More and more apartment developers in our major cities are offering so called “rental guarantees” to lure in buyers.
But investors should avoid rental guarantees like the plague as they often disguise a weak market or an oversupply of units. A typical sales pitch offers investors a guaranteed rental income for a year, three years, or longer.
While these returns might appear attractive, they’re actually a trap as developers use this ploy to keep flooding the market with over-priced units.
How the trap is set:
Developers offer rental guarantees when they’re struggling to offload apartments at the prices they want.
For example, a developer has a block of 100 units and he needs to sell them for $350,000 each.
However, prices are falling in an over-supplied market and the true value of the apartments has fallen to $300,000.
As the market is oversaturated, the rental market will only pay $300 a week.
Furthermore, at a sale price of $350,000, the gross return for investors is only 4.5%.
They won’t buy at these numbers and will look elsewhere.
By offering rental guarantees, developers can trick investors into making an unwise investment.
The developer prices each unit at $350,000 and offers to guarantee rent of $400 per week for two years.
This provides a return of 6%, which looks great to investors.
Investors see two years of income security and a great rate of return.
Once the investor commits, the developer puts in tenants paying $300 per week (the true market rate) and secretly pays the $100 shortfall to the investor.
Over the two-year period, the developer pays $100 per week to make up for the renters’ shortfall.
However, the developer has been paid $350,000 for a unit that’s worth only $300,000.
In a development of 100 units, he makes an extra $4m by selling units for more than they’re worth.
Once the two-year agreement expires, the investor now has to find tenants on the open market.
Unfortunately, because the rental market remains oversaturated, the weekly rental stays at $300.
The investor’s return falls from 6% to 4.5%, and the yearly income drops from $21,000 to less than $16,000.
Additionally, the value of the unit has fallen because income has dropped.
If the investor decides to sell, he’s competing with developers selling units with the same deceptive rental guarantees.
The unit is now worth only $260,000 on the open market and the value of the investment has crashed by $90,000.
To avoid such financial disasters, the smart investor will look elsewhere