Rental Guarantees: Beware of Fools Gold

The short term rental guarantee lends itself to one of the most insidious scams in residential property investment.

They can take different forms but most commonly the scam works by convincing – through basic math manipulation and psychology – a purchaser to pay more than the true market value. The sellers are typically ‘investment promoters’ one step removed from the developer (albeit often linked at the financial hip). They guarantee a rent that is above market, and when the guarantee period ends, the purchaser is left with a lower rent and much poorer than promised investment. Many rental guarantee schemes result in substantial capital loss.

This is an example how a basic rental guarantee for residential property works:
– Market rental is $500 per week
– Purchaser is sold property on a market investment basis at a 10% gross yield
– Purchase price is the annual rental divided by the gross yield
( $500 x 52  / 10% ) = $260,000
– Promoter guarantees rent for two years at $600 per week
– Purchase price is based on the same 10% initial gross yield
( $600 x 52 / 10% )= $312,500
– The cost to the promoter is $100 per week for two years or $10,400
– The true value to the purchaser is $10,400
– However, the difference the between sale prices is $52,000
– So the developer pockets $41,600
– The value to the developer is often more pronounced than this as the guarantee is over time, and therefore inflation further reduces the guarantee’s cost

Caveat emptor (buyer beware) perhaps and yes markets can turn sour. However, the key component of the scam is when the purchaser is sold the investment as if  $600 is a realistic market rate.

Rental guarantee scams are more common in off-the-plan sales as settlement is typically a year or more out and over embellished market rent estimates much easier to promote. They are also often offered for renovated high yield, low price property. The sales tactics are typically investment based seminar hard sells with the psychology focused on the yield and leverage. The guarantee is promoted as being their belief in a rising market and their superior investment selection prowness as opposed to a logical look at the assets true value. Near the latter stages of a property cycle, these schemes always appear to resurface – I have first hand experience with them in three countries now, across two property cycles and the tell tale signs are all so obvious.

There is nothing wrong with investment seminars to sell property. However, the problem arises where the promoter knows full well market rent is less than being touted but is prepared to subsidise for a short period of time to make the sale at an inflated price. They then hope for higher rentals in the future or blame the difference on market conditions. Worse the promoter simply disappears.

In New Zealand the rental guarantee became especially problematic with serviced apartment rentals where the occupancy rates and room rates were guaranteed far in excess of what actually and should have been reasonably forecast to materialise. Many were also not protected by a commercial lease arrangement with sound backing.

Different variations exist in lease arrangements where investors are sold a guaranteed yield for the first period of the investment. Another variant is where a tenant has part of their rent for the first term pre-paid by the promoter before the property is sold to an investor.

There are  three types of rental guarantee which makes sense and are more aligned with an insurance policy rather than a sales gimmick.

1. If the rental guarantee is equal or less than current market rent  it effectively acts as an underwrite. This guarantee may offer piece of mind and protect your downside in the case of deteriorating market conditions. There is nothing wrong with these guarantees – often used to market properties in flat markets – so long as you don’t overpay for the privilege in the first place.

2. Even if at an inflated market rate, if a private rental guarantee were offered long term, the difference between value of the guarantee and the difference in upfront purchase cost would reduce, to the point it may be worth the piece of mind to have rental guaranteed for a longer term. Solvency of those paying the guarantee, if required, then becomes the prime concern. However, a long enough guarantee ends up being a zero sum game so why not just pay based on the real market rent at the outset?

3. Long term government leases often tie in a rental rate for a long period of time. With these you shouldn’t worry about solvency of the guarantee – if it is provided by the government on behalf of the tenant as opposed to a guarantee paid by the promoter. In addition, the rental rate is likely to be much nearer true market value as the government should have done substantial due-diligence before committing to a long term lease.

Commercial investors often employ much more rigorous logic, not to mention lawyers, to the terms they sign up on – so they should be well aware of dubious rental guarantees. There are also many private investors who enthusiastic to get into the market act like speculators and their lack of due-diligence, coupled with fairly average legal and accounting advice are key enablers of property scammers.

It is the mum and pop investors who often end up holding iron pyrite.

So, the next time you see a rental guarantee being offered it may pay to take a real close look at how golden its really is.

If anyone has any examples of residential rental guarantees that look like scams, or alternatively those which look to add real value, I would be interested. I have researched and found both the good and bad currently active in residential property markets around the world. Some actually promote the choice of a discount or a rental guarantee which is a step in the right direction. Be very aware if buying off the plans in Dubai and Eastern Europe and maybe take a second look elsewhere, including New Zealand…

1 comment

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