10 things you should know about property syndications
Over the past five years, unsuspecting investors have poured more than R5 billion into property syndications in South Africa. However, these investment schemes are fraught with danger, and the cracks are beginning to show.
On the back of soaring property prices and low interest rates, property syndications have undergone a revival in recent years. But a slowdown in the property market is likely to expose the flaws in these investment schemes.
In simple terms, a property syndication is an investment scheme that facilitates the sale of a property to a group of investors, who become direct or indirect part owners of the property. But, as you will see, property syndications are a lot more complex than this because they can be structured in many different ways.
Sanlam estimates that more than R5 billion has been invested in property syndications in South Africa over the past five years.
Property syndications were previously the rage in the late 1980s and early 1990s, but faded in popularity against a background of massive fraud, a slump in the property market and inappropriate syndications, including instances where buildings were in a state of disrepair. Once again, elderly people seem to be the main targets of fast-talking, high-commission-earning sales-people, who use glossy brochures and complex prospectuses to sell syndicated properties, often not disclosing all the facts.
Until now, many of the more dubious schemes have been able to hide behind soaring property prices. But, as the property market slows down, poorly constructed and overpriced syndicated properties are not going to deliver the returns that investors have been expecting. In fact, investors may even lose their capital.
As with most types of investments that are sold in a raging bull market, their flaws are not always obvious. But when the market starts to flatten out or, even worse, goes into a slump, the hairline cracks become gaping chasms just ask anyone who invested in foreign information technology shares in the late 1990s, only to see the bubble burst and the rand regain its value against the United States dollar.
The Masterbond and Owen Wiggins Trust scams have been South Africas most spectacular property syndication failures. Thousands of investors lost hundreds of millions of rands when the previous property bubble burst and the pyramid nature of those operations was exposed.
Masterbond and Owen Wiggins investors have not been the only ones to get burned by property syndications. Reputable companies, such as BoE (the former independent Board of Executors, which is now part of the Old Mutual stable) and Seeff Properties, saw many of their property syndications come apart. Both eventually pulled out of the property syndication market as more and more disappointed investors came banging on their doors.
By exploiting ideal economic conditions, property syndicators have managed to revive what had, in effect, become a dead market.
However, a "perfect storm" is brewing as conditions in the property market are changing. The market has changed in the following ways:
The property sector has been providing excellent returns because of a surge in prices off a low base. But statistics show that prices are slowing down and that the market is levelling off.
In nominal terms, interest rates are very low. This has a dual effect:
The credibility crisis of more formal investments. There is a growing distrust of more formal investments as a consequence of the controversy surrounding the high costs of investing and poor practices in some sectors of the financial services industry, particularly the life assurance industry.
Karin Coode, the director of education and compliance at the consumer and corporate division of the Department of Trade and Industry, warns: "An investment by non-professional investors, such as uninformed elderly people, in property syndication is fraught with unknown risks."
Coode also warns that no two property syndications are the same.
She says it is relatively "easy to mislead consumers when marketing public property syndications. The property, for example, could be sold at an inflated price to unsuspecting investors, or investors could be left in the dark regarding the terms of rental agreements."
Here are the 10 main issues that you must take into account before investing in a property syndication:
1. Consider alternatives
Most individuals should have a property component in their investment portfolios in order to diversify their risk. Another advantage of property is that often it is not correlated to other asset classes. For example, when equities are flat, property prices may be rising.
Property is also an investment that can generate an income (through rentals) and show capital growth (its underlying value can increase).
Property syndications are but one of a number of ways in which you can access property investments. You must consider all the property investment options before you decide to invest in a property syndication.
You can buy property directly or indirectly. For example, you can buy residential (apart from your own home) or commercial property in your own name. However, the problem with buying one property for investment purposes is that it increases your exposure to risk. The risks include:
Many people who would like to own a property for investment purposes cannot afford to do so.
Furthermore, investing in one investment property may result in you investing too great a proportion of your assets in property. Most responsible financial advisers will tell you that you should not have more than 20 percent of your investible assets in property (this does not include the home in which you live). And you should not have more than five percent of your investible assets in one property investment scheme, such as a single property syndication.
Many of the people caught up in the Masterbond and Owen Wiggins scams invested most or all of their retirement savings in these schemes. When the schemes collapsed, about 14 elderly people committed suicide as they were left destitute and without any means of recovering financially.
For many people who want to make limited property investments, pooled investment products are the answer. In other words, you and a number of other people (you could be one of thousands) buy into a property or a pool of properties.
