Why you need to understand a rental guarantee

For many property investors, a rental guarantee (by a developer or marketer for a certain period) can sound very attractive.

It is being used liberally in the inner-city Melbourne apartment market, where finding tenants is getting tougher and rentals are on the way down. RP Data CoreLogic reports Melbourne apartment rents fell 1.8% in the year to July 2015 and the gross yield is 4.2%.

But rental guarantees usually have strings attached. The cost of the guarantee, and often more, is usually factored into the purchase price.

So in effect you are paying the developer upfront for the rent he will repay you over the next few years - that is if he is still around to honour his guarantee.

"Rental guarantees allow the developer to hoodwink investors," says Neil Jenman, a real estate agent turned consumer advocate and business consultant.

Typically rental guarantees are offered because the developer wants to charge more than the market price. An example would be where the market price is $400,000 and the market weekly rental is $350, giving a gross yield of 4.5%, but the developer wants to charge $450,000. So it sweetens the offer with a two-year rental guarantee of $500 a week, giving an attractive yield of 5.7%.

The developer leases the apartments at $350 and tops up the rental by $150 a week. Over two years this costs the developer $15,600 but it makes an extra $34,400. On 100 apartments it would make an additional $3.44 million.

In two years, when the rental guarantee runs out, the investor may be faced with a nightmare situation. If the market is still oversupplied, they will find it difficult to tenant the property at much above the original $350 rental ($18,200 annually).

And if the investor wants to sell, they are likely to find that, at a 5.7% yield (propped up by rental guarantees on new apartments), the property is valued at around $320,000.

Sometimes an investor doesn't even get their full rental guarantee, which is only as good as the company behind it.

Former Adelaide-based developer Charterhill Group, founded by George Nowak, sold many properties with long-term rental guarantees through Australian Leasecorp, of which Nowak was sole director.

When Charterhill collapsed in early 2014, Nowak emailed investors telling them the company could not meet its rental guarantee commitments.

Other markets are expected to follow Melbourne's inner-city apartments into oversupply. Forecaster BIS Shrapnel says median prices will tumble 2% to 12% in real terms over the three years to June 2018. Investors should proceed with caution.

There are other pitfalls, including off-the-plan purchases.

WBP Property CEO Greville Pabst wrote in Money's August edition that WBP research showed investors in more expensive $600,000 to $800,000 off-the-plan apartments can make losses.

Those who buy off the plan in rising markets - such as Sydney's over the past two to three years - can make money.

But even they can be stymied, as shown where contracts are cancelled. An investor paid $890,000 in June 2013 for a two-bedroom apartment in Sydney's inner-city Surry Hills.

The contract cancellation came after she had seen ads for resales of other two-bedroom apartments in the complex, with asking prices of more than $1.3 million, reported Domain.

Developer Samadi Group could rescind the contract because the work was running more than a year late.

Samadi director Ash Samadi cited rising building costs and an amended floor plan as reasons for cancelling the contract.

"I can't deny the fact that the market has moved further up, but if my sole motivation was to increase my revenue I could have rescinded every single contract, but I didn't, I just rescinded a few," Samadi told Domain.

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