Rozanna Wozniak: Investors in rentals need to take care

COMMENT

Another group of investors lured by "guaranteed" returns is finding out the hard way that guaranteed is a much-overused word.

The woes of those who bought apartments in Auckland's Heritage Hotel are reminiscent of the Metropolis bondholders who are likely to get less than half their money back several years after property developer Andrew Krukziener declared a default.

The environment of low deposit rates and volatility in both share and bond markets has encouraged some investors to look for better rates of return elsewhere.

Fitting into this category of alternative investment vehicles are contributory mortgage schemes and debenture and bond issues secured by residential property. In some cases investors are attracted by the additional lure of guaranteed rental returns.

Because the housing market has been buoyant during the past few years, the risk on these investments is often mistakenly perceived to be low.

When making a decision on whether to invest in such offers, investors need to keep in mind one of the basic rules of investing - that there is a relationship between risk and return.

It might be tempting to believe that they have found the exception to the rule, but wishful thinking should not get in the way of common sense.

Anyone who is being offered a return of 8 to 10 per cent in an environment in which rates of return of 4 to 7 per cent are more common needs to ask why.

In the case of contributory mortgage schemes, investors need to remember that the funds will usually be lent at interest rates much higher than those available through traditional lenders. This usually reflects the higher risk being undertaken - that is, the borrower is often unable to obtain finance through traditional, cheaper sources.

If the return either directly or indirectly relies on a guaranteed rental return, investors should determine whether the return is realistic. It is worth finding out what similar properties are worth, what they are renting for and whether estimated occupancy rates and capital growth projections are realistic.

And they need to make sure that the valuation provided is reasonable and find out whether it has been inflated by the rental guarantee. That rental guarantee will eventually expire and the value may fall when it does.

They should also determine if the level of occupancy and rentals can be maintained at levels high enough to sustain the required rate of return once the guarantee expires.

Investors in Heritage Equities have found to their dismay that the refusal of the hotel operator to renew the leases on similar terms has cut the value of their investment by 40 per cent or more.

There have been several other cases in which investors in property-related financing deals (where the money raised has been used to fund apartment developments) have lost a significant portion of the capital they invested.

Housing market conditions certainly suggest some need for caution. Yields have been declining over the past few years as rent increases have not kept pace with the rapid pace of growth in property prices.

In boom times, such as the past two years, investors tend to forget that residential property is not immune to cycles, including periods of decline in both capital values and rents.

Resales of Metropolis apartments were reported to be as much as 25 to 30 per cent below their purchase price. In fact, falls in the resale price of apartments were reasonably widespread during the last residential property downturn, which started around the late 1990s.

It would be foolish to assume that periods of decline in capital values or rents will never happen in the future. Furthermore, it is not only capital values that can fall. Residential rents and room rates in serviced apartments have also come under periods of pressure from events such as the Asian crisis and Sars.

The peak of today's housing cycle appears to have passed. Real estate turnover has peaked and anecdotal evidence suggests the pace of capital growth is slowing. In many locations, there is no longer the shortage of rental properties evident a couple of years ago and properties are becoming more difficult to fill.

There is mounting evidence that some landlords are being forced to drop rents to get tenants.

In the next few years rapid gains in the supply of apartments and slower migrant inflows are likely to cap growth in capital values. According to Bayleys Research, the total stock of apartments in Auckland stands at just under 8500, up from just over 1000 only 10 years ago. Another 4570 are being built, and 3200 are proposed.

Given the sharp increases in residential property prices during the past few years, some locations and types of properties are vulnerable to a decline in prices during the next few years. Poorer-quality developments and those that are poorly located will be most vulnerable.

Also at risk are dedicated student apartments and smaller apartments that rely on foreign student tenancies. Foreign student numbers are well down this year, and many of these smaller apartments would not appeal to the wider rental market.

One final word of caution: although high rates of return should serve as a warning to investors to do their homework before making a decision, this does not mean that the rate of return being offered is always an accurate guideline of the underlying risk.

In some cases, what looks like a realistic rate of return relative to the market may, on reading the fine print, fail to compensate for the risk being undertaken.

* Rozanna Wozniak is an economic adviser to Spicers Portfolio Management.