VENDOR RENT GUARANTEES. Not. Worth. Anything.


We aren’t talking about lease guarantees here, where you as the tenant guarantee to pay the rent and outgoings owed by your business.

No, this post is about the sale of serviced apartments leased to the property’s manager.  I originally meant to write this on the wrong end of the last property cycle.  But then rent guarantees went away for a while, so I shelved it.  However, they seem to be coming back, and here we are.

In my opinion, they aren’t worth anything, and never were.

Oh, ok.  That’s a blanket generalisation, I concede.  I am sure that some developers do things differently from what I’m about to describe.

This post, then, covers the specific hypothetical where a property developer sells you an apartment in, say, Queenstown, that is going to be used as a serviced managed apartment chasing the tourist accomodation dollar.

The apartment is priced at $850,000 and is leased to the property manager for six years, with the first two years of rent guaranteed to be at least 6% of the purchase price.  That’s $102,000 of guranteed rent.  Pretty good, right?

Nope.

Firstly, your mind is now thinking of the apartment as being worth $850,000 – because it generates $51,000 rent per annum.  But what actual evidence do you have of that?  No one is in fact leasing it for that much.  Really, you say?  You might think that some developments will go fantastically well and generate more than 6%.  Well, yes.  That is theoretically possible.  Maybe there are buildings where it has occurred.  I just don’t happen to know of any.  6% might not sound like much, but it is based on the purchase price.  If the purchase price is too high – because it has been marketed on a fat rent guarantee, for instance – then your property manager, when exposed to the real world, is in practice trying to get more like 8% or 10% per annum of the realistic apartment value.  Or more.

Once the guarantee comes to an end, nearly all of these leases will say you only get as much rent as the property manager leases it for to visitors, less expenses and the manager’s cut (which can be substantial – there is a reason that the big hotel chains just manage someones else’s buildings, they don’t own much themselves). And you are locked in, normally for at least another 4 years…but beware rights of renewal that can see your apartment trapped in a low value lease for another 6-12 years earning no one any money but the manager.  Who is usually owned by the developer, or sold by the developer to a a professional management firm.

All too often, once these guarantees come to an end the hapless purchaser finds themselves earning a return of closer to 2-3%, and the value of their apartment decreases accordingly…way, way below what they purchased it for.

You need a rental and property valuation from an independent expert as to what the room is worth, taking into account seasonal factors, the economic forecast, costs and vacancy rates.

Second.  Who is actually providing this guarantee?  If the property is being sold by A, the guarantee tends to be provided by company B, a subsidiary of A or in some way connected to or controlled by A, but to which A is not liable.  Company B may, if you are lucky, be funded for an expected contingency amount to pay out guarantees, based on happily optimistic rent and occupancy forecasts.  If, as nearly always happens, rent income doesn’t meet that mark, the funds that B has will soon be exhausted and the company liquidated.  You won’t be able to sue the directors because they had a prudent amount in hand to cover expected shortfalls based on valuation.

If you are unlucky, company B never had any substance in the first place (eg Blue Chip’s worthless guarantees), and was incorporated overseas where you have no hope of suing directors without spending large sums of money you don’t have on lawyers you don’t know in a jurisdiction that may be either corrupt or hostile to foreigners or both.

If you are very, very lucky, the rent guarantee is backed by a bank.  This is worth something but…..it leads on to point three.

Third, you have most probably already paid for the guarantee out of your own pocket.  If a developer decides to market apartments with rent guarantees, they simply add the cost of the rent guarantee to the listing sale price.  Let’s say the developer expects the apartments to actually make about 4% rent or $34k per annum.  The difference of 2% over two years, which is $17k pa x 2 = $34k, is just tacked on to the indicative price.  Without the rent guarantee they would have been willing to sell at $850k – $34k = $816k.  If the apartments do even worse there is some upside for you (sort of…your apartment value is still tanking, after all), but if they do better than 4% but less than 6% thanks to your own efforts, all that has happened is that you have made the developer some money.

Sometimes a developer will actually add the entirety of the rent guarantee to the purchase price, even though they don’t expect to pay all (or sometimes any, if they are intending to keep all of the money and let a guarantor fall over) of it out.  It depends what they think they can get for the apartments.  It happens more often if the apartments are being marketed in another country, where investors have less idea of New Zealand realities.

Conclusion

Developer rent guarantees are, far too often, unenforceable when called upon, give a false view as to the value of the apartment, and you have probably paid for them already, often in full.

You will, generally speaking, be better off negotiating a lower price and forgoing any rent guarantee.  You will need professional advice on any lease to the property manager, in particular keeping your options clear to exit if the manager isn’t performing well, and how the manager can be removed if they aren’t.

There is no substitute for an independent valuation from a competent valuer.  You must have one if you want to buy a serviced apartment leased to the manager.

 

 

Advertisements

About Ivan McIntosh

I am a partner of Carter Atmore Law...residing in City Road just off the busy thoroughfare of Symonds Street, Auckland, New Zealand....where we are specialist business & property development lawyers, working for both local and international clients. Proud husband to Joanna, and dad to two sons. Passionate rugby supporter. Email: imcintosh@calaw.co.nz Ph: 64 9 921 5026
This entry was posted in Banking & Finance, Commercial Property, Leases & Leasehold, Property Law, Residential property and tagged , , , . Bookmark the permalink.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s