The risk or otherwise of relying on rental guarantees is something that we get asked quite often. I seek Damian Collins opinion on that.
Kevin: Ask any wise investor and they will tell you that if it sounds too good to be true, then it probably is. Now, this can apply to rental guarantees. Let’s find out what they are, first of all, how you should be a little bit wary of them, and what you should be aware of before you start to get involved with rental guarantees.
Joining me is Damian Collins from Momentum Wealth. They are buyers agents in Western Australia. Damian, firstly, tell me what a rental guarantee is and why you think we should be cautious of them.
Damian: Kevin, a rental guarantee is usually provided by developers, whether that be residential property, sometimes serviced apartments, or hotel operators. What they’re providing to the investor is a guarantee of the rental return over a period of time. Sometimes they range from one year, sometimes even up to three, four, or five years.
What it effectively does is it means that the investor gets a certain level of return over that period, so they’re not subject to the vagaries of the market going up and down. It sounds good in theory, but obviously, there are reasons why the developers offer it.
Kevin: Why do they offer them?
Damian: Well, it’s to give their investors certainty. Nervous investors – particularly first-time investors – in the market think, “Well, what do I do if my tenant leaves? What happens if something goes wrong? What happens if the rents drop?” All those things, they provide them with that certainty of the rental return.
But, of course, nothing is for free. Any developer offering those sorts of rental returns has factored that into their sales price, so as a buyer of one of those properties you’re going to be paying for, that rental guarantee is going to be loaded into the sales price.
Also, importantly, I think what we often see is that the rental guarantees are not necessarily reflective of the market. When you come to getting a loan for the property, you often find that the valuers and the banks will only take the actual income based on the real market value, not what you’re getting offered as a guarantee.
Importantly, you have to understand that when that guarantee period runs out, you’re going to go back to the market levels. I’ve seen them offered at 6 and 7% returns on properties where the real market value is probably closer to 4.5 to 5%. Investors get lulled into a false sense of security thinking they’re going to get that rent forever, but the reality is that it’s over market, and you’re paying for it. One day, you’re going to have to pay the price when it comes back to normal market terms.
Kevin: Damian, is it drawing a long bow to say that you could apply that to all properties that offer rental guarantees?
Damian: Look, definitely. Nothing is free in this world. Anyone offering a guarantee is either struggling to sell it and they need to offer some extra incentive for people to buy it, hence, it might be overpriced, or alternatively, some other developer offering it, they have their profit margin they need to make. If they are going to pay 1 or 2% extra rental return for a couple of years, you can guarantee that there could be 4 or 6% in extra cost out of their pocket. They’ve put that in the price, as well.
There’s certainly nothing for free in this world, and one way or the other, you’re going to pay for a rental guarantee.
Kevin: If I were to see a property that seemed to be fairly reasonable on the surface in terms of its price and that rental guarantee looked fairly good, how should I proceed to make sure that I’m not going to get trapped?
Damian: The first thing I would be asking, Kevin, is why are they offering the guarantee? If the property was that good and stacked up on its own, why are they offering the guarantee? What’s the purpose behind it? What am I missing here? What’s hidden?
I’d certainly be doing my own thorough market research on what is the proper and fair value for that property without any rental guarantee. At the same time, I’d be looking at also what is the fair rental market without this inducement of the rental guarantee. Do your numbers based on that.
The guarantee is a nice little additional bonus, but most people do get lulled in that false sense of security and end up paying too much for it because of that security. Do your homework, find out what’s the real market value of the property, what’s the real market value of the rent, and if the numbers still stack up, well, it’s worth having a look at. But in my experience, the vast majority of them, that guarantee is loaded into the price.
Kevin: We’re talking here about rental guarantees, of course, but could you draw the same conclusion from a property where they may offer you a Mercedes Benz with every unit that you buy or an overseas holiday? Could you draw the same conclusion from those?
Damian: Definitely, Kevin. Again, there are two reasons why. People offering a Mercedes or offering overseas holidays, it’s simply one or two things. It’s that they can’t sell them at the price they want and they need to load that in, so it’s over priced for the real market value and they’re using those as additional incentives. It’s either that, or they’re really just looking for other ways to maintain that price.
Nothing is for free. Developers factor that into their project. Holidays, Mercedes, anything over and above or just to buying a normal property on fair market terms and conditions, at the end of the day, the buyer is usually paying for one way or the other.
Kevin: Good advice there from Damian Collins from Momentum Wealth. They’re buyers agents in WA. Damian, thanks for your time.
Damian: Pleasure, Kevin.