IL Postcard
Beware: Guaranteed Rental Returns Exist in Only One Place
Date: 12/15/2007Saturday, Dec. 15, 2007
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I’ve been recommending the French leaseback program for 10 years. I continue to believe the idea can make sense, though you should view a leaseback as a financial instrument, not a real estate investment. In my mind, when you buy a French leaseback property, you’re buying a bond…a bond backed by the real estate. Your return comes from the annual rental yield, not capital appreciation.
And here’s the twist: The annual rental yield is guaranteed. You know when you buy what your net rental return will be for the next nine years (that’s the typical term of a leaseback agreement). The rate of return is not huge and has fallen in recent years to as little as 3% per year, for example. Still, it’s guaranteed cash flow. As the French leaseback program has grown in popularity over the past decade, others have borrowed the idea and offered “guaranteed” rental yields for their developments for specified terms after you close on the property. I’ve known of developers from Thailand to Brazil who have guaranteed buyers rental returns from 8% to 12%, sometimes more, for up to three years after purchase.
When a developer offers you any kind of “guaranteed” return on your investment, rental-related or otherwise, you should be suspicious.
For…how is the developer going to come up with the cash to pay you what he’s promising you? A developer builds…he doesn’t manage rentals. It’s the management companies that put renters in units, collect rents, and pay owners their percentages.
If the developer isn’t collecting the rental income, how can he promise you he’ll pay you a guaranteed percentage of it over time?
The truth is, when a developer signs a rental income guarantee for you, he’s most likely taking a portion of what you are paying him when you buy and setting it aside as a reserve out of which to pay you your 8% to 12% over the term of the guarantee. In other words, you are probably over-paying for the property by the amount of the guaranteed return, and the developer is using the excess to pay you out over time!
A few years ago, I read an article about a project in New Zealand where the developer had sold his units by guaranteeing three years of rental returns to buyers. At the end of the three years, when the guarantee had expired, some owners decided to resell…only to discover that resale values were about 25% less than what they had paid three years prior. Coincidentally (or not), 25% was just about the total amount that had been paid to the buyers as “guaranteed rental return” over the three years they’d owned.
To clarify, management companies can offer a guaranteed rental yield. This is how the French leaseback properties work. The developer builds. Then, in the case of the French leaseback, he partners with a management company, which runs the development as an apart-hotel for tourists. The groups that manage these properties have the experience to be able to calculate what returns they can guarantee to unit owners. Understandably, they are conservative in the initial rates they pay. (The rates are adjusted upward slightly over the term of the agreement and can be renegotiated after the initial term of the agreement expires.)
As I’ve mentioned, rates have fallen in recent years. Ten years ago, new leaseback properties in France were paying 4.5% to 6%, which wasn’t a bad return, considering it was guaranteed. Today, you’re doing well if you get 4% to 5%.
You can’t predict the future. That’s why, other than for these French leaseback projects, which operate under a long-established and time-tested system, it’s crazy, in truth, to believe any developer who tells you he can guarantee you a rental yield. How does he know what the occupancy rates will be? How could he be certain of maintenance and repair expenses during the term of your agreement?
Of course, he can’t.
Lief Simon
For International Living
Editor’s Note: To learn more about the French leaseback program, read Lief’s in-depth report on how to make the most powerful real estate intelligence in the world work for you.
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