Buyer-funded developments: is the potential return worth the risk?
Post the financial crisis of 2008, the buyer-funded development model has become increasingly common. Recent media coverage tells a tale of failed projects, substantial financial loss and allegations of fraud. We explore how these schemes operate and the risks.
In the post financial crisis era developers have found it increasingly difficult to secure project finance from mainstream lenders. As a result, they have turned to alternative finance models, buyer-funded developments (sometimes known as investor led fractional sales) being one of them.
What is a buyer-funded development?
A buyer-funded development is a property development which is funded by the purchase deposits of individual buyers as opposed to a commercial lender. The properties are sold to buyers off-plan who pay a substantial deposit which is used to fund the project in its entirety. This can include construction costs, marketing costs, professional fees and even sales commissions.
Buyers (often overseas investors) are attracted to these schemes as the properties are often sold at prices below market value and with the promise of high returns in rental incomes after completion. The potential return on investment is significantly higher than the return available on a traditional property investment.
Their popularity with overseas investors can also be attributed to the mistaken belief that the developments are associated with (and therefore in some way protected by) the UK government.
The primary risk to investors when participating in this type of scheme is the substantial deposit paid on exchange of contracts. The conventional property purchase requires a 10% deposit to be paid which is more often held by the seller's solicitor until completion or protected by a new build warranty scheme.
A buyer-funded development can require up to an 80% deposit and this money is released to the seller and used to finance the project. In the event that the developer goes into administration, this deposit (having already been spent) is lost. Examples of this can be found across the UK with several failed projects in Manchester and Liverpool.
Construction often begins before the total monies required is secured. Further funding is often obtained as more and more plots are sold. Without the full funding in place at the offset there is a high risk of substantial delays as construction grinds to a halt as funds deplete. With construction dependant on sales, there is no certainty as to when the project will be complete.
The Solicitor's Regulation Authority ("SRA") estimate that investors lost over £100m as a result of buyer-funded developments last year alone. As a result, the SRA has issued a warning to UK lawyers against involving themselves in such projects. They have noted the 'substantial risks' associated with such developments and the possibility of buyers 'unwittingly financing high risk or fraudulent property development.
If you are considering investing in a buyer-funded development, ensure that you are aware of the associated risks and conduct thorough research on the relevant developer. If you would like to obtain further advice on this topic, please contact a member of our Residential Property team.