Investor Alert: Dont' Get Scammed By Rental Guarantees

By: Chris Anderson
Submitted: 09:46AM on Friday 10 April 2009

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.