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What is a Rental Guarantee?

In the second article in our 360 Series, we take a look at Rental Guarantees - and why it is essential to know what yours entails.

UK property rental guarantees

What is a ‘Rental Guarantee’?
A rental guarantee is typically offered by developers selling off-plan investment property, guaranteeing that a certain percentage return will be paid to the owner of the property regardless of the rent that is being achieved, or, the occupancy. If a developer is offering a NET rental guarantee, the developer will also be assuring the operating costs.

 

Why are rental guarantees offered?
Rental guarantees assure rent during the stabilisation period of a development until such point that the investment can achieve the advertised rental yield.


The stabilisation period can be around 1-2 years for student accommodation and around 12-months for residential property depending on the number of units available. Once a development has been completed and is ready for occupancy, a large number of similar properties are all of a sudden available in the local market, which takes time to absorb the increased supply.


Rental management companies use tried and tested strategies to release the rental units in stages, so as not to compromise on the rent that can be commanded, however, they will still have to do deals to get a development fully occupied at the very start.


Rental guarantees are in most cases subsidised by the developer during the stabilisation period by topping up the deficit between the actual rental income achieved and the guaranteed rental income. If a development has been correctly priced, the developer can recoup their losses once the development has been stabilised as the rental guarantee caps the rental income that the investor receives. Anything over and above the rental guarantee is further profit for the developer.

 

How is rent guaranteed?
Rental guarantees can be broken down into two categories:

  1. Rental Assurance – This is the most typical form of rental guarantee, whereby a developer will contractually guarantee the gross or net rental return directly with the investor. The legal mechanism behind a rental assurance is commonly provided in the form of an Under Lease, whereby the investors leases their property back to the developer for a specified period for a fixed annual amount, payable monthly/quarterly.
  2. Rental Guarantee – This infers that there is something of substance behind the guarantee, which may well be a bond or insurance policy, but this in itself must be interrogated to ensure that the underwriter is credible and operate within the jurisdiction of where the investment is held.

 

Rental guarantees UK housing

 

Are ‘Rental Guarantees’ too good to be true?
Yes and no.


If a property has been correctly priced, a rental guarantee can be of benefit to both the investor, with reassurance that the rental returns won’t be low during the stabilisation period, and also to the developer, whereby they can benefit from any surplus once a development has stabilised in the local market.


The developer is incentivised to establish a rental manager with an excellent track record of performance to ensure that the development is fully tenanted and rents are optimised as it will require less subsidy from them and increase their profits. With NET rental guarantees, it also incentivises them to keep the operating costs under control and competitive, which is good news for the investor once the rental guarantee period draws to a close.


The viability of a rental guarantee needs to be independently assessed as part of your own due diligence and when assessing the viability of a rental guarantee, investors should consider:

  • What is the gross annual rental return as of today?
  • What is the likely percentage increase in gross rent per annum?
  • What are the rental management fees including Value Added Tax?
  • What are the operating costs of the development, including facilities management and utilities?
  • How have these charges been calculated; are they projected, or, based upon a similar development?
  • Does the net rental guarantee include or exclude the annual ground rent?

 

UK property market

 

Collective Investment Schemes and ‘Rental Guarantees’
If the legal mechanism of a rental guarantee is not correctly structured, products may be classified as Collective Investment Schemes, if they do not have control of the day-to-day management of their investment.


A prime example of products that potentially could be classified as CIS by a regulatory authority may be described as:

  • Hands off investment
  • Armchair investment
  • Fully managed investment


These terms would suggest that the investor has no control over the day-to-day management of their investment property and in the worst case scenario and income is not being produced, they may not be able to self-manage.


This can lead to a number of difficulties with the exit/re-sale of your investment, day-to-day management, the cost of management and the risk to the capital that you invested.

 

UK rental guarantees residential market

 

How does PrinvestUK ensure that NET rental return and in turn, an open market exit strategy is realistic?
PrinvestUK undertake thorough due diligence on a product before we launch to the market to ensure that the investment stacks up on paper.


This research has resulted in us offering property in some well-known cities across the UK and also some lesser known areas, as the investment proposition works extremely well.


We also ensure that the operating costs of a rental property are realistic and are taken into account. Many of the student accommodation investment and residential property investments that we sell have operating costs based upon similar existing developments that are fully operational. We believe that by using figures derived from actual operating expenditure will provide us with a more accurate idea of the likely costs that will be incurred to manage a development.


For further information on rental guarantees, please contact PrinvestUK.

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