Have you been tempted to buy a property with a rental guarantee?
Ask any wise investor and they will tell you that if it sounds too good to be true, then it probably is.
In a recent Real Estate Talk show I asked Damian Collins from Momentum Wealth what a rental guarantee is and why he thinks we should be cautious of them.
Here’s the transcript of the interview:
Damian: Kevin, a rental guarantee is usually provided by developers, whether that be residential property, sometimes serviced departments, or hotel operators.
What they are 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.
It effectively means that the investor gets a certain level of return over that period so that they’re not subject to the vagrancies 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: It’s to give that investor certainty.
Nervous investors, particularly first-time investors in the market, they think, “What if my tenant leaves? What happens if something goes wrong? What happens if the rents drop?” and all those things.
They provide them with that certainty of the rental return.
But of course, nothing is free.
Any developer offering those sorts of rental returns has factored that into their sales price.
As a buyer of one of those properties, you’re going to be paying for that rental guarantee.
It’s 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 will often find that the buyers 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, and I’ve seen them offered at 6% and 7% returns on property 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, and 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: 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’re having to pay 1% or 2% extra rental return for a couple of years, you can guarantee that that 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 is 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’ll 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 the proper and fair value for that property without any rental guarantee is.
And at the same time, I’d be looking at also what is the fair rental market without, obviously, this inducement of the rental guarantee at the same time?
Really do your numbers based on that.
The guarantee is a nice little additional bonus but most people do get lulled into 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 and what’s the real market value of the rent?
If the numbers still stack up, it’s worth having a look at. But in my experience, the vast majority of them are extra, 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 are offering a Mercedes or they’re 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 overpriced 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 and Mercedes – anything over and above just buying a normal property on fair market terms and conditions – at the end of the day, the buyer is usually paying for it one way or the other.
Listen to the full show at RealEstateTalk.com.au and while you’re there subscribe and receive our weekly podcast (or the transcripts) where I interview Australia’s leading property experts.
You may also be interested in reading: Are rental guarantees as safe as they sound?