Scam alert

2010 seems to be hotting up to be another one of those years – investor sentiment is strong and the good old Aussie habit of feeling that we are invincible is permeating the housing market. Ask anyone in the street how they feel about the GFC and they are likely to say ‘What GFC?’. Being geographically isolated always seems to allow us to pretend we aren’t part of this world and that events from overseas won’t impact here.

And of course the spruikers are destined to return to the market, as they always do when enthusiasm is so strong. If you are thinking of investing in property at all this year, I want to make you are aware of just a small handful of the sorts of schemes you should look out for by taking a look at some of the more common scams, strategies and spruiking methods you may find in Australia this year.

Wraps

In a nutshell, wraps work like this: the investor (hereto known as the ‘wrapper’) purchases a property then approaches a potential homebuyer who is currently renting, but for some reason cannot borrow — they may be credit-impaired or simply cannot afford the repayments and so do not satisfy bank lending criteria. The wrapper ‘sells’ the property to the homebuyer with a contract that settles at a pre-determined time in the future at a price greater than what the wrapper paid, but less than it should be worth when the time comes. In the meantime, the buyer lives in the house for a ‘rental’ payment, which is actually a loan repayment. However, since the wrapper is now taking on some risk (in selling to a person who cannot borrow), he not only adds a premium to the house price but he also adds a premium to the interest rate (say 3%).

Here are the catches as I see them:

• The property remains in the wrapper’s name up until settlement. The wrappee has no protection.

• If the buyer cannot get a loan or defaults on payments the wrapper keeps the home and all repayments are forfeited.

• If the property market falters even a tiny bit, then the buyer is disadvantaged.

• The premium paid on the interest rate usually makes the ‘rent’ repayments at least double that of standard rent returns.

Wrapping is immoral and fraught with danger. Stay away from these schemes and question the professional ethics and other teachings of anyone who recommends this as a strategy.

Renovators

I have seen people purchase property, apply their considerable knack for renovating (as well as a considerable amount of their time) and sell the same property a short time later for a substantial gain.

I have seen dozens, even hundreds, more people who had the same idea but could not pull it off, spending time and money to make no more time or money for themselves at the end of the process.

By the time you take into account the material costs and the true cost of your time, and then deduct the capital gains tax you will pay on the gain then the chances that you will make real profits from this kind of renovating and trading are very small. Even if you can make money this way you have to be good at renovating, have time on your hands and you must purchase property that is as close to you as you can get it (since travelling to and from a property some distance away is simply not feasible). For busy people who want to build a portfolio that will one day provide the income to allow them to leave the paid workforce, this is simply not an option.

Buying ‘off-the-plan’ to sell for profits

A perfect market with stable growth would indicate that you could buy a property ‘off-the-plan’ (that is, yet to be built) at today’s value with a long-dated settlement and then, just before settlement becomes due, sell it to someone else for a profit. This way you don’t even need to borrow any money as you will never take actual ownership of the property.

In real life, it very rarely seems to work this way and the danger for people trying this is great.

Firstly, developers do try to sell off-the-plan property for a price that is somewhere in between today’s prices and the expected future price, given stable and consistent growth. This means that if those expected future values are not achieved, the buyer may well lose out. He or she will be required to proceed with the purchase (or lose the deposit) and he or she may then have to take out the loan after all to proceed with the purchase.

Another drawback is that many off-the-plan contracts have a clause in them allowing the developer to pull out of the deal, at any time, for any reason. There have been many purchasers who have bought property off the plan and when, some years later and just before settlement it is actually worth more than they agreed, find that the developer exercises his right to terminate and pulls out of the deal, preferring instead to reap the profits for themselves.

Rent guarantees

Rent guarantees themselves are not necessarily bad things and for some people they can provide a comfort and security to someone wishing to buy a property that seems a good investment for many reasons.

A rent guarantee is a promise to pay an agreed sum for a pre-agreed term. It is not a promise to secure a tenant, nor is it a guarantee that the property can attract the amount of rent specified in the agreement. The ‘guarantor’ has no legal obligation to prove that he or she can actually finance this promise, nor is he or she required to give any evidence as to how the amount of the guarantee was arrived at.

Rent guarantees aren’t worth the paper they are written on. They cannot magically turn a bad investment into a good one  and once they are over you are still left with the bad investment. 

