Too good to be true
19/07/2007 NST-PROP By National House Buyers Association

Call them what you like - leasebacks, buy-to-let, cash back or own-for free. Developers have indeed come up with many creative plans to woo investors to their yet-to-be-built properties.

Known generally as Guaranteed Rental Return (GRR) schemes, their offer of eight per cent to 12 per cent per annum yields, or recovery of a proportion of the purchase price over a certain length of time, are certainly attractive baits to many. But, investors need to know that the scheme is not as simple as it seems, much like the advertisements that appeal to our desire to lose weight quickly.

Pitfalls

Generally, GRRs are best for the laid-back investor. However, there are issues that they have to be aware of and get comfortable with before entering into such an agreement.

A typical mortgage lasts 20 years. If you have a guaranteed rental for just three years, what will happen for the next 17 years?

A typical table of returns will show surplus income for potential buyers. However, they have to take into account the cost of maintaining the property, the taxes that come with being a property owner, mortgage costs and other ancillary fees.

Additionally, under most GRR schemes, investors will need to buy furniture packages as well as pay into a sinking fund for their projects. These costs will often take a substantial bite out of any rental money left.

Since GRRs are also specifically aimed at selling units to investors, a situation of 500 apartments all going to the rental market rather than be occupied by purchasers at the end of the scheme is quite likely.

Investors need to consider how many people will be chasing tenants at the end of the guarantee period and more particularly, how many prospective tenants there are. If there is stiff competition, rental and market values of the units could go down, rather than up.

When supply exceeds demand, developers will look for ways to avoid reducing the prices. While GRRs may offer attractive secure returns, they will only create a false economy in the long run as buyers could end up overpaying for their properties.

A guarantee is only as good as company that underwrites it. Even if the GRRs seem reasonable and are offered with honourable intentions, investors need to be sure that the developer can sustain the returns if the rental or sales market takes a turn for the worse.

Terms and conditions in GRR agreements are not regulated by law. As such, inexperienced investors may not understand that the fine print is often written in the guarantor's favour.

One example of such clauses is: "Provided always and it is hereby agreed between the contracting parties hereto that the Developer reserves its right to terminate the GRR agreement for any reason whatsoever by giving two (2) months written notice to the Purchaser wherein such a case the Developer's obligation to pay the guaranteed return to the Purchaser shall cease from the date of such termination. Such notice is deemed to have been received within three (3) days from the date of the letter."

Bad experience

An observer who was at a developer's office recently told a member of the National House Buyers Association about an elderly man who had just taken "vacant possession" of his investment, comprising four units of apartments under a GRR scheme.

He wanted the developer to "take back" the units and give him a full refund after he discovered that the properties had depreciated in value. However, instead of doing this, the developer terminated the GRR scheme as provided for in their agreement, leaving the man frustrated with his failed investment.

Buyers beware

The rental market is volatile and dependent on market conditions. People investing in GRR schemes are not just buying properties that they hope will increase in value over time, but also using "other people's money" (from the rental) to pay for their purchases.

However, it is a cyclical market, subject to the laws of supply and demand, as in any other sector of the economy.

Thus, any GRR offered should be checked carefully against the local market and competition. A simple survey within a location will give investors a fair idea of whether what is offered is realistic.

If a rental guarantee is higher than the existing market rate, then a rent decline after the guarantee period is over is likely.

It is a classic case of caveat emptor: Rental guarantee can sometimes guarantee nothing but trouble.