With real estate seemingly stuck in a nosedive, some sectors continue to offer investment promise. The luxury fractional ownership market, still in its infancy, may be the perfect opportunity, offering relatively high returns and showing strong sales growth even in today's market.
Imagine a 4,000-square-foot luxury home, overlooking aquamarine tropical waters and white sandy beaches. There's an infinity pool outside the master bedroom with rollaway walls to bring the outdoors inside. A personal chef is working in the gourmet kitchen - with its 4-inch granite countertops and duo SubZero refrigerators - filleting the fresh local catch for dinner.
Now imagine that this vacation home doesn't cost $3 million. You could have it for a mere fraction of the cost, say $500,000 for a one-eighth ownership share.
The fractional ownership segment of the vacation home market is characterized by high-end properties, from condominiums to single-family homes in the most sought-after destinations around the world. "Buyers might not be able to afford whole ownership in the kind of luxury residence they want to be in," says Randall Harris, a fractional developer and consultant with Island Fractional Homes, "which makes fractional ownership all that more appealing."
And all the more lucrative for developers and investors.
Fractional properties sound a bit like timeshares, but don't be fooled. Most timeshares don't exude this level of luxury. Timeshares are prepaid vacations, while luxury fractional homes are an appreciable exclusive asset," says Hart Rist, sales manager at The Hammocks, a North Carolina fractional development. Nonetheless, being associated with timeshares isn't necessarily bad, he says. People familiar with the timeshare model are quick to understand the benefits of fractional ownership. "The best prospects we get are those who have owned a high-end timeshare, perhaps at a Marriott or Hyatt."
Outrageous potential
This luxury fractional niche has demonstrated remarkable resilience in today's real estate market, showing consistent sales growth in each of the past three years. Ragatz Associates, a research and consulting firm specializing in resort market tracking for more than 30 years, recently began tracking sales in the fractional ownership market. According to the company's latest annual report, fractional sales dollars grew 7.8 percent in 2006 and 8.3 percent in '07. Further, this level of growth may only be the tip of the iceberg.
"There are currently 50,000 households in the United States that own a fractional property," says Rist, citing statistics from the recent Ragatz report. "And given the income threshold of most buyers is around $200,000, the market size is over 5 million households nationally. We've only tapped 1 percent of the market."
Penetration levels are expected to reach 5 percent in five years and 10 percent within a decade, growing from 50,000 owners currently to more than 500,000 fractional owners nationwide in 10 years, according to Ragatz Associates. And baby boomers will form a large segment of this growth as they reach retirement age and want a second home within their means. If these numbers prove accurate, this is an early stage, rapid-growth industry with tremendous profit potential for early movers.
The rest of the story
Such a bullish outlook begs several questions: How does one get into this industry as an investor or developer? What kind of return on investment can be anticipated, and what are the risks? Like any emerging industry, the biggest barrier to entry is finding information, and as little as four years ago, there was very little available in terms of research or successful case studies. Today, you can turn to research reports and online sites such as LuxuryFractionalGuide.com and HalogenGuides.com, talk to other developers, attend conferences, and network with consultants who specialize in developing fractional projects.
The return on investment depends largely on three factors: location, the amenity package, and local market conditions. "We want to see a product that is in the right location and meets the criteria for a high-end property," says Tom Ward, principal with Ward Financial Co., which provides developer and fractional buyer financing.
Sherman Potvin, fractional consultant and author of Fractionalize to Maximize, uses the following formula to calculate the total price for a fractional home: in a cool market, the sales multiplier for a fractional in a great location and with five-star amenities, such as a pool, golf, or beachfront views, should be 1.25 to 1.5 times the fair market value of a property sold as whole ownership. In short, that means that a luxury home that would sell at $1 million as whole ownership could generate between $1.25 and $1.5 million if sold as fractional ownership.
According to Bruce Cuthbertson, president of La Sarenne Luxury Properties in California, the profit range hasn't dissipated because today's down market may actually benefit the sales of fractional property. "Buyers are more discriminate with their purchases," Cuthbertson says. "Buying a fractional for $300,000 starts to make more sense than laying down $1 million to $2 million for an entire vacation home, which [the buyer] will use infrequently."
Fractional projects are seeing profits in the 25 percent to 35 percent range, say Rist, Harris, and Cuthbertson. Moreover, the time-value of money is an important factor not to be overlooked, especially for the small developer doing one or two single-family home projects at a time. As fractional shares sell, the developer can pay down his debt and obligations in incremental steps, and not have to wait for the entire property to sell, says Harris.
