Introduction
NotHarry used to work for a building society and qualified as a Chartered Banker, so knows a bit about property lending. This is useful in spotting scams or just risks in property investments schemes. Here is a simple but common example explained.
Rock and Roll
A small or maybe not so small building company has acquired some land in a location where it could develop quite a few houses or flats, maybe a holiday destination in the UK or in this example more likely overseas. But it can’t afford to pay for the building work to get to the point where the development is more than just the attractive artists impression with all those instant trees and healthy looking people with happy kids and well behaved dogs.
So as you would expect the builder (for simplicity I will call the firm ‘he’ from now on but it will be a limited company or similar) goes to a bank for a loan. The bank lends an amount of money that is covered by the value of the land with a margin of safety to protect itself. It tells the builder he can’t have any more money until he has sold some units and paid back the initial borrowing. This is called a rolling loan. The bank lends as its sees that the development is actually saleable and it can have more security from finished, saleable units. In the main banks are cautious!
But the problem for the builder is that the loan on the security of the land is not enough to build out the whole development. In fact he can only build a very few properties with that money and he wants to market the whole concept. He also has to pay for the marketing and commissions to sales agents. Plus his costs for laying roads and common services all come up front.
Interest Free Loans
The marketing people have the answer to his problems. He sells the properties ‘off plan”. They will tell prospective buyers that if they put down a deposit now, they will get a better price than if they wait until there are finished sold units when prices will shoot up, “like they did last year” (or some similar exaggeration or tale). The deposits are set quite high, maybe 20% or more.
The marketing agents makes sales, deducts its full commissions of course and pays the remaining deposit to the developer, who now has interest free money to finish off a few more properties. As the units are actually finished and paid for, the builder can meet his obligations to the bank and ‘roll’ his loan facility to keep building. In an extreme situation, he might not even need the bank at all, just using the deposits taken, but that is going to be unusual, I would suggest.
Oh Dear 🙁
This works for a while, but suppose then there is a recession and the value of the units already finished falls as buyers dry up and the site looks tatty and unfinished as well. The bank refuses to renew its rolling loan as it has become more cautious. The builder can’t finish units part built and goes into insolvency as there are now no new buyers supplying deposits either.
What happens to the deposits of those people with part built or even not even started properties? You can guess. They join the list of unsecured creditors of the building company and are unlikely to see a penny or a cent come back.
The lesson
An obvious one, but people don’t seem to want to accept it: never pay a large deposit on anything without a cast iron guarantee backed up by legal advice from a specialist in the region where you are buying that you can get it back if your purchase is not delivered.
Personally I see the idea of ‘off plan’ sales as being open to all sorts of other risks (eg differential pricing of the same units, preferential or delayed completion times and so on), so would avoid the concept absolutely. Of course, some people, some time have made money speculating in this way, but I am not writing for speculators! Stick to playing Monopoly!