"Guaranteed Grief"

Crack Down on Guarantees!

The one thing that stood out the most to me 6 months ago was the seeming limitless amount of firms offering guaranteed investment returns. To me this was a tell tale sign of a boom town market that was headed for trouble. Sadly, we have yet to see a crackdown on these “guarantees”. Today, I received an email from a friend regarding a “Buy Back Investment Consortium” being proposed by a real estate agency. According to the email(which I did btw confirm by calling the real estate agent), Smith and Ken “have taken away the uncertainty and are offering a guaranteed profit on your investment within 6months of 30%.” I do have to admit these marketing ploys are impressive. The words “Buy Back Investment Consortium” even caught my attention. Here is how it works. You put up what amounts to 10% down on a developers project. In return, Smith and Ken will give you post-dated checks repaying your investment and also entitling you to 35% return for the 6-months of your investment. Minimum amount you can put up is 100,000 aed. The current max is 18,000,000. Presumably this is because they have raised 22,000,000 of the 40,000,000 they are seeking(the project is valued at 400,000,000). Pretty straight forward. Smith and Ken raises 40,000,000 for the developer which can than market and launch their project. The developer than sells the units off-plan and at a decent markup and thus can buy-back the property or in effect the 10% down payment you provided them because it has swapped that down payment out with one from a purchaser. The developer in question in this transaction is M-Holding which the UAE property development arm of the Mundia Group. M-Holding has recently launched two executive tower projects in Ajman. Based on the success of these launches they acquired 15 plots of land from Dubai Investment Real Estate Company(DIRC) for 615 million aed(in July of 2008). Their goal is to develop a 3billion aed freehold community in Mirdiff. Seems pretty sensible. So, then why can’t the developer come up with the money needed to market this project? There are really only two answers to this question.

1) The developer has the funds but doesn’t want to take the risk and thus would prefer to pass it onto investors

2)The developer doesn’t have the funds.

My guess is their previously hot Ajman project is seeing more than its fair share of problems and this is now compounding the problem of what was probably a gross overpayment for land in Dubai this past summer. Thus, I do not see how this buy-back will ever be accomplished. The developer can claw back 8% of the funds from sales for their operations. That is supposedly how they intend to pay you back. If we take the 40 million and add the 35% promised return, we get 54million in cash outflows that will need to be made between the end of month four and the end of month 6. With the 8% claw back(not sure if they are right on this my impression was that RERA is allowing roughly 5% of the escrow funds to be used for marketing, broker fees, and disbursements) that means they need to come up with some serious sales to unlock the funds needed to pay you.

RERA’S Interpretation of Trust Law No 8. Of 2007

1. Payments will be managed on the following basis:

§ Installments will be made to the contractor of the project according to the agreement between the project consultant and the bank.
§ 5% of the sum will be given to the developers for marketing and other miscellaneous purposes.
§ Installments could be taken from the account if the sufficient funds were available for the completion of the construction of the project for the which the account has been opened.

Smith and Ken’s QA

2. Why does the Developer need to borrow cash?

With the trust account laws in Dubai, Developers have to have the funds in place in order to build their projects without using the purchaser's funds, and can no longer use the money from purchasers until the project is complete. They can, however, claim back a percentage of the money once the project has been launched which calculates to around 8% of the value of the project. In order to launch the project, the Developer needs money, and with their money tied up in escrow accounts(what money are they referring to here…this makes no sense) they can't launch. Hence the creation of the Buy Back facility providing the Developer with the cash to launch, releasing further funds, allowing/enabling the Developer to pay the Buy Back within either a 6 or 12 month timescale.

Doesn’t make much sense does it? The funds they need are for marketing and launch, which theoretically should produce sales, which then will lead to funds in escrow as trust law requires each project to have a separate escrow account. So, what additional funds are going to be released? Are S&K referring to other projects in which their money is tied up? To come up with 54million through the 5% release the escrow account needs to have 1billion aed in it. So, that is a pretty weak explanation. My guess is they are treating this as a free ride. They have bought the land and the only way to make any money of it is by launching a project. So, they cut a deal to come up with the funds for launch knowing that once they have a launched project that is generating some sales they can more easily fund their ops. If they are dead wrong, well then the land goes to Smith and Ken at a fraction of what M group paid for it. Seems sweet for S&K, but then again I am sure the details here are not as clear as we think. But in this market you never know.

Ironically, the notable headline of last week was angry investors looking for Imran Khan of Al Barakah Investments, who has failed to deliver the 50% returns he promised more than 100 investors who made down payments on Ajman and Dubai projects. Mr. Khan has presumably defaulted on his post dated checks and is now seeking time to repay these investors. In an emailed statement he says and I quote, “I am out of touch with the outside world and the real estate market in Dubai for more than a month now. Due to the above, I am not in a position to make a realistic forecast of the future.” I guess Mr. Khan is learning the hard lesson that actual returns can and often do vary greatly from expected or anticipated returns. Had he done just a little bit of reading before he formed his investment firm he would have known that promising or guaranteeing returns via post-dated checks to investors could end up very badly for him. He goes on to say that he “deeply regrets the we are in this unfortunate situation..I never expected the real estate market to come to such a standstill.”

But Mr. Khan isn’t the only person at fault here. Investors who were willing to put up money thinking there was such a thing as a guaranteed 30%-100% return in a six month time frame should have known better. Enter irrational exuberance and the madness of crowds. If people were willing to spend 20x their annual salary or the equivalent of 12 acres of land for one tulip bulb in the 1600’s, we should not be shocked by their willingness to put up money for a piece of property. This is why we need regulators to step in and create as many possible obstacles to stand in the way of self-destructive human behavior.

I am not calling for mass regulation, but rather just some level of oversight that prevents irresponsible behavior like the aforementioned “guaranteed” profit schemes. The people or entities propagating these schemes could be fairly characterized as reckless or even moderately deceptive. If you wanted to take it to the next level you could argue that some of them were being fraudulent as they knew that ultimately what they were selling was a ponzi scheme(which btw we’ve had a few of the plain vanilla variety in the UAE and Middle East in general over the past couple of years) that would leave some investors hanging dry. A good first step might be that RERA prohibits any marketing in which profits are guaranteed to investors or forces any marketing material to contain a disclaimer warning investors that actual returns may differ from anticipated returns.

It would be a step in the right direction for this market and would ultimately give other investors confidence that precautions were being taken to look out for their interests.