This kind of return isn't without risks. Traditional developers who haven't been able to sell their existing stock may try the fractional market only to discover it's a different animal to master. "Fractional developers have to wear two primary hats, one as the developer and a second as the hospitality manager," Cuthbertson says. Developers cannot treat a fractional project as an in-and-out affair. The lesson: Do your homework before jumping in.
Some investors might find the learning curve too steep or perhaps the day-to-day time commitment too extreme. They may choose instead to team with a development partner or with like-minded investors who are interested in the fractional niche. Cuthbertson says he and other developers are beginning to partner with homeowners and investors who want to either fractionalize their existing vacation home or invest in developing fractional property without having to be the day-to-day operations manager.
"I'm approached every week by people who want to fractionalize their vacation home or get into the market," says Cuthbertson. "I'm working with a few individuals who have the right product in hand. But not just any home will do. It needs to be five stars, not four-and-a-half stars."
The feasibility test
Most investors who've spent time researching and executing fractional projects say there are four to five key factors to consider before investing. "Getting into fractionals as an investor or developer isn't for the faint of heart," says Harris, adding that you can expect to spend months in the education phase, just learning about the industry, talking to other developers and consultants, and thinking about a possible location.
Rist agrees. "The first thing is get your hands on a feasibility checklist to see what questions need to be answered up front." See Project Feasibility Checklist for a sample.
Your checklist should address the various components required for a successful fractional development, starting with the most important: location. In this case, the location almost definitely has to be a resort-like destination that is well-known in and of itself, such as Whistler, Cabo, Hawaii, Jackson Hole, or Vail. Each of these locales evokes the feeling of a luxury resort destination, perhaps even exclusivity.
Along with location, your property has to have that five-star intangible feeling. "A fractional home should be held to the same standards as a first-class hotel," says Potvin. "You would expect everything to be fresh, clean, and pleasing to the eye."
Of course, there are exceptions to the rule, but few developers would try to create a fractional destination home in an area without resort-like attractions, such as a beach or ski setting, or that select atmosphere, which you can find in an upscale condo in the heart of New York or San Francisco. "Developing a fractional property in just any community will not work," Rist says.
Harris says he chose to develop fractionals in Hawaii in part because it passed the feasibility test but also because he had an affinity for the area. Harris worked in management consulting for 25 years before becoming a fractional developer, and he wanted to choose a location that he could appreciate and enjoy. He cautions, however, not to let your taste interfere with making a sound business decision.
Hart, Potvin, and Harris all recommend hiring a fractional consultant or expert to do a feasibility study before pulling the trigger on a project. "Better to uncover those hidden landmines before pouring hundreds of thousands of dollars into a project," says Harris. Generally, a feasibility study, which can run from $3,000 to $6,000 for a single home, will analyze the local conditions and attractiveness of a fractional product, determine any legal restrictions that may apply, and address the viability of a particular property, lot, or existing vacation home to be turned into a luxury fractional property with all the necessary amenities and services.
"Objectively evaluating your home and ruling it out if it isn't a good fractional candidate is critical," Potvin says.
Bringing it all together
With a feasibility study in hand, you have a blueprint for a successful project. Now, the devil is in the details. The property and concierge services must have the look and feel of a five-star resort. "Nothing less will do," Cuthbertson says. "We're selling a lifestyle, not simply real estate, and those impressions and attention to detail are what the buyer wants. We like to say we want our buyers to start their vacation the moment they arrive, not a second later. That means having the fireplaces stoked, outdoor and indoor lights shining, and a gift basket with their favorite single malt scotch waiting for them when they arrive." It's a much different experience than driving up to a cold, dark cabin in the dead of winter.
Developers often underestimate two vital areas: owner's dues and marketing costs. Far too often a developer will create an unrealistic annual dues structure that won't cover all the expenses associated with a property, such as ongoing maintenance and repairs as well as replacing all the furnishings every five to seven years. The thinking is to keep the dues as low as possible so as not to scare away buyers. "But be realistic," Harris says. "Don't underestimate those costs." Plus, your prospective buyers will appreciate having a realistic sense of those costs up front.
On the marketing side, you can't sit back and let a real estate agent list your fractional property on the multiple listing service (MLS) and expect buyers to find you. According to Rist, it's a whole different ballgame. "It's a relationship sell, where you might have to spend as long as six months or more getting to know a prospective client. Real estate agents need to be trained, otherwise they won't know how to sell it." Cuthbertson agrees. "Marketing is where you need to get creative and think beyond an MLS listing," he says. "Create relationships with fractional jet or luxury car clubs, restaurants, cigar clubs, and other affinity partners. We've even teamed up with our competitors to co-host events. The market is so young that co-marketing helps everyone."