Tuesday, February 8, 2011

10 things you should know about property syndications

10 things you should know about property syndications

10 things you should know about property syndications(part1)
By Bruce Cameron of Personal Finance | www.persfin.co.za

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. This is part one of a two-part article.

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 Africa’s 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:
* It has a negative effect on people, particularly pensioners, who depend on their investments to provide them with an income. The yields that property syndications claim they are earning are often double what can be obtained from traditional interest-earning investments, such as bank fixed deposits and money market accounts. This is why mostly elderly people and pensioners are targeted by property syndicators.

* The cost of borrowing money is cheap. This stimulates property sales and prices, because more people can afford to borrow money to buy property.

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:

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:

Not being able to find a tenant;

Not having the time or expertise to properly manage the property; and

Not being able to sell the property if you need the money invested in it.

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 investor’s 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 FSB’s 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.

Property unit trusts (PUTs). Unlike ordinary unit trust funds, PUTs are listed on the JSE and invest mainly in commercial property. As with unit trust funds, PUTs are highly regulated and enable you to invest smaller amounts of money in companies that specialise in investing in property.

Property loan stocks. You invest in a company listed on the JSE that owns a portfolio of properties. Unlike PUTs, property loan stocks can borrow an unlimited amount of money to buy properties.

Normal unit trust funds, registered under the Collective Investment Schemes Control Act, which invest in property companies listed on the JSE. Marriott is the best-known example of a company that offers such a fund.

Life assurance endowment policies where the underlying investments are in property.

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 Milne’s 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 arm’s 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:

The promoter (syndicator) identifies a property.

The property is bought, or an option is taken to buy the property, in the name of a company – say, Property Syndication A Company Ltd – which is registered with the Registrar of Companies.

Simultaneously, another company – say, Property Syndication A Holding Company (Pty) Ltd – is registered, which owns the company that purchased the property (Property Syndication A Company Ltd). So Property Syndication A Holding Company (Pty) Ltd is the holding company of Property Syndication A Company Ltd.

The holding company then sells shares and issues debentures to investors. In effect, Property Syndication A Holding Company (Pty) Ltd is borrowing from investors to finance the purchase of the property.

The value of the debentures and the number of shares is directly linked. In other words, the prospectus sets the number of shares in Property Syndication A Holding Company (Pty) Ltd. The number of shares will equal the number of debentures issued. So, say there are 10 000 shares (normally registered with a value of one cent each), each debenture will be sold with a value of say R999.99 and a share with a value of one cent. To buy a share, you are obliged to purchase the linked debenture. The syndicator is therefore raising a total loan of R9 999 999 from investors to finance the purchase of the property.

Property Syndication A Company Ltd then borrows the money (the R9 999 999 put up by investors) from Property Syndication A Holding Company (Pty) Ltd to purchase the property. The loan is unsecured. In other words, the holding company has no preferential claim on the property owned by Property Syndication A Company Ltd.

The investor has no direct ownership of the property. As the Silverton and Magalieskruin prospectuses make clear, the investor is making an “unsecured” loan (debenture) to the holding company. Even where debentures are not used and you own shares in a company, the company that sells the shares will not necessarily be the direct owner of the property.

The debentures are normally open-ended (no fixed repayment period) and only repayable on the sale of the property. In other words, there is no guarantee that you will receive back what you paid.

The investor has no say in how the company or the property is managed (including setting the rentals). Ownership is structured in favour of the promoter, who has ultimate control of the property.

The investor receives no capital or income guarantees. If any of the companies in the structure go bankrupt or no rents are collected, investors have very little claim against the company. The promoters are even further removed, although the directors of the promoting company are usually also the directors of the holding company and/or the company used to buy the property.

(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).
“A market where share prices are determined by supply and demand does not exist for these unlisted shares (see point 7 on liquidity).

“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:

Add value, by making large properties more accessible to the investment public.

Buy properties to be syndicated directly from developers or the owners. This cuts out estate agent’s commissions, thus saving on the purchase price. (However, this is not always the case. In the Silverton property syndication, commission of 2.23 percent was paid. This is lower than the average of 4.5 percent commission that estate agents normally earn. They can earn commission of up to 7.5 percent.)

Pay cash for properties or structure the purchase as a cash sale. This enables the syndicator to negotiate a lower price.

Negotiate favourable leases. In other words, they get higher rents, increasing the value of the property.

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.

