Investor Alert: Rental Guarantees
April 9, 2009, Writen by: Chris Anderson, Ph.D
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Another one bites the dust. Another investor lead astray by what looks like a great thing to the uninitiated: the rental guarantee.
As I write this, I learned that an investor went from buying what I think is one of the best properties that I have seen in the Go Zone to what is in my opinion, junk. Why? Because they were lured in by the “security” of the marketers rental guarantee.
Now don’t get me wrong….. Sometimes a rental guarantee is a great thing on an investment property but the reality is that it is rare. In fact, we are evaluating a deal right now with a rental guarantee but our Red Flags were immediately raised…. Time will tell if the project we are examining happens to be one of those rare cases that works with a rental guarantee.
WHAT IS A RENTAL GUARANTEE?
Quite simply, it is an agreement between the seller and the buyer that they, or a related company will lease the property for some period of time. One example that can work really well is when a subdivision builder sells their model home to an investor and then leases it back as a sales center. That can make a lot of sense for everyone involved.
These rental agreements tend to be as short as 3 months and can be as long as 2-3 years. In addition, the seller might be leasing back a single unit, such as for the model home above, or they may be leasing back a ton of units and then they plan to sub-lease them to minimize their negative cash flow.
RED FLAG #1
When done with multiple units for long periods of time, the lease back represents a substantial monetary liability to the seller. So why would a seller offer this? One possible (and common) explanation is that they are making a boatload of money on the sales of the units and the leaseback represents a small risk. By offering a leaseback that hope to get a bunch of investors to start buying in which case the seller will do just fine.
Generally this occurs when the property is overpriced relative to market. So the “game” is to mark up the property higher than market value, make a bunch of money, and then offer a rental guarantee to make this attractive to investors. But of course, they can’t show that the property is overpriced so somehow they will also need to convince the investor that they are getting a good deal.
For this Red Flag, you should take any discussions on “appraised value” or “market value” with a degree of skepticism and really try to verify. Every once in a while you will find a property that has a leaseback AND is actually priced right…… then you have found an interesting deal. Just realize this is rare.
Red Flag #2
This leaseback can be a substantial financial undertaking for a builder/developer if many units are involved. So, for example, suppose that they offer this for 50 units in a complex at $1,000 per unit, for 24 months. So their total liability is:
50 Units *$1,000 * 24 = $1.2 Million
Obviously they probably PLAN on renting out these units, and they PLAN on selling enough units to be strong enough to cover this but will their PLAN work? If not, good luck on getting all your PLANNED lease payments. However, if what you are buying is till very rentable on the market, with or without them, then your are in a great position.
Red Flag #3
Is the leaseback consistent with market rents? One other common “gimmick” is to offer a leaseback higher than market rents to make the numbers look good. Based on Red Flag #2 and you always needing to plan on those leaseback payments stopping, then you really do need to know the market rent values. If, however, the lease back amount does line up with market rents, then that is a good indication…… the question is how will you, as the investor, know what the market rents are for the area?
Conclusion
Again, don’t misunderstand my intent. SOME RENTAL GUARANTEES are good and as mentioned earlier, we are evaluating a deal with one right now. However, when you hear about an offered property with a rental guarantee, always go back and check your 3 Red Flags.
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4 Responses to “Investor Alert: Rental Guarantees”
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Who Is "REALLY" Making $ In Today's Real Estate Market?
Our 29,689 Members Tend To Agree...
It's Usually Not The GURUs
Have you ever noticed that every "Guru" real estate pitch sounds the same........
They once were poor, but now are rich working only 5 hours per week, and you can be rich too if you just buy their "can't fail system".
Or have you noticed that every property promote has a can't miss proposition, if you just buy TONIGHT.
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Reminds of the Hanover Companies deals….aka Gerry Guterman, those deals are total ripoffs
I had never heard of this kind of deal. Seems like a really “interesting” way of luring investors in. I’m sure it was something that would have perked my interest. Thanks for the article; its nice to be able to spot some red flags for a young real estate guy.
Hi Kyle:
Glad we could help. Like any other businesses out there, there is good parts and bad parts. When you work the business everyday as we do, you get exposed to the dirty little secrets.
As part of our “No Bull” approach, we are going to do everything within our power to really try to keep investors up to date.
Chris,
I really got burned by a rental guarantee. Being new to the business, I thought the rent being guaranteed ($1,200/mo.) was consistent with market rents in the area. The real estate agent even sent me a spreadsheet showing how that amount would increase in succeeding years. In reality, the rental market in the area crashed and what I am now getting in rent is less than half of what the rental guarantee was. I’m coming out of pocket for $500/month to make up the difference between the current market rent and my monthly mortgage payment. I am so glad you wrote this article because I would hate to see other investors have to absorb that much negative cash flow. Of course, I can’t refi because I owe more than the house is worth.