By buying into a property syndication, you join a pool of buyers. However, a downside of most property syndications is that you are buying into a single property. This exposes you to additional risk in much the same way as if you owned a property directly in your own name.
Alternative pooled investments
To reduce risk, a "pool of investors" can buy into a "pool of properties". There are a number of ways to do this. The choices include:
Mortgage participation bonds. You lend money to someone else to buy property. A financial services company seeks people like you, with money to lend (invest), and people who need money to buy property (normally property developers).
The borrower pays less interest than on a "normal" mortgage bond from a bank and the investor receives a higher-than-normal interest rate than on a fixed deposit. In other words, the gap (margin) between the borrowing rate and the lending rate is lower than through a bank.
An investors money is pooled with that of other investors, reducing the investment risk. You are also protected by the Collective Investment Schemes Act, which controls participation mortgage bonds and unit trust funds. Fedbond is the biggest mortgage participation bond company in South Africa. A few years ago, at the request of the Financial Services Board (FSB), Fedbond was placed under a joint management order by the Pretoria High Court after the company ran into financial problems.
The regulator was able to detect problems and take remedial action, because Fedbond is registered with the FSB. As a result of the FSBs intervention, investors have continued to receive their interest payments, although they have not been allowed to withdraw their capital.
One of the main reasons Fedbond was placed under joint management is because it lent too great a proportion of investors money to a single property developer, who ran into trouble when the property market went flat. The recent boom in the market has resolved most of these problems.
2. Legal structure
Most property syndications are structured as unlisted companies. Unlisted companies must be registered with the Registrar of Companies and issue a prospectus, which details the what-and-how of the syndication. This includes details of the syndicated property or properties, the investment structure, how the company intends to attract investors, and how it hopes to make profits.
Although an unlisted company may well be a legitimate business, scamsters often use the structure to give a legal patina to a crooked scheme. There are many examples of unlisted companies that have been little more than scams. They include Masterbond, Owen Wiggins, FundsTrust, Supreme Holdings and Jack Milnes PSC Guaranteed Growth Fund all of which have cost investors billions of rands. The biggest scams were Masterbond and Owen Wiggins, both of which involved property syndications.
You need to be warned that most property syndications do not give you direct ownership of the syndicated property, and most do not give you ownership in perpetuity.
Personal Finance and Sanlam recently analysed the prospectuses of two property syndications that are currently on the market.
Personal Finance examined the prospectus of Silverton Acquisitions Limited, which is being marketed by property syndication company Blue Everest Investment Holdings (Pty) Ltd.
In a newsletter for its financial advisers and broker consultants, Sanlam scrutinised the prospectus of Magalieskruin Holdings Ltd, promoted by Sharemax, which is currently the largest promoter of property syndications in South Africa.
The structures of both syndications are typical of most other property syndications currently being sold. An analysis of the two prospectuses shows a complicated ownership structure that ensures investors are kept at a very long arms length from actual ownership of the properties being syndicated.
It is important to note that a new company structure is established for each new syndication, as is the case with Silverton and Magalieskruin. Multiple properties are not pooled into a single ownership structure. This single property structure significantly increases the risk to the investor.
This is typically how the ownership structure of a property syndication works:
(Note: At one stage, property syndication promoter Sharemax used trust structures rather than company structures to sell syndications. The FSB investigated and put a stop to the practice of using trust structures to sell syndications.)
One of the more puzzling aspects of property syndications is the syndication price and how it is determined.
There is a huge difference (mark-up) between what the syndication promoter pays for the property (which one would assume is its market value) and the total amount the promoter expects to receive from investors. Often the amount paid by investors can be up to one-third more than what the promoter paid for the property.
Coode says that in many cases investors do not know the real value
of their investments (shares).
"In those cases where the promoter of the property syndication sells existing shares to buyers, the buyers do not know whether they have paid too much for the shares, and the seller has no assurance whether they could have sold the shares for a higher price," she says.
SP du Toit, a director of the South African Association of Property Syndicators (SAAPS), says the purchase price of a property is not necessarily the "market value".
Du Toit says property valuers feel quite strongly that the "price" paid for a property is not necessarily the same as the "market value".
In the context of a syndication, he says, the "purchase price" paid by the syndicator is also called the "wholesale value" (which is the conventional market value) and the "syndicated price" is the "retail price".
He says syndicators buy properties for less than market value because they:
Du Toit says the mark-up is, however, not all profit. Included in the mark-up are the costs of putting the syndication together and selling it to investors. This will include the profit for the syndicator, commissions, valuation fees, auditing and legal costs, and provisions for things such as maintenance.
