The pros and cons of rental guarantees
Here, a developer promises a purchaser a guaranteed rent – typically for a period of one to two years – to help make the investment more attractive to buyers and their lending institutions.
Coupled with stamp duty savings and depreciation benefits, developers have used rental guarantees cyclically since the late 1980s, to help start projects that may not have otherwise got off the ground.
Rental guarantees are also used by student and tourist accommodation providers, who take management of the leasing and outgoings and pay an owner a weekly rent.
One such investment currently on the market is the Enterprize Hotel in Spencer Street. Promising a 6.5 per cent return, the building owner is offering studio-style suites from $164,000, leased back to the hotel operator for three years.
Nearby on the corner of Spencer and La Trobe streets, a similarly sized apartment, without a rental guarantee or indeed a tenant, was asking $145,000.
So what does the extra money buy you?
According to Enterprize Hotel marketing agent Carlo Rosetti of Melbourne Business & Investment Corporation, it buys security.
“Rent will be paid into the investor’s bank account immediately after the property settles,” Mr Rosetti says. “Investors buy the security of knowing rent will continue to be deposited into their bank accounts for the next three years.”
In the case of the Enterprize Hotel, the rent received would cover most banks’ minimum mortgage repayments, leaving buyers with an asset that virtually pays for itself for at least the next three years.
But it’s what could happen at the end of those three years that property valuers say should send alarm bells to potential investors.
“If a deal sounds too good to be true, it usually is,” says Richard Bowman, principal of Ernst & Young Advisory Services in Melbourne.
Mr Bowman says that in most cases, particularly related to off-the-plan apartments, the guaranteed rental is factored into the initial purchase price of the property, which is often higher than market value.
This is reflected in bank lending criteria, which usually requires investors to have deposits of up to 40 per cent to finance a rental guaranteed investment.
“Lending institutions will usually strip out the rental guaranteed component of an investment such as this, and value on a vacant possession basis,” Mr Bowman says. “They will then add the value of the rental guarantee to the property for however number of years that guarantee is offered.”
He says in many cases, the amount of rent received drops once the rental guarantee period has ceased.
Buyers’ advocate and director of Morrell & Koren David Morrell says “people get sucked into rental guarantees, not thinking about what will happen when the rental guarantee falls over”.
Mr Morrell points to the number of inner-city apartments sold with rental guarantees when the market started to falter earlier this decade. “When market conditions are strong, rental guarantees are not as prevalent. “(Lower-grade) properties have to have a twist to make them digestible to the market.”
Investors should also conduct research into the developer’s ability to honour the rental guarantee after the property is purchased, Mr Morrell says.
“Developers don’t have to lodge any documentation to a government body for an investment of this type,” he says. “What happens if a builder goes broke?”
For the past 10 years, Mr Morrell has been lobbying against developers using rental guarantees to attract investors. He argues that real-estate agents and developers proffering rental guarantees have no legislative right to do so under the Corporations Act, and is taking the fight to the Australian Securities and Investment Commission to rid this kind of carrot being waved to unsuspecting purchasers.
A satisfied customer
The owner of this Malvern apartment was paid rent even when there was no tenant.
Carol Stack (pictured) appears to have survived her rental-guaranteed investment unscathed. In January 2000, Ms Stack had first choice of a six-unit apartment development in Childers Road, Malvern. Her payment of $290,000 bought a two-bedroom unit with courtyard from developer the Benson Property Group.
Ms Stack negotiated a rental guarantee period of 18 months, six months longer than the period the developer had advertised. For this period, the developer agreed to pay Carol $330 a week, equating to a rental return of 6 per cent. That rent dropped to $260 a week when the rental guarantee ended.
According to Ms Stack, the timing coincided with an influx of new rental properties that presented towards the end of Melbourne’s property boom.
At a market rent of $260 a week, the investment showed a 4.6 per cent return on the purchase price, which Ernst & Young Advisory Services principal Richard Bowman says is consistent with the market range achieved for most apartments.
On top of that, the suburb of Malvern recorded an increase in median apartment value over that period, which saw Ms Stack pocket some capital gain. Had she invested in some of the inner-city suburbs she was being shown at the time, the increase in property value might have been lower.
Ms Stack admits she was surprised by the drop in rent but was satisfied with the investment, which paid her rent even during a period when her property was vacant.
How it can go wrong
A developer is marketing a new project of 50 apartments in the inner city for $400,000 each.
However, the market is considered oversupplied and the apartments’ true value is only $320,000.
Market rent for an apartment of this type, and in this area, is $350 a week. At a purchase price of $400,000, the investor’s return is 4.5 per cent.
Rental guarantees allow developers to manipulate these numbers.
To make an investment offer a return of 6 per cent – well above the average of most other investments – the developer will offer the buyer a guaranteed rent of $460 a week, paid for the next two years.
Once a buyer signs a contract, the developer will lease the apartment at the highest possible market rate – and make up the shortfall for a period of two years.
Assuming an apartment leases for $350 a week, the developer will make up the extra $110 a week. The developer can afford to do this because they have been paid $400,000 for a unit that’s only worth $320,000.
When all the apartments in this project are sold, the developer has pocketed an extra $4 million simply by promising rental guarantees.
If the development is to be financed, the developer has enough pre-committed sales to get finance from the bank, plus the financial responsibility of the apartments has now been handed to the investor.
When the rental guarantee period ends, the apartment owner has to find tenants in the open market.
Under the developer’s guarantee, the investors were earning $24,000 a year. Assuming they now receive $350 a week, their annual return from the apartment is $18,200.
The investor’s returns have fallen from 6 per cent to 4.5 per cent overnight – and it gets worse.
A fall in income reflects a fall in the apartment value.
If the investor decides to sell, they find themselves competing with developers selling new units with guaranteed 6 per cent returns.
At $350 a week rent and a 6 per cent return, the apartment is now worth only $305,000 on the open market. Their income has fallen $11,440 a year and the value of their investment has fallen $95,000.
Generic example cited by David Morrell of Morrell & Koren Buyer’s Advocates.
