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A common enough practice adopted by some developers who specialise in investment type residential
housing is to guarantee above market rentals for a defined period. It would be unfair to term the practice as a
scam, but it can be misleading.
The practice was brought to it's crowning glory on the Gold Coast of Australia some years ago. Potential
investors were commonly flown in on the 'red eye' at the expense of the developers. They were then driven
around for the day and deprived of sleep. Finally they were encouraged to sign up to purchase property, often
with deposits taken off their credit cards. Everything was pre-arranged by the marketers, finance, legal and
even tame valuations. Most or all of the outgoings were covered by the 'guaranteed' rental. A good deal
overall, or was it?
However if it seems too good to be true, it probably is. When rentals reverted back to market levels at
termination of the guarantee, may of the purchasers were left having to prop up short incomes and were
stuck with properties worth substantially less than the original cost.
This practice and the fallout became so scandalous that the Queensland government brought in a law
change giving purchasers a cooling off period and time in which they could get Independent advice.
The practice is not limited to Australia, so be aware if you purchase a property with a rental guarantee which
is above market levels.
A similar excess rental situation can occur in commercial properties but for different reasons.
Commonly rental may be artificially above market because of a ratchet clause in the lease. In other words
rental can increase at rent review time but it cannot reduce. It is possible that in a falling market such rentals
may remain above market.
Excess rentals are likely to reduce current market levels at the end of the current lease term. With a ratcheted
lease the most likely time for a downward rental adjustment is at the next renewal date. This is the time that
the tenant has the option to renegotiate the terms of the lease or to vacate the premises. A new incoming
tenant would be unlikely to pay rental above levels otherwise available in the market place.
Example:
Say the market rate of return for a specific category of property was 8%. The contract rental for a property (kept
hight by a ratchet clause in the lease) was $80,000 but the prevailing market rental should only be $50,000.
The investor has the temporary benefit of an extra $30,000 per annum for a period of 2 years period. What is
the value?
Clearly if you capitalized $80,000 of rent by 8% you would overvalue the property and if you used $50,000 you
would undervalue it. As you can see there is a huge difference between the two values:
$80,000 ÷ 8% = $1,000,000 or
$50,000 ÷ 8% = $625,000
| Excess Rent Calculator |
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| PO BOX 9018, Wellington 6141 | phone: (04) 240-0124 | fax: (04) 232-4414 | email: valuer@ vcnz.co.nz Innovation + Experience |
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