In the Silverton property syndication, R2.1 million are added in costs to the purchase price of R6.1 million paid by the syndicator for the property.
The declared profit taken by Blue Everest Investment Holdings is R382 500 (included in the R2.1 million of total costs). So, on the purchase price of R6.1 million, the total mark-up is R2.1 million. This means the cost of the investment to a Silverton investor is an extraordinary 35 percent.
Investors in the Magalieskruin syndication paid over R29.9 million for a property that cost R22 million. This equates to a cost of 26 percent to investors.
Du Toit says it is not an issue of whether there should be a mark-up, but rather the size of the mark-up. He says as a result of market conditions over the past few years, the size of the mark-ups has not been a serious issue.
"Yesteryears overpaid-for property becomes acceptable a year later" because of the generally higher property values.
The question Du Toit does not answer is: what happens when property prices stop improving and, even worse, move into a slump?
Du Toit says one of the objectives of SAAPS is to make the difference between the wholesale and retail prices transparent so that investors can make more informed decisions.
He says some syndication companies retain a 15 percent stake in the eventual capital growth of the property of each separate syndication, and therefore they cannot overprice the property because it will minimise the eventual capital growth upon selling the property for them and investors. These syndicators therefore share in the risk, because of their involvement throughout the investment period.
Du Toit fails to mention that the shares held by the syndicator are bought at the cost price, less the mark-up, and not at the same price that investors pay.
Property economist Erwin Rode, who serves as a board member of SAAPS, suggests that a property mark-up should be below 20 percent to be acceptable.
The initial mark-up is only one aspect of the cost structure; there are also annual charges to consider (see point 5 on returns).
Both the condition and the position of a property must be carefully considered. The factors you must take into account include:
State of repair of the property. Before you invest in a property, you need to inspect the building to ensure it is in good order. If it is not, you need to establish how repairs will be effected and paid for.
In a number of the syndications that went sour in the 1990s, syndicators cynically sold decrepit buildings, some even with structural defects, leaving investors to pick up the repair bills and resulting in substantially reduced returns.
Du Toit says the situation differs from syndication to syndication, with some syndicators only involving themselves in prime and new properties.
But he warns that the onus is on you to make sure you have checked on the state of the property.
State of readiness. In the case of a new building, you need to ensure that the construction work has been completed, the building contractors have been paid in full, there are no disputes over outstanding payments and there are no outstanding mortgage bonds on the property. You should demand that the syndicators provide certificates to verify that all the finances are in order.
Du Toit says SAAPS believe this issue can be addressed through its guidelines and requirement that syndicators should disclose lease and other pertinent information through a professional valuers report.
Position of the property. The old adage applies, so what counts with a property is location, location, location. If a property is situated in the wrong area, this can have serious consequences for future rental income.
The type of things you need to check on are:
For example, when you are working out the increase in the capital value of the property, you should not assume that property values will continue to rise as they have done over the past three years. Rather, base your calculation on the average annual increase in property prices for the area in which the property is situated over the past 20 years, as that will give you a more accurate figure.
The projected yield is also a total return (not guaranteed) over the full period of your investment, and not what you will actually receive as an interest payment on your investment every month.
The interest payment, which, in most cases, is entirely at the discretion of the directors of the company, is the rent received from the tenants, less all costs, including the costs of maintaining the property, and administration and management fees.
Be aware that "yields" and "interest income" are often used misleadingly as interchangeable terms.
The Silverton syndication has projected a total income of R950 504 in its first year, but expenses are projected at R151 332. This is an extraordinary 15 percent of the income. The property manager collects a fee of three percent of the gross rental income – and the fee escalates at rate of 10 percent a year for the first 10 years.
With the Magalieskruin syndication, Sharemax receives between two and four percent of the net rental income each year, escalating at 10 percent a year.
The escalations are interesting considering that inflation is running at less than five percent.
On top of this, both syndication promoters are the managers and administrators of the various companies involved in the syndications, for which they take further fees, which also escalate at 10 percent a year.
Many of these annual costs are contractually concluded between the various parties before the syndication is sold to investors.
This means that you will be unable to change any unfavourable terms when you become a shareholder in the holding company of the syndication.
But the real whammy in the Magalieskruin property, according to Sanlam, is that the returns projected for the first year simply include paying you back some of your own capital that you lent to the syndication.
