he Guarantee Rental Scheme was a hit in Sydney in the year 2004, when the real estate sector was in decline due to an over-supply of apartments. Now after eight years, it is here in Kathmandu as well. The Guarantee Rental Scheme is a proposition where the property developer guarantees an amount of rent for investors/ buyers of the property for a certain number of years, which is higher than the normal rent. It is a simple theory of innovation that had emerged during a difficult phase for real estate dealers; however, such innovation has also been a way to pass one’s burden to somebody else and get away with it. Guarantee Rental Scheme is a similar innovation. More specifically, it is a marketing gimmick used by real estate developers to pass their known risk and burden to investors or their customers by creating a very attractive scenario.
ATTRACTIVE COVER
The rental guarantee scheme portrays that developers have accepted the present real estate crisis and are ready to take a cut on the value. In Nepal—where the return from rental income to property price is below 1 percent or in some decimals, a guarantee of rental income starting from 7 percent up to 11 percent of the property value—this surely looks like a jack pot scheme. In addition, the so called bumper gifts make schemes even more attractive to the gambling nature of Nepali investors. The overall package normally illustrates a higher level of return through the assumption that property prices will appreciate in future, thus total returns from such investments are exhibited normally above 20 percent per annum.
WHAT HAPPENED IN AUSTRALIA
In 2004, during the real estate decline, developers offered a scheme of guaranteed rent of US $ 400 per week for an apartment (i.e. 6 percent on the property value) as against the actual rent of US $ 300 per week (i.e. 4.5 percent on the property value) prevailing in the market. By doing this, they increased the property price worth US $ 300,000 to US $ 350,000. The additional cost that developers had to bear with the guarantee rent was approximately US $ 10,000 per apartment for two years but they made an additional net income of US $ 40,000 per apartment by increasing the price during crisis.
After the expiry of the two year period, investors had to find tenants from the open market who were willing to pay the market determined rent of US $ 300 i.e. 4.5 percent and thus, their returns fell overnight to the original rent. While selling the property after the two year period had lapsed, investors had to compete with these developers who were selling new apartments with the same guarantee scheme of 6 percent on the property value. The price of the property that the investors bought at US $350,000, after the end of two years, had fallen to US $ 260,000. This led to a double dip decrease in their rental income as well as in the property price.
THE CATCH
The following paradigm explains the situation very well. A 400 sq ft shop in a commercial complex worth say Rs. 9 million boasts of guaranteed rent starting from 7 percent to 11 percent of the property value for five years. When the investors calculate the property price, they deduct the rental income for five years that is Rs. 4.05 million (i.e. 45 percent discount). As per this calculation, per square feet rate of Rs. 22,500 will be reduced to Rs. 12,375, which makes investors believe the deal is reasonable. The first catch here is that the investor ignores the time value of the money. If a discount rate of 15 percent is applied, then the present value of the rental income will amount to only Rs. 2.62 million (i.e .29 percent discount) i.e. Rs. 15,920 per sq ft, which is surely an expensive proposition during a real estate crisis in Nepal. It is natural for any layman to forget what they get today is always higher than what they will get after one year or five years and this is how the scheme creates illusions for the investors.
Further, investors tend to forget other risks that they are subjected to apart from the expensive deal.
Normally in a period of five years, the actual foot fall of a commercial complex (number of customers coming to a mall) will decrease drastically since there will be other new malls being built in the city. Take the example of Ansal Plaza in New Delhi that used to be one of the most popular malls five years back but is now almost deserted. Thus, once the guarantee rental period is over, the lower foot fall will further decrease the rental income and the property value.
If developers are still supplying spaces in new complexes with the guarantee rental scheme, it would be impossible for existing investors to find buyers even at the cost price of their property, since the property will be old plus there will not be any guarantee scheme.
Thus, the key attraction of returns above 20 percent per annum under these schemes on the cover page of any advertisement is merely an illusion for the investor. The assumption that there would be property price appreciation is actually a false note because the appreciation has already been paid by the investor at a very high price at the time of buying the property under this scheme.
The first thought with these kinds of schemes is of them being “too good to be true”, which unfortunately does hold true. Since these kinds of schemes are eye catching for most investors, at a time when there are no specific investment opportunities available in Nepal, it is bound to fool those who cannot think logically while engulfed in greed. It is very likely that we will witness a few more real estate developers coming up with similar schemes since herd mentality is quite pervasive in Nepal. However, investors need to be aware that with these schemes, they are guaranteed a financial loss rather than a return.
The author is a co-founder of Beed, a consulting firm that delivers consulting, management and advisory services
Related story
Half-yearly review of monetary policy not as expected by capita...
