Beware shiny wrapping

By PHILIP MACALISTER

Warning: before you buy an attractive, high-yielding, property-based investment, make sure you know what is inside the package.

Investors have been given several reminders in the past two weeks that, often, they are buying something quite different to what they thought.

The area where this is most prevalent is investments based on property assets.

As Tower Managed Funds managing director Jim Minto says, most investments are "commodities" and the promoters are always trying to change the look of them.

The idea is to change an investor's perception of the product, thus encouraging them to buy it.

When it comes to investments, there are only a set number of what we would call traditional areas you can invest in. The main ones are the four asset classes: shares, bonds, property and cash.

Because of competition and marketing pressure, promoters of various investments in these areas are always looking at new ways of packaging a product to make it attractive to investors. Sometimes that may involve melding asset classes to make a hybrid investment vehicle.

The idea is not new, and there are plenty of examples in other areas. Take the Chinese gooseberry, for instance. First they renamed it kiwifruit, then, when other countries started growing the brown fuzzy fruit and taking some of New Zealand's market share, the marketers introduced the Zespri brand - while all the time what people were still buying was a good old-fashioned Chinese gooseberry.

The sharpest warning for investors this week has been in the area of syndicated property, where New Zealanders have in recent years invested an estimated $1 billion.

The Securities Commission has just released a report on the way the promoters of syndicated property act, and it concludes that some of the marketing practices are not up to scratch.

The commission describes what syndicators are offering people as an "investment in commercial property through genetically modified corporate struc-tures."

Syndicated property is a bit like broccoflower - the vegetable you get when you cross a cauliflower with broccoli.

In this instance promoters have taken an equity investment in property and dressed it up to look like a bond so that it will appeal to people wanting a high regular income.

The commission's report focused on the "stapled products" - that is, the ones where an investor has to buy a package containing a minimum number of mortgage bonds and shares.

As the commission says, many of the stapled investment packages are pro-moted on their returns and the income from the bonds, yet many fail to tell investors of the risks.

"The focus is on short-term cash distributions rather than the true nature and risks of the investment - an investment comprising two parts."

While they are presented as a proxy for fixed interest with a better return, they are actually a property-based equity invest-ment.

Instead of asking people if they want to buy something that looks like a fixed-interest investment, it would be more accurate to ask people: "Do you want to buy an equity stake in a small property company and issue yourself some interest-bearing mortgage bonds?"

Commission chairman Euan Abernethy warns property syndicators about the potential to mislead or confuse investors when they highlight one piece of information - usually the positive aspect - for marketing purposes, to the exclusion of other, usually negative aspects.

The warning is also a reminder to investors and their advisers that they need to be clear about what they are buying and what the risks are.

Contributory mortgages is the other area where investors have had a fright in the past fortnight, when one of New Zealand's biggest financial planning firms, Harts Reeves Moses, said it had some problems with the way it was running them.

As a result of these problems, which related to management of the mortgages, Harts Reeves Moses and its former owner, ASB Bank subsidiary Sovereign, have offered to buy back contributors' investments in about $19 million worth of under-performing loans.

In total, this buyback represents about 15 per cent of the mortgage portfolio.

Contributory mortgages were popular in the mid-1980s through the likes of RSL and Landbase, but these companies collapsed in spectacular fashion after 1987 and many investors lost significant sums of money.

A contributory mortgage is where a solicitor, financial planner or mortgage firm gathers money from investors, pools it, then on-lends it as a mortgage to a borrower.

A distinguishing feature of the contributory mortgage is that the investors get to put their name, as opposed to the intermediary's, on the mortgage .

The intermediary's role is to collect and distribute the interest payments back to the investors and ensure the borrower honours his or her obligations under the terms of the loan.

Contributory mortgages, while once popular, have become reasonably rare, as Governments have tightened the rules and made it necessary to provide a high level of documentation.

Former Reeves Moses executive director Roger Moses warns in his 1995 book, A New Zealand Guide to Living Well in Retirement, that if the documentation is incomplete, the borrower may have the right to deny owing the money.

"If the borrowers can substantiate their claim that the lender did not complete the required documentation, you may never get your money back," he says.

Mr Moses also tells investors to have the intermediary certify that "all forms that are necessary under the appropriate laws" have been signed.

Contributory mortgages have appeal to the same sort of people who are attracted to syndicated property. On face value, they offer a premium interest rate and the wonderful security of a first mortgage.

But the entrails can look quite different.

Often, money is borrowed to fund high-risk development-type properties that banks are either unwilling to advance money to, or charge such a high interest rate on that borrowers look elsewhere for a better deal.

A good analogy of the risks involved in funding development properties is the construction of a building. First a big hole is dug and there is a risk you'll fall in and get injured. But, hopefully, a building will rise out of the hole and become a successful investment.

The difference is that on the property site there will be warning signs, while the investment proposition dangers will be less clearly marked.

This is a point made by the commission in relation to the syndicated property offerings.

Mr Abernethy says the promoters will often give prominence to the good points, such as the rates, but fail to explain the risks.

Mr Minto says one of the big issues in the market is investors mispricing credit risk, and this is illustrated in the contributory mortgage area and with some of the junk bonds that have been issued to finance property developments.

For instance, a bank, which has very sophisticated credit analysis skills, may offer to lend money to a developer for, say, 20 per cent, because it considers the risks to be high.

However, an organisation such as a contributory mortgage firm may offer finance at a much lower rate, say 15 per cent, and fund that through raising money from the public.

The public are offered a rate somewhere between 10 and 15 per cent and look at it as a good deal, because it is far higher than they could get through a bank term deposit.

But while there is a negligible risk the bank will default on its term deposit, there is a far higher chance the borrower in a contributory mortgage will default.

The developments of the past fortnight are a salient reminder to investors of one of the most basic rules of investment: the bigger the risk the bigger the return.

As the Securities Commission keeps telling us, if the returns look too good to be true they probably are.

* Philip Macalister is the editor of online money management magazine Good Returns, which provides news and information on managed funds, mortgages, superannuation and financial planning.