Sanlam says, "the structure artificially inflates the initial income to investors, by using a margin in the investment amounts of the investors. This structure means that the investor pays too much for the property, only to receive a portion of this amount back as income, with the apparent disadvantage of paying tax on the repayment. Investors therefore increase their taxable income without any gains."
Du Toit says SAAPS believes the problems of unrealistic projections can be addressed through its guidelines and the requirement that syndicators disclose how projected returns are calculated – that is, the assumptions that went into the calculations.
The syndicator’s due diligence report must also highlight these issues.
To protect yourself, you should have the syndicator or the intermediary selling you the investment do "what if" scenarios. For example, what if vacancy rates are average or above average; what if the costs are higher than stated; or what if the rental increases are lower than projected. In this way, you will be more aware of the risk you are taking.
The calibre of the tenants should be an important factor that influences your investment decision. The issues you need to investigate include:
It can be difficult to sell property investments, particularly shares in a property syndication. There is no formal market in which to trade property syndication investments, and you will probably have to depend on the person or syndicator who sold you the investment in the first place if you want to sell.
The two questions you need to ask yourself are:
The price you receive will also depend on the property market and the popularity of property syndications in general at the time of selling. For example, you would probably have taken a hard knock if you attempted to sell an investment in a property syndication in the mid-1990s.
In its analysis of Magalieskruin Holdings, Sanlam says even after the sale of the units (shares and linked debentures), it can take more than two months for you to receive your cash. Compared with an investment in, for example, a unit trust fund or a life assurance policy, where you could receive your cash within three days, Sanlam says the Magalieskruin syndication’s liquidity is "extremely poor".
Although Du Toit agrees that the shares of syndicated properties are not as liquid as those of listed property funds, he says "investors nevertheless have more liquidity than when they are the sole owner of a single property".
Du Toit argues that the current increase in property prices makes buying a "second-hand" share (a syndication share owned by an investor) in a property syndication attractive to other investors. He says the purchase price of a share being sold by an existing investor will be dictated by current property prices.
The degree to which syndicator companies create a secondary market for their investors’ shares differ. Some syndicators will do a lot to help you sell your shares while others will not.
Du Toit says this is an issue that SAAPS will be addressing in future.
He also claims that demand for an existing syndication can also be higher in, say, year three of the project, because the income stream connected to a specific share might have escalated three times, and is therefore sought-after compared with other income-generating investments.
Du Toit says investors must realise that, as with most other investments with predetermined investment periods, you are penalised for exiting early. You should accept that a property syndication investment is for the long term.
"We are of the opinion that liquidity can only be a problem if the product is marketed incorrectly. The investor must be informed of, and agree to, the exit terms and conditions of the syndication."
8. Management agreements
You need to scrutinise the management agreements very carefully. The issues you need to consider include:
You will often find that administration charges are not limited to a percentage of the rental, but will include a wonderful list of other expenses, such as secretarial charges, office expenditure, telephones and travel costs. Most seem to duplicate or even triplicate a charge for the same service. All this reduces your potential return, but serves to skim off ever-greater profits for the syndicator and its associated companies.
You should always get full details of the commissions and other incentives given to financial advisers selling property syndications.
There is plenty of evidence that intermediaries tend to sell products that pay the best commission, and the high commissions being paid by property syndicators are a driving force behind these schemes.
Documentation supplied by syndicators, even to intermediaries, is often vague on what commissions will be paid. Most commissions appear to be in the six-percent-plus bracket. And commissions are not the end of the story. There are also profit-share incentive schemes whereby intermediaries receive a share of the syndicator’s profits for achieving sales targets. This can take the commission to above 10 percent. This is extremely high when compared with the three percent paid by the unit trust industry.
Du Toit says that, according to SAAPS’s knowledge, commissions currently paid by SAAPS members to brokers vary by between three and 6.5 percent. Some brokers opt for three percent immediately and the balance annually (justified by regularly reporting to their clients about how their investments are doing). Others opt to receive the full commission immediately.
Du Toit says that in terms of the general code of conduct in the Financial Advisory and Intermediary Services (FAIS) Act, a financial adviser (broker) is compelled to disclose his or her remuneration or any incentive payable on any transaction.
10. Legal protection
You are mainly protected by three laws: the Companies Act, the Unfair Business Practices Act and the FAIS Act. However, you must also do a number of things to protect yourself, including:
Ensure that any intermediary or promoter who is selling you a property syndication is registered with the FSB as a financial services provider (FSP). Refuse to do business with an intermediary who tells you that there is no requirement for him or her to register.