“Yesteryear’s 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 valuer’s 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:
* Property sales in the area. If property prices have not matched increases in other areas, this is a good indication that it is not situated in a desirable area.

* The rentals in the area compared with those in other areas. It is a bad sign if, for example, rentals in the area where the syndicated property is situated are R20 a square metre, while in nearby areas they are R50 a square metre.

* Is the area generally run down or not? An in loco inspection of the property will quickly provide the evidence.

* What are the crime statistics in the area? No business wants to be in an area where crime is rampant.

* Is the property in an area where it is exposed to public view and will have “feet through the doors”? A commercial property two blocks back from the high street is unlikely to attract tenants at competitive rentals or those who will sign up for long leases.

Most individuals, particularly pensioners, buy into property syndications because they want to generate an income.

If you invest in a RSA Retail Bond for two years, you will earn interest of 7.5 percent a year, a three-year bond will pay you interest of 7.75 percent and a five-year bond will earn you interest of 8.25 percent.

Against this, property syndicators project yields of between nine and 20 percent a year.

But investors need to be wary, because it seems that many syndicators overstate the rental potential while understating the management costs, which they often have an almost unfettered discretion to adjust.

In the case of the Magalieskruin Holdings Limited syndicate, the annual returns are projected at an average of 15 percent over a term of 10 years.

Sanlam says it seems the returns are based on “unfounded” assumptions, which also do not appear to take into account all the taxation consequences (personal income, capital gains and corporate tax).

The “unrealistic returns” are based on equally unrealistic assumptions, such as projecting rental increases at a rate of 10 percent a year when a rate of less than 7.5 percent would be more realistic, Sanlam says.

Returns are illustrated in many different ways by property syndicators, often to confuse you.

The issues you need to take into account when evaluating returns are:

The yield. Most returns are expressed as a yield. In most cases, the yield is a calculation based on the projected (but not guaranteed) rental income less annual costs, plus an increase in the capital value of the property. So, not only should the rentals be fairly and realistically stated, but so should the annual costs and the increase in the capital value.

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.

Capitalisation (cap) rate. You may also be told about a “capitalisation” or “cap rate”. The cap rate is calculated by dividing the value of the property by its expected rental income over the next 12 months. Any cap rate over 10 percent is unlikely to be accurate. You also need to establish whether the projected returns are net or gross of all costs and tax.

Tenancy vacancy rates. This is the period of time, expressed as a percentage, during which the property, or part of the property, will be without tenants. Anton Gildenhuys, the chief executive of client solutions at Sanlam, says property syndications often assume low tenancy vacancy rates, pushing up the projected returns to unrealistic levels. The tenancy vacancy rate is often put as low as 1.5 percent, while the industry average runs closer to six percent.

Rental increases. Increases should be based on those contained in signed leases and not on projections by a syndicator. Projections can be affected by numerous factors, including the state of the economy and the state of the rental market. In the residential property market, rentals are under pressure because there is a surplus of properties that investors have bought to let out.

Annual management, administration and other fees. These fees are often not clearly defined, but are usually in excess of 10 percent of the projected income, when all annual costs of the property and the administration of the companies involved in the legal structure of the syndication are taken into account.

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.

Management charges are collected from all the structures. There are administration and management charges for the property itself. In addition, there are annual management and administration charges for each of the legal structures. So, if two companies are involved in the legal structure, the syndicator will levy charges for the administration of both these companies.

The advantages of investing in property are:

It helps you diversify your investments;

Property can provide an income stream (rent) that usually keeps ahead of inflation; and

You can get capital growth, too, if you buy in the right area.

The disadvantages of investing in property are:

You can incur significant losses if you buy in the wrong area. You need to be extremely careful about where you buy a property investment.

You stand the risk of buying a building with structural defects or other problems.

Not being able to find a tenant can put your income stream at risk.

You usually need fairly large amounts of money to buy a property directly. This hurdle can be overcome by buying into pooled investments, such as property unit trusts.

The costs of buying and selling property are high when you take into account taxes, transfer fees, commissions and legal fees.

Your money may be difficult to access if you need to sell in a hurry (you have to find a buyer). If property prices are stagnant, the urgency may result in you having to sell at a loss. However, in an emergency, property is considered to be sound collateral for a loan. This problem can also be overcome by buying unit trusts that invest in property. Unit trusts are very liquid (they are traded on a daily basis and there are many buyers and sellers).


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