If you’ve been following these property fraud blogs by now you’ve probably already noticed some common and regular themes of property investment scams.
Property scams are huge business. In fact, in 2011, in America property scams were the third largest type of scam reported to American Consumer Credit Counselling (ACCC), causing more than $10 billion of losses.
Get educated on the most common property investment scams and learn to spot them early, and you’ll avoid becoming a sucker for a scam. Here’s my list of the most common warning signs that you’re getting suckered into a scam.
PROPERTY FRAUD #1: You’re paying the agent’s commission, and if it’s over 10% it’s going to hurt you
Okay, so you’re not actually paying the commission directly, but you might as well be. When the agent is on a commission rate of 10% or more, there’s only one place that payment is coming from, and that’s the potential return. An agent’s commission has to come from somewhere, and that somewhere is the investor’s return, the developer’s return, and the deal itself.
The average commission on a deal is around 2%, and for small deals will probably be a fixed fee, and every penny paid reduces your potential return. A commission of 10% and higher is going to decimate your profitability. The first challenge you face is finding out how much is being paid to the agent.
One other thing about agents’ commissions that you need to remember is that it will usually be paid upfront, as soon as you’ve committed and paid your investment money or deposit. So don’t expect any ongoing support, because the agent will already have moved on to the next deal to be sold.
PROPERTY FRAUD #2 You’re promised a return of at least 15%
This is a biggie, if not THE biggie. A mass-marketed development that promises a return of at least 15% – especially if it’s combined with agent’s commission of 10% or more – should be a real turn-off. It looks promising, of course. In fact, it looks almost too good to be true (and remember what I said earlier about a deal that looks too good to be true?).
When the deal is a partnership, it might be possible to make a return of 15% or more, but mass-marketed deals often fall over at some point. Remember that as a partner you’ll be expected to do a lot more for your money, and so should expect a higher return. If you are investing and not involved in the development process in any other way, then expect returns to be lower.
Bernie Madoff, when asked about his massive property investment Ponzi scheme, replied with a question like, “How did these people expect to earn 15% every year, year after year, when other funds are only paying 8%?” He had a point.
PROPERTY FRAUD #3 Guaranteed Buybacks
This is another massive red light. You may be tempted to think that a guarantee is a sign of supreme confidence on the behalf of the promoter or developer, but in my experience one of two things happens. Either:
The market goes up and the guarantee is never required or the market performs badly and they shut up shop and start again elsewhere.
This basic synopsis, however, masks how guarantees blow up in the face of the investor. North Dakota is a classic example of this guaranteed buyback which never was.
Here’s how it works (or not):
Imagine that the investor is guaranteed an uplift of 15% over three years. The guarantee means that not only will the investor have to be repaid the amount they paid, but also 15% on top. Now, to get the investor on board, let’s say the developer paid the agent 10%. Now the developer needs an uplift of 25% to be able to honour the buyback guarantee.
Suddenly, you can see the problem with the guarantee. The developer probably couldn’t get finance before (which is why it needed investor backing) so it’s probable they won’t be able to now.
I know of one company whose exit strategy is to sell to new investors after five years. What it hasn’t allowed for in this business plan is a market downturn – which is simply a reality of the property cycle. They’ll be reliant on new money coming in to pay the older investors. That’s a classic Ponzi scheme.
If offered a guaranteed buyback, always consider that it may not be worth the paper it is written on. The company making the guarantee rarely has the assets to back it up. Other guarantees are backed by insurance, with an insurance company that has no validity. A guarantee without backing is no guarantee.
A guarantee isn’t necessarily the sign of a deliberate scam, but you should do your research and make sure that the guarantee is solid.
PROPERTY FRAUD #4: Guaranteed Rental Income
The developer offering a buy-to-let opportunity will be very aware that cash flow is top of the list when it comes to an investor’s assessment of the opportunity. A guaranteed rental that has been inflated above realistic market price will give an equally unrealistic cash flow for the first two or three years.
That’s all very well, but when the developer’s subsidy drops out, the investor is left with an asset with an income that doesn’t pay the mortgage. A positive cash flow suddenly turns negative, and it might also be that the property value doesn’t match up to the outstanding mortgage. It’s a double whammy of woe.
My rule is cash flow is king. However, I expect the property investment to take two or three years to build to capacity. That’s being prudent and conservative. I always take my time to work out cash flow, and research realistic market rental potential. When investors work with my company, they always receive a two-page, detailed cash flow assessment.
Here are three steps to ensure cash flow meets expectations and remains on course:
- IGNORE: First, ignore any rental guarantees offered by the developer or promoter. It’s no more than an inducement, and most likely overinflated hogwash.
- RESEARCH: Conduct market research to find out what real rental rates are in the area and for the type of property you are considering as a buy-to-let investment. When doing this, also be wary that quality affects the amount of rent a tenant will pay.
- ENSURE: When discussing comparable properties and rents, make sure that both you and the seller are on the same page. Ensure that the comparables you ask for are, in fact, comparable. I once spoke to a student hotel room provider that gave me comparable room prices based on the most expensive area, and the best rooms during high season; yet the property I was considering wasn’t in the best area, and certainly not the best rooms. That provider was Harlequin. Needless to say, having done my research I refused the ‘opportunity’ to invest.
PROPERTY FRAUD #5: Vendor Finance is For The Foolhardy
By now, you’ll be aware that I’m sceptical of any investment. That scepticism has led me to miss some investments that would have turned out well, but has also led me to avoid a lot more that would have turned out terribly for me.
One of the things that set those alarm bells ringing in my head is vendor finance. In fact, I feel so strongly about this that I never invest in a vendor finance project. Let me explain why:
If I fund through an independent third party, such as a bank, there’s an extra layer of comfort for me. I am confident that they will have done some research as well as me. In other words, they are also reasonably confident of the investment potential.
Of course, I also have to weigh this up with the question over what risk the bank is really taking: it may only be willing to loan, say, 75% of the value of the property, and so its risk is way below mine. It is, however, another tick in the confidence box.
It’s my experience that a vendor is able to offer finance by jacking up the price of the original sale. Expectations of yield will be inflated, using a valuer and a no-strings-attached appraisal at which a bank would turn up its nose.
Often, there’s something the investor isn’t being told by the vendor. It could be that the finance is on favourable terms for a couple of years, and then the interest rate ratchets upwards.
The agent will tell the investor that it will be possible to refinance through a bank at that time, but when it comes to it, only then does the investor realise that the property isn’t worth as much as the vendor first said. The investor is then forced to continue with the more expensive vendor finance, as the bank is unwilling to loan on the previously inflated valuation.
PROPERTY FRAUD # 6 : Be Very Wary Of Developers That Sponsor Football Clubs
There are numerous examples of property developers and promoters that have sponsored football teams and seen their company go belly up.
I’ve mentioned a couple in my previous post about property fraud case:
EcoHouse and Harlequin. Experiences in Spain have been similar. A fair number of property investment opportunities have been sold using endorsements by sportsmen (footballers, golfers, cricketers, boxers, and so on).
Football is a sport. It has nothing to do with investing. Don’t play the game of being swayed by a well-known celebrity. Separate investment from the enjoyment of playing or watching sport: they are completely different beasts. Besides which, you should be supporting rugby!
Find out the next 6 warning signs of property fraud or a scam on my next article…
Live with passion,
Brett Alegre-Wood