Surprisingly, property syndications are excluded from the list of financial instruments that require a financial adviser to be licensed under the FAIS Act.
However, this potential loophole is closed because many syndications are structured around the sale of shares of companies and/or raising cash through the sale of debentures. Anyone selling property syndications that involve the sale of shares and/or debentures must register as an FSP in terms of the FAIS Act, Warren Neale, of the FSB’s FAIS department, says.
An FSP can be an individual or a body, such as a property syndication company, which ensures that its agents meet the requirements of the FAIS Act.
Being registered under the FAIS Act places a requirement on a financial adviser to ensure that you are properly advised. Do not accept that someone is registered merely because they tell you that they are. Check with the FSB.
Gerry Anderson, the FSB’s deputy chief executive in charge of the FAIS Act, says a number of syndicators have either not yet registered or have had their registration applications rejected.
He says the FSB has concerns about the syndication industry in general. The FSB has received complaints about intermediaries "giving clients incorrect information about this type of financial product".
If you believe that you have been ill-advised by a financial adviser at any time after October 2004 (when the FAIS Act become operational), you can lay a complaint with Charles Pillai, the Ombud for Financial Services Providers.
Anderson rejects a claim made to Personal Finance by Du Toit that, although SAAPS encourages its members to register as FSPs, intermediaries do not necessarily have to be registered under the FAIS Act.
Du Toit says the most typical structure used for syndications is the company structure. It is therefore assumed that everyone selling shares in a syndication company must be registered as a FSP.
"This is not correct. All syndication products consist of some form of property. Many syndication products, such as lifestyle syndications, fractional ownership or private club memberships are sold by estate agents, without them being obliged to register in terms of the FAIS Act," he says. "Many syndication companies employ in-house brokers who will not be able to offer investors the required choice of three products in terms of FAIS, and are therefore not required to register as a FSP," Du Toit says.
Anderson says the requirement to register as an FSP depends on whether the sale of a particular product "is a regular feature of their business or not. Even if the product constitutes five percent of the business on an ongoing basis, it will be regarded as a regular feature."
He says that Du Toit’s claim about "three products" is a "fallacy". "The FAIS Act does not prescribe three products. One is enough to require registration."
Coode says consumers have an "inalienable right to be informed". Consumers also have the right to invest in any investment vehicle they wish, provided they are aware of the facts and make informed decisions to invest on this basis.
"The withholding of relevant information, whether by accident or design, is considered an unfair business practice and, in terms of the Unfair Business Practices Act, consumers may lodge complaints with the Unfair Business Practices Committee to investigate," she says.
The steps you can take to ensure you are properly informed include:
* Ensure you are provided with a prospectus. In terms of the Companies Act, you must be provided with a prospectus if you are purchasing shares. The prospectus must be approved by the Registrar of Companies and must provide you with full details of the company and how it intends to do business.
However, having a prospectus does not necessarily mean that you will be protected from a scam. As has already been pointed out, many scams are camouflaged by the use of unlisted companies. The fact that the Registrar of Companies has approved a prospectus also does not mean that the business will succeed, or that it will earn the income projected or that your capital will be secure.
Du Toit argues that an unlisted company does not automatically offer less security to an investor.
"The level of risk will be determined by the purchase of shares and/or shareholders’ agreements used by the syndicator, together with the compliance procedures put in place to ensure that the funds flow according to these agreements. The company’s assets, liabilities and gearing policy will also play a role. The safeguards provided for in terms of the Companies Act (such as annual audits and annual general meetings) in most cases are sufficient to minimise risk.
"We believe that properly structured and efficiently run syndications bear little risk to investors compared to other investments," Du Toit says.
Obtain independent advice. At the very least, you should have a lawyer check the prospectus and read any contracts before you sign them.
Pros and cons of property investments
The advantages of investing in property are:
The disadvantages of investing in property are:
How to protect yourself
Note of caution
Take heed of the following cautionary note, from the Registrar of Companies, which you will find in the prospectuses of property syndications:
"The Registrar of Companies has scrutinised the information disclosed in this prospectus. The Registrar of Companies does not express a view on the risk for investors or the price of the share. However, the attention of the public is drawn to the fact that the shares on offer are unlisted and should be considered as a risk capital investment. Investors themselves are therefore at risk, as unlisted shares and debentures are not readily marketable, and should the company fail this may result in the loss of the investment to the investor."
This article was first published in Personal Finance magazine, 1st Quarter 2006.
Article by: Bruce Cameron - www.persfin.co.za