If a property needs a rent guarantee, then what is wrong with it?

Buying overseas

Buying overseas is currently emerging as the next best thing for property investors. You must consider the following:

• We are not short of good properties in Australia.

• You may need a complex structure in an overseas country which you may not legally understand

• You cannot use your property here in Australia to cross-collateralise and this will limit your leveraging ability

• Investing rules are very different than Australia’s and you would need to learn about them before going ahead

• You cannot establish accurate information about the property and cannot know enough about the market at arms length. 

Investment clubs

While these clubs may seem ‘free’ and independent, and are set up so that they look like it is a group of your ‘peers’ providing free assistance for you to buy property safely, few are really like this. I caution you to question the impartiality of any group that charges a ‘commission’ on the sale of the properties it recommends. Some of the companies also receive undisclosed kickbacks from the developer after the settlement which actually adds many thousands of dollars to the true market value. Most of these clubs are not what they seem, their advice is subjective and they profit from every purchase you make with commissions way above acceptable levels as well as purchase prices above market value.

Contracts with a ‘rebate’

Some properties are sold with a rebate promised after settlement. While having a rebate clause in the back of a contract is not illegal per se, the acts that it inspires may be. If you apply for finance based upon such a contract, you may break a law if the actual final price after rebate ends up being less than you told the bank it was. Be very careful that any action you take when purchasing any property is transparent and you are sure it is within the law. This includes making false representations to the bank about what you can afford to repay and taking out ‘lo doc’ loans (loans that require you to simply sign a statutory declaration as to your ability to repay) in which you lie about your earnings.

Land banking

Land banking in general can make sense, if you are able to buy land with every chance of future planning approval and you can afford the high costs of holding an asset that does not generate income for you. However, the strategy becomes incredibly risky if the land being sold to you is overseas as many of these schemes are.

Always take care and be very wary about anything that is presented to you with any dubious or difficult to confirm information.

Two-tier marketing

Two-tier marketing was banned in Queensland some years ago, but it doesn’t mean it no longer happens. In its most basic form, two-tier marketing involves the sale of property to out-of-towners at a price higher than what the same property would be sold to the locals for. While it can happen anywhere, it is most prolific in Queensland. You do not necessarily need to view a property before you buy it for it to work for you, but you do need to take time to carry out the research.

More than one company

An investor I met once told me that he had been told he should start out by setting up a company in order to buy property. No doubt an endless array of benefits in adopting this approach had been paraded before him, while the considerable drawbacks, such as loss of valuable tax benefits and CGT concessions, would have been glossed over.

The advice that really worried me was that given to counter the problem of reaching borrowing limits with the bank. He was told that this was a simple issue to get around. ‘Just set up a new company,’ he was told. This way, the commitments of the other company that had so far made all of the property purchases would not be considered by the bank and the new company, having no commitments, could freely borrow.

When you borrow from a bank, it will perform a director’s search on you, which will reveal if you are the director of any other company. If you are, you will be asked to prove that the other company – or companies – does not have an unmanaged debt and the commitments, income and expenses of all companies of which you are a director will be considered when ascertaining your borrowing capacity. So, not only does this particular strategy mean that you now have the cost of setting up and maintaining another company, it also does nothing to change your borrowing status! 

Cash flow mortgages

The cash flow mortgage is a concept that claims to enable ‘property investors to invest in high-growth property and get positive cash flow as well’. In fact it is all smoke and mirrors and a loan like this can be highly dangerous. It involves obtaining a loan to buy property, where the interest rate is higher than a normal loan. In year one you pay a discounted rate of interest, while the remainder is tacked on to the balance of your loan. Each year the interest you actually pay is increased by 1%, with the balance between that and the actual rate being ‘capitalised’ into the loan. After five years your actual rate of interest repayment is the same as the applicable rate of the day.

The theory is that, as you essentially have a lower ‘interest’ expense, you can make a previously negative cash flow property positive. The truth is that the property is not really positive cash flow as the interest charged is still the entire amount — you have just avoided paying some of it in the first few years. More importantly, the scheme relies on great markets. You cannot predict future growth and if you do not get good growth then you could end up with a loan higher than the value of the security it has bought.

Stay safe

Stay safe by making it simple. There are a boundless number of really good opportunities to simply buy good solid residential property with no clever structures and certainly no reliance on any type of loophole.