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Rental Programs – Magic Trickery Risk and Reward

Rental Programs – Magic Trickery Risk and Reward

People who buy property to let it stand empty either have too much money; didn’t study even a chapter of economics; are possibly money laundering or underestimated the oversupply of condominiums in the market they are investing in.

With the trust in bankers at an understandable low, based on the often proven fact that fund managers can’t outperform robot trackers but still happily take their fund management fees, property, like gold, is often seen as a ‘safer’ place to park money in turbulent economic times. However, property is built on land, made from bricks and mortar, and requires asset management to realize and maintain value. That isn’t free. To leverage additional money from property, the art of renting is now a practice of many property developers, experienced and inexperienced, offered as a ‘property fund management’ service to those willing to invest in their projects.

With the advent of the sharing economy, people share their information on property investments worldwide and can now compare experiences more quickly and more accurately. However, there is still a lot of misinformation on the internet and through other mediums on ‘Rental Programs’ and ‘Rental Guarantees’.

This article explains how rental programs in Asia are typically structured, and some pointers to look out for in relation to ‘Rental Guarantees’.

Rental “Pooling”

Units which are part of a large number of units in a project are more likely to be part of a ‘pooled’ rental program. This is where the accounts of all of the units are combined into one ‘pooled’ account, so that revenue, expense and profit are calculated on an aggregate basis. At the end of the calculation, it may be that the pooled profit is not shared equally – it may be shared according to the ‘type’ of unit. Some units may command a higher percentage return than others in a pooled program, on a fixed basis. If you invest more in the purchase price for an ocean view penthouse, then you will be rewarded.

This system has many benefits but also has its challenges. With a pooled income, even if a specific unit doesn’t perform very well, the owner will still get a return. The economies of scale in relation to the expenses and maintenance of the units are often managed well when the expenses are being apportioned across a group. The upkeep of the units is often uniformly applied because of the group nature of administration. There will be less arguments and nit picking about individual expenses, when in fact the bottom line is shared.

However, developers now find this program a challenge for a variety of reasons. If a developer markets this product at a property exhibition then depending on the jurisdiction the developer or the real estate agent acting on its behalf may find that it is subject to investment regulation for ‘collective investment schemes’ and would need to apply for an administratively burdensome and impractical ‘license’. Property shows have been known to be raided by the authorities when property developers have not sought advice on what they are selling in law before committing to an event. This disadvantage has been strong enough to mean that some developers adjust their rental programs to be individual revenue / profit share based programs.

Individual Revenue / Profit Share

To avoid the issues relating to pooling, multiple units in a project can each have their own ‘account’ under which their performance relates to the return the owner receives. This obviously does not prevent the property from being managed within a system that conceals the individual nature of the financials of the units. No renter will necessarily know and they may book through a central reservation system and select the unit in question as an ordinary booking. Alternatively, for high value villas, a unit may be presented as a ‘unique’ rental, there may be a website devoted to that unit which may have it’s own name and be sold as a unique rental product in order to try and command a high yield. There will be higher costs for maintaining and individual property to a competitive standard. Those that rent such units have a global choice of locations and properties and will ruthlessly compare their experience and value from the rental of such a unit. Domestic help, cooks/chefs, easy transport and maximum convenience are a must.

Bottom Line / Top Line Accounting

If you aren’t an accountant, a business owner/manager or someone with a reasonable financial education then you might be surprised about some of the decisions made as to the return you will ultimately receive from your unit in any rental program – pooled or individual.

In order to see through any opaqueness, a property investor should ask for a sample accounting work through of an account for the rental program. This is of course so that a rental return isn’t simply presented as a few items on a payment slip with a message in small font “This is what you get and you have signed away any rights to look into why”.

When the revenues come in, what is a property asset manager ‘entitled’ to deduct? Well, the answer is – whatever they are entitled to under the contract you have signed. Therefore, look into the definition of ‘Gross Operating Expense’ and any other expenses carefully. Are there any expenses at all that the asset manager will absorb or will all expenses come out from the ‘top’ and then a share is made afterwards? If you have other expenses, outside of the rental program, such as common area fees, sinking fund contributions – are these paid for within a rental program by the asset manager, or are they your responsibility in addition to the expenses that come out of the ‘top line’.

Alternatively, you could be provided with a ‘top line’ share – that is a flat percentage rate directly from revenue, before any expenses are deducted. Often this will be a lower percentage than in a bottom line model because you have more of a potential stable revenue flow. The asset manager then has to use everything that is remaining to cover expenses. This does of course encourage an asset manager to be careful about expenses when all of the expenses affect its share. However, it may lead to over-caution and the property might not be maintained to the correct standards over time. This all depends on the experience and abilities of the asset manager.

“Guarantees”

Nothing in this life, in the business world, comes for free. If someone offers you a ‘free lunch’ then surely they will be asking for something during or after the lunch, which may greatly exceed the value of the lunch. Lawyers often get asked out to dinner, because the inviter has calculated that even with an expensive bottle of wine if the subject of conversation centres around a legal issue the information will be more valuable than the meal.

Similarly, when a developer plans their budget and financials, recognizing that that a certain type of investor wants a guaranteed fixed rate of return, at least for the first few years post purchase, they may build this into the asset price. In order to stay competitive on price per square meter, the built in guarantee may also be taken back through a higher management fee.

When the word guarantee is used, I have the advantage of a legal education allowing me to interpret the word and analyse it so see if it is being used correctly. I was taught that to offer a guarantee on behalf of a client without the client wishing to offer a guarantee constitutes professional negligence. I was also taught that if you seek a guarantee for a client but don’t look what is backing the guarantee and report to them on it, that is also professional negligence.

Therefore, look at what is behind the guarantee. Is a company that was set up yesterday offering the guarantee. What would happen if that company were to become insolvent, which assets would be ‘liquidated’? Hopefully not the land underneath the project? If you were to present the guarantee contract to one of the very same bankers offering to manage your money in return for ‘management fees’, would that banker treat your guarantee as ‘cash’ or would they point out the risks and state they wouldn’t treat the guarantee as collateral.

Jewels amongst the Stones

Notwithstanding the different programs; accounting treatment issues; the misconstruing of the meaning of ‘guarantee’ in many situations, there are still some great deals out there. Clients that are happy with their investments report to me that they can cover the entire costs of maintaining their unit with a month of high yield maximum rentals during a ‘peak period’. To identify a property capable of yielding that return and continuously attracting the renters takes skill, some luck, and often a higher amount of capital than the hordes of investors chasing rental yields.

Read reports on rental returns, research professional information on the performance of property in the location you are thinking about investing in. Consider the last 10 years in that location and consider where the location is heading towards in terms of development. If the market is saturated or is a prime city location, then are you buying in the right spot. If you are buying in a resort area, will that resort look like a car park in 5 years time. Are the beaches becoming polluted? Are the transport networks reliable and is there good airlift to the spot. These may be factors ‘outside of your control’ but you can make a reasonable prediction and measure your risk, and cut your cloth, accordingly.

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Desmond has operated and owned 2 law firms in Asia in 14 years spanning Thailand; Vietnam; Indonesia with clients in all of Asia and other markets investing inwards into the region with his existing firm Hughes Krupica possessing a large market shares in its fields of expertise. Desmond’s professional expertise comprises real estate from the most complex mixed use development structuring through to assisting with private property transactions. Desmond also assists investors in relation to hotel disposals and acquisitions and restructuring. Desmond keeps his market knowledge fresh by presenting at seminars; participating in real estate industry events; writing prolifically for different printed and online publications and by meeting and networking amongst his client base.

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