Recently, housing developers have come with interesting ways to market their properties. One recent example in the papers is the rental guarantee offered by the developer CD Developers for investors in Grande Towers, Dhapasi for a limited number of units. Figure 1 shows the ad that appeared in the Kantipur daily of September 11, 2014. The guarantee is for five years and ranges from USD250 per month for a one BHK apartment to USD1,500 for a 4 bedroom Duplex. This is an ingenious method of trying to instill a false sense of rental security to potential investors. The real estate market in Nepal is a buyer beware market.
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| Figure 1: Advertised in Kantipur daily of 2014/09/11 for Grande Towers |
What are some of the questions you might want to ask before
investing in one of the apartments at Grande Towers?
First you might want to find out the specifics of the guarantee
and how it works. What does the fine
print say? When can you make claims and get recompensed? Can you immediately
exchange the guarantee for a five year lease to the developer so you do not
have to worry about looking for tenants?
Second will the developer live up to its guarantee? Once you have handed your money, there is
very little you can do but rely on the developer’s goodwill to fulfil its end
of the guarantee. Of course, you have the legal route but that has its own
issues and challenges in Nepal.
Third you might want to know value of the guarantee you are
receiving? Mathematically, you can
calculate this as the present value of an annuity that pays the guaranteed
monthly rent for five years discounted at your expected return rate. We will
look at an example later.
Fourth and probably the most important part of your analysis
will be to get an idea of the rental ability or salability of the apartment
after the guarantee is over. This will
depend on the state of your apartment, the state of the apartment complex, the availability
and demand of apartments in Kathmandu.
Unless your apartment is in an ideal location, people who rent will
always prefer newer apartments for the same rental rate. As I have written in my previous articles
related to the real estate market in Nepal, the pool of clients who can afford
these upper-end rental units is very limited.
The same is true of the salability of apartments. Unless the location is
such that it will always be in demand, the price of most apartment units will
decline over time. Investors will also
tend to prefer new apartments for the same price in similar locations. My personal view is that rentability and salability
of upper-end apartments in Kathmandu is very uncertain.
Let us now do an exercise to get an idea of the value of one
these apartments from an investor’s perspective and also from a developer’s
perspective.
The value of the apartment from an investor’s perspective is
basically the sum of three components: (a) the value of rental income during
the guarantee period, (b) the value of the rental income during the non-guarantee
period and up to the time of the sale of the apartment, and (c) the sale value
of the apartment at time of sale. For
now let us ignore recurring expenses such as taxes, and maintenance which can
sometimes be pretty large.
For this exercise let us assume that you can immediately
exercise the guarantee that is give the developer the apartment on lease in
exchange for the monthly rental guarantee. When you do this, you will have
given the right of the use of the apartment for five years. Let us also assume that your target rate of
return is 10% and that exchange rate will be fixed at 96 Nepalese rupee per US
dollar. With these assumptions we can
calculate the value of the guarantee.
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| Table 1: Valuing rental guarantee offered for units in Grande Towers |
The table below lists three apartments from the “Sun” Tower
in the Grande Towers Complex. The data
has been taken from the developer’s web site. I have taken the smallest units
of 1BHK and 2BHK apartments and applied the lowest guarantee from the range
provided in the advertisement given in Figure 1. What
this analysis shows is that the value of the guarantee is not proportionate
with your investment. Value per square feet of investment declines
significantly as you move up the value amount of the investments. The guarantee for the most expensive apartment
is only 39% in per square feet terms of the guarantee of the least expensive
apartment. This is primarily because the
rate of return of your investment during the guarantee period declines from
8.31% for the 1BHK apartment to 5.90% for the most expensive apartment. So what
this is telling is that if you want to invest in Grande Towers and take
advantage of the guarantee, you want to look at the smaller units. For the 1BHK
apartment in our analysis, you might also be better off paying only 23.2 lakhs
and giving a lease for the developer for five years at the guaranteed rent.
Of three components mentioned above, we have calculated only
on the first. How do we go about
calculating the expected cash flows and the resulting valuation of the other
two components? This is where all the
risk of the potential investor lies. As
I mentioned above your expected rentals after the guarantee is over will depend
on a variety of factors but most likely due to competitive pressures it will be
less than what the guarantee is offering you now. Keep in mind that the rentals envisioned for these apartments means that your target pool of potential renters is very small. Similarly the sale price will also depend on
a variety of factors and as I mentioned earlier, unless the property is in a
location or becomes a branded property such that there will always excess
demand over supply, the sale value for old apartments will decline again due to
competitive pressures. You also need to
take into account of the fact that the apartments will be vacant for some
portion of your holding period.
Furthermore, we have not even looked at taxes, other charges and
maintenance costs that you might have to pay during the holding period. Keep in mind also that the present value of
cash flows decline significantly as you move into the future. So the same one
year rental income received say ten years from now will be much lower than the
rental income received in the first year.
We will not go into this exercise but what I would like to
point out is that the basic decision you will be making is whether the present value of
your rental income and sale of property after the completion of the guarantee
period will be in excess of your net investment with exercise of the guarantee
given in column 5 for these three units.
Let me emphasize that I have assumed that you can immediately exercise
the guarantee and give the developer the unit on lease for five years on
payment of the net price. If the fine
print does not permit this then that brings additional uncertainty.
So how can developers afford to give these guarantees? To get an idea of this let us look at the
valuation from a developer’s perspective.
For the developer also the value of the sale of apartment again consists of
three components: (a) the initial sale price (column 3), (b) the value of the
guarantee it is offering (column 5) and the expected rental income during the
guarantee period. For the developer
there is less uncertainty relative to the investor. The minimum value is the net price with
exercise of guarantee (column 5). This
occurs only if the developer is not able to rent out the apartment at all
during the guarantee period which is hardly going to be the case. The developer can rent at half the guarantee price
and still recover 50% of the guarantee value that it has offered.
For a developer who has already priced in a high margin in
the initial sale price, the guarantee will make a partial recoverable dent on
the initial expected margin. If the
initial margin was say 50%, then the developer is still better off. For
the developer who is being financed by a bank loan, it is in its interest to
quickly offload the apartment and pay back the debt even if it means getting a
lower rate of return. The consequences
of not paying debt on time is much larger than stalling for a higher margin on
the sale of apartments.
My advice to potential investors is to do your proper due
diligence before purchasing any real estate units especially apartments before
putting your hard earned money into one of them. The last thing you want is to be an owner of
a white elephant: a high priced-apartment
that you can neither rent nor sell and whose value will decline over time.
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