This article was originally published in Blakes Bulletin on Real Estate & Mortgage Financing - March 2005
In 2010, Vancouver and Whistler will host the XXI Olympic Winter Games. That fact, along with British Columbia’s steadily growing tourism industry, is fuelling interest in new, flexible recreational property products. One such product that has been successful in British Columbia recently is the marketing of fractional real estate interests, or "fractionals". This article will explain the concept of fractionals and will analyze some of the issues surrounding the development and financing of fractionals that will be of concern to lenders.
Legal Nature of Fractionals
Most people are familiar with time-share interests, which are a quasi-real estate product where buyers receive a contractual right to use a unit for a specified period of time rather than a registered interest on title. Fractionals, by contrast, allow the buyer to actually acquire a registered fractional interest in the property. Typically, a purchaser will acquire an undivided fractional interest as a tenant-in-common with the other purchasers of the property. The purchaser’s use of the property will be governed by an agreement made between all the purchasers of the fractionals, or by means of an owners’ association to which all the purchasers belong. In this respect, the fractional is similar to a co-tenancy interest. However, as with time-share interests, a registered fractional interest entitles the buyer to occupy and use the unit only for a specific period of time corresponding to the size of the fractional interest. Unlike most traditional time-share interests, the fractional offers the benefits (and risks) of common ownership of real property.
Financing of Fractionals
The nature of fractional ownership makes it difficult for purchasers to finance their investment through conventional lending institutions. Consequently, in order to increase the marketability of fractionals, most developers of fractionals will attempt to finance the development with a lender who is prepared to offer financing to individual purchasers. This is usually accomplished through a form of vendor financing that passes from the developer to the lender. The vendor financing is secured by a mortgage granted by the purchaser to the developer, which mortgage is assigned to the lender.
In addition to the complexity of this overall structure, lenders need to understand and address the risk that default by a borrower (whether the developer or a purchaser) will potentially put the lender or its assignee in the position of being a party to an agreement with a number of other common owners. In this respect, fractional financing is similar to separate mortgage financing to individual co-tenants. Construction lenders typically wish to have no part of such an arrangement. Accordingly, construction lenders will generally require an unconditional take-out commitment from the term lender prior to committing the construction financing of a fractionals project.
From a due diligence perspective, lenders should be aware that, in British Columbia, the Real Estate Act (Act) governs the marketing and sale of fractionals. Navigating the onerous legal framework that regulates fractionals can be a complicated and costly process. Part 2 of the Act requires developers to file a detailed prospectus in prescribed form with the Superintendent of Real Estate, a government regulatory body, before they can begin the marketing of fractionals. As in the securities industry, the prospectus prescribed under the Act is designed to enable prospective buyers to make an informed decision. The approval process can be quite lengthy. As the prospectus is required to disclose the essential details of the financing, many of the terms of the financing must be worked out well in advance of the actual completion of the loan.
Clearly, fractionals are unique real estate products which are likely to become more prevalent given the growing demand for recreational property in British Columbia. Fractionals will likely play a substantial role in meeting that demand. Specific expertise and understanding of the structure and legal framework of fractional interests will be crucial for lenders and others in dealing with fractional developments.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
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