Rental guarantees are often used to sell new apartments, but you might pay in the end.

More new apartments will come on stream in Melbourne in the next year than at any time in a decade. One consequence of the raised competition is that developers are increasingly offering rental guarantees to entice people to buy units off the plan.

There’s no doubt a rental guarantee for a fixed time can deliver tangible savings and benefits to property investors. But you have to recognise the costs involved and understand why a developer is offering the inducement.

At first glance, a rental guarantee looks a great deal. A guarantee typically ranges from six months to two years. The developer promises an above-market rent for their property, irrespective of what a tenant might actually be paying. If the rent is set at $400 a week but a tenant will pay only $350, the developer pays the difference.

The benefit is an immediate and protected source of income. But the problem is hidden costs.

”There are usually two reasons why a developer will go for a rental guarantee,” says Greg Hocking, of estate agency Greg Hocking City Residential. ”One is to inflate the price. The other is to move stock that he can’t move.”

You need to be realistic. If the guaranteed rental yield (the return on an investment as a percentage of the amount invested) is significantly above the market rent the unit could reasonably expect to generate, your antenna should go up.

In the early 2000s, some off-the-plan apartments at Docklands had a guaranteed rent of $800 a week and an accelerated depreciation schedule. This meant the investment looked to be revenue neutral in the first year. But when the guarantee ran out, the rent fell to the market rate of $200 a week and the depreciation schedule had decreased from $15,000 to $4000 a year.

Melbourne-based adviser Greville Pabst of the WBP Property Group says off-the-plan investors need to be conversant with market rents for units in specific areas and buildings.

He says buyers should research the on-the-ground situation for rents and not just take the developer’s word for it.

Never forget developers typically increase the sale price of a unit to cover their outlay for a rental guarantee.

All too often, investors struggle to match the rent once the guarantee has expired. Many are forced to accept a lower-than-expected income for the property. Before buying, ask: What is my competition? How will my unit perform on the open market? Are rents growing in the suburb?

Rental guarantees were widely offered between 1998 and 2003, when apartment construction last boomed in inner Melbourne. The inducement then became less common, but rental guarantees are zooming back to prominence.

The managing director of Advantage Property Consulting, Frank Valentic, says 25,000 new units are expected to be completed in Melbourne within the next 12 months.

”That has created a big glut,” he says. ”But low interest rates are a driver – the gearing for investors is as good as it has been for a while.”

A quality, well-located property will attract tenants without the need for a guarantee. This means that if you buy an A-grade unit (close to transport, employment, lifestyle precincts etc) with a rental guarantee thrown in, you’re getting some icing on the cake.

It’s considerably more problematic when you buy a lesser-quality unit in a secondary location, or in a regional area or outer suburb that has poor public infrastructure. A unit may come with a guaranteed rental yield of 6 per cent for 12 months but once it ends, a landlord could struggle to get 3 per cent.

In the worst-case scenario, a B-grade unit in a crowded market can be without a tenant for months.

Mr Hocking says a rental guarantee needs to be considered in light of whether you buy at the first stage of a project or at a later stage. ”If a developer introduces a rental guarantee halfway through the sell-down of their project, it means that the sales have stalled and they have to rev them up,” he says.

”You might think you are being paid a premium to purchase, but you are buying unwanted stock.”

He says a property should sell and rent on its own merits: ”People can end up buying financial products and not a piece of real estate.”

Buying into a project during its first-release stage is usually the best bet for off-the-plan buyers.

Adviser Sam Saggers, of Positive Real Estate, says by buying in stage one you get the best price.

”Developers withhold further stage releases in order to make additional profits and sell the properties at a higher rate of return,” he says.

Posted by Chris Tolhurst – The Age on 6th July, 2013