Are rental guarantees really as safe as they sound?

Wednesday, 15th Sep 2010

family home
As the old saying goes, if it sounds too good to be true it probably is. If you come across a property marketed with a rental guarantee, tread carefully. Rental guarantees are usually a sign of an over-supplied product or area, a weak market, or simply a property that would otherwise struggle to meet an investor’s criteria for a “solid” investment.

Although guarantees are traditionally associated with government supplied housing, it is actually becoming more commonplace to see private developers provide rental guarantees, offering guaranteed yields of 6% or 7% for up to three years. But be warned. The guaranteed rental is usually already factored into the initial purchase price of the property (because of the security the guarantee offers) making it overvalued. Perhaps just as concerning is that when the guarantee period is over, the rent you can realistically achieve will in most cases be far less.

But how exactly do rental guarantees work?

Imagine a developer is struggling to sell his new units in an oversupplied market. He needs to sell them for $600,000 but the market value is realistically only $520,000. Looking at comparable rents in the area it’s also likely that the achievable rent for the property will only be about $530 per week, a 4.6% yield on the $600,000 purchase price. So the developer decides to sell the units for $600,000 each and offers a rental guarantee at $690 per week for two years, a 6% yield, to make the properties more enticing. Once the unit is purchased, the investor will rent them out at the best market rate of $530 per week and the developer will make up the difference, which totals $16,640, over the two years.

Given that the developer sold the units at $600,000, he ends up pocketing around $63,000 more than if he had sold them at market value without the guarantee. When the guarantee has ceased, the investor will be left to rent the property out at market value, not the inflated value they had been receiving.

Aside from private developers, there are also government agencies and hotel operators providing extended lease backs or rent guarantees, and although you may think the lengthy lease guarantees provide a level of security, do consider that if you need to sell at any point during this long period that you are locked into a rental contract with the tenant, meaning you can only sell to other investors. This effectively eliminates around 70% of potential buyers and restricts the asking price. Along with the often inflated purchase price, this potential situation also makes some banks overly cautious and could make securing finance difficult, as would refinancing to realise any
potential equity.

When it comes to properties being offered with rental guarantees and long lease backs, I strongly advise to proceed with caution. Although there may be a handful of good buys, do be alert to the downsides and always get an independent valuation before purchase. Peace of mind can be achieved without a rental guarantee, as long as you always buy a well-researched desirable property in a good quality area.

Momentum Wealth and its affiliated entities are not Accountants or Financial Planners. While all information is provided in good faith, you should seek your own independent advice in relation to all matters regarding investing, taxation and superannuation.