Stepping outside the world of property investment, would you ever just get out your wallet or purse and hand this random guy £100 without finding out who he was and who he represented?
Written by Bruce Wayne, August 2021