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The pros and cons of guaranteed rent
Why a rental guarantee might not be as reliable as it seems.
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Most everyone knows the old adage that if something seems too good to be true, it probably is. So what does this mean for property investors? When investment properties offer perks like guaranteed rent, should investors jump on the opportunity, or is it too good to be true?
While there are some cases in which the claim of guaranteed rental income might be trustworthy, in most cases it should raise a red flag.
Who offers guaranteed rental returns?
There are a few situations in which investors might find themselves being enticed with the promise of guaranteed rental returns. Some are much more reliable than others.
Defence Force housing
Defence Housing Australia (DHA) is a government-backed enterprise that has a unique platform for property investors. Investors buy houses either built or acquired by DHA and then lease the properties back to DHA for a set period of time (generally three or six years). During this time, the investor receives guaranteed market rent and DHA undertakes all property management and maintenance.
Is the rent actually guaranteed?
In this case, the guarantee of market rent is a reliable one. Because DHA is backed by the government, you can be certain your rental income isn’t going to evaporate over the term of the lease.
What’s the catch?
There are some definite downsides to DHA properties. Firstly, DHA charges fees for the upkeep and management of its properties. These fees, at 16.5%, are generally much higher than those of a private property management company.
DHA properties also have serious drawbacks when it comes time to sell. Investors are limited to DHA-owned homes, which are located within the proximity of Defence Force bases across Australia. The location of these properties can significantly limit the potential buyer pool.
Serviced apartments
Serviced apartments are usually used by business travellers and tourists as a short- or long-term accommodation option, often as an alternative to a traditional hotel. Investors can purchase serviced apartments and lease them back to the operator, who then takes care of tenancy and property management.
Is the rent actually guaranteed?
This largely depends on the operator. The attractive feature of serviced apartments is that they often offer guaranteed rental income above the rental yield that investors would be likely to see from traditional properties. But this guarantee is only as good as the operator. While large serviced apartment companies are reliable, should an investor buy from a small operator and find that it’s mismanaged, the guaranteed rent could quickly evaporate.
What’s the catch?
A well-managed serviced apartment can generate strong rental returns and a reliable stream of regular income. However, the downside appears when it comes time to sell. Serviced apartments usually don’t see strong capital gains and the buyer market for serviced apartments is quite narrow.
Read more about the pros and cons of serviced apartments
Off-the-plan properties
Developers of off-the-plan properties will sometimes entice buyers with a period of guaranteed rental income. They will promise potential buyers a certain rental return for a period of two years or so, at which point the guarantee expires.
Is the rent actually guaranteed?
This is the scenario in which investors should be particularly wary. The rent is guaranteed, for a certain period. After the guarantee expires, investors may find it very difficult to find tenants willing to pay the amount that will generate the returns they’ve become accustomed to. This is because of the way these rental guarantees are often structured, which amounts to a bit of smoke and mirrors on the part of the developer.
What’s the catch?
The way that developers often structure rental guarantees means that the rental income investors are receiving isn’t actually in line with the market. They do this by inflating the purchase price of the property and then using part of the profit to make up the shortfall between the market rent the property actually generates and the amount they’ve promised to investors. For instance, if they’ve promised an investor a guaranteed $600 a week in rent but can only find tenants for the property at $400 a week, the developer will use the inflated purchase price to help make up the additional $200 a week for the term of the rental guarantee.
The real catch comes when the guarantee expires. Investors are unlikely to be able to find tenants willing to pay the inflated rental amount that they were getting from the developer and could end up seeing their rental income fall by several hundred dollars a week. At the same time, having paid a highly inflated purchase price to get the rental guarantee in the first place, when it comes time to sell they may find the property valued lower than the price they originally paid for it. Developer rental guarantees tend to actually be too good to be true.
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