It appears to me that the fractional ownership vacation home industry has been dancing around a topic of fundamental importance for too long - the mark-up or "premium" charged to fractional buyers.

What's a fractional premium?

I was enjoying a slice of my favorite pie (rhubarb in case you're wondering) at a local restaurant recently. My slice cost $1.95, but the whole pie (six slices) cost $8.00. I was not that hungry and could not possibly eat six slices of pie at one sitting so I did not want the whole pie. It did not occur to me to complain to the manager that I could have purchased the entire pie, with all six slices, for $8.00. In addition, nobody else in my family likes rhubarb pie so I was not about to take the rest of the pie home. I only wanted one slice. I only needed one slice. I only wanted to spend $1.95. If I would have purchased the whole pie, most of it would have gone to waste and I would have spent $8.00 when I could have just spent $1.95 per slice for a slice or two. What justification does the restaurant have for charging $1.95 for one slice of pie when the whole pie is only $8.00?

Fractional Home
Fractional Home in California
We all recognize that when anything, pie, milk, land, or a vacation home is divided into smaller, more affordable parts the process takes some effort and involves a certain amount of risk. The effort lies in the division, independent packaging, independent marketing, delivery of and accounting for each separate piece. The risk lies in the costs associated with those efforts and the possibility that not all pieces will sell at a profit. Fractional vacation home developers face the same efforts and risks.

For example, your luxury vacation home can be "fractionalized" and offered for sale in fractional interests (1/10th, 1/8th, etc.). In such an offering, the premium associated with fractionalization may be obvious, because the simple math of (fractional price) $100k x (number of fractions) 10 = $1,000,000, whereas a neighboring property may be listed at about $700,000 for whole ownership.

How can a fractional developer charge $1MM for a home that is worth only $700k? He cannot - and it is important to recognize that he is not. He is, however, charging $100k for a 1/10th interest in the luxury home ten times over.

The difference is key. Fractional developers are no different than any other business people. They have a Cost of Goods Sold and a Sales Price. The difference, multiplied by their number of units, is their gross operating margin. In our luxury home example, the unit number may be only one, as in a single home. The fractions of that home are then "marked-up" to a higher price in order to pay for the division, independent packaging, independent marketing, delivery of and accounting for each separate piece of the underlying property. In California, fractionalizing even a single home is considered a "subdivision" by the Department of Real Estate. Fractional developers know how to comply with your state's subdivision laws and ensure that the vacation home is legally and permanently divided. Once property is divided to a higher and better use, value is created. Subdivision has never been free, yet because fractionalization of vacation homes is not obvious from the outside, fractional developers must have the ability to explain to their listing agents, buyers, and buyer's agents why the premium is justified.

What fractional premium is appropriate?

Numbers differ depending on product (resort fractional, residence clubs, or single family vacation homes), location and number of shares (1/4 up to 1/12). Resort fractional has the highest premium because they have the most shares. Resorts frequently offer very small fractions (1/26 for 2 weeks per year). Premiums on these fractions vary but may easily exceed whole ownership value x 2 (a "2.0 multiple"). Private residence clubs generally have a multiple between 1.6 and 2.0. (Hobson, W. and D. O'Reilly, Northcourse 2007 Annual Fractional Interest Report - United States, Canada and the Caribbean, p. 69.) For single family vacation homes, a multiple of 1.3 to 1.5 is typical.

The multiple system is rudimentary and will eventually be phased out. The reason that system is in place is because there are currently not enough sales comparables for other fractions in most locations, or if there are, they are wholly controlled by a resort fractional company, and therefore not much use to anyone else. Eventually there will be "comps" for fractions in resort and second home locations around the world.

Comments along the lines of "because you pay a premium over whole ownership you immediately lose money (as a buyer)" clearly miss the point - you cannot compare the fractions to the whole in terms of value. Doing so goes against the foundations of supply and demand, and simple market economics - rhubarb pie anyone ?.

As with all other assets, the value of a piece of real estate is what someone is willing to pay for it. Fractional developers open the market up to five to ten times as many people as whole ownership. When more people can afford a "slice" of a vacation home due to fractionalization, demand goes up, but supply is presently short because, relative to the market, there are presently only a few fractional developers. Therefore, the price increases because those who can afford are willing to pay more for the fraction than a straight division of the whole ownership value. Like the rhubarb pie, you may not want or need the whole vacation home. You may want to match your costs with your use of the vacation home, and you may not want to take on the risk of holding the whole vacation home yourself.

Accordingly, we encourage sellers to utilize the services of a fractional developer that knows how to effectively and permanently divide the vacation home into subdivided parts, and can provide a comprehensive management and accounting structure for the co-owners once divided. We also encourage fractional buyers and realtors to understand there is a premium, to investigate and verify the fractional developer's efforts to subdivide and, assuming it's satisfactory, embrace the premium as a price you are willing to pay to have the convenience of a smaller "slice" of a vacation home. Finally, we encourage the fractional industry to adopt strategies to educate buyers and realtors of the nature of an appropriately sponsored fractional offering (subdivision). Perhaps the industry should embrace the role that developers have always played in real estate projects. It would certainly eliminate negative connotations of "mark-up" or overpricing.

Gary L. Winter, Esq. is a member of the California Bar and practices real estate, corporate and trust law with the firm of Powell & Pool, PC, in Fresno, California. Jody L. Winter, Esq. is also a member of the California Bar where he practices real estate, probate and business litigation with the firm of Gilmore, Wood, Vinnard & Magness, PC, in Fresno, California. The brothers are founding members of Lloyd Lanson Fractional Ownership, a fractional development company specializing in single-family fractional vacation homes.