The darker side of serviced apartments

Imagine an affordable, hassle-free investment in one of our major cities that offered a guaranteed rental return of over 6% and a long term lease with fixed annual rent increases.

In cash-strapped times, this would seem an opportunity too good to miss.

But, as always, there is a darker side.

Welcome to the world of serviced apartments.

Serviced apartments are basically strata-titled units within a hotel development.

Traditionally, a hotel would be owned by a single investor or a small group of investors.

As the hotel business is generally high-risk in nature, it can be difficult for a hotel operator to raise funds to construct a hotel project at a reasonable rate of interest.

Hotel developers came up with a strategy to reduce their funding cost and free up equity by strata-titling the apartments and selling them individually to mum and dad investors.

Some hotel operators offer fixed leases to the purchasers of the properties, while some offer a share of the income generated by that unit (or pool of income) from the operation as a hotel / serviced apartment.

So why do some investors buy serviced apartments?

Well, for anyone who is used to investing in houses, a 6% or 7% guaranteed rental return with no vacancies would appear very attractive indeed.

Serviced apartments promise security as they usually involve a leaseback agreement with the hotel operator, who may have a five or ten year lease to manage the property as a serviced apartment hotel.

Sometimes, the operator may even pay the body corporate fees.

But let’s examine why investors should be wary.

What happened to my rental returns?

Given that serviced apartments are sold on the promise of their strong rental returns and short-term rental guarantees, it’s worrying that many of the claims simply do not stand up to scrutiny.

In reality, many rental guarantees simply do not deliver or even if they do the returns following the guarantee period are often far less. 

The occupants of serviced apartments are typically tourists and business travellers.

As we know, the accommodation industry is typically a very cyclical business and impacted by a number of external events ranging from terrorist attacks to airline strikes.

That is why rental returns are often lower than expected.

Plus, in the case of rental guarantees, it’s important to know who exactly is underpinning the guarantee.

If the company or person guaranteeing the rent goes out of business, then the guarantee could be worthless.

Generally speaking, rental guarantees should be a warning sign to investors.

They offer comfort but it’s what they hide that is a real danger.

A good question to ask yourself is ‘how good an investment can this really be if the seller needs to offer a rental guarantee?’

Another question to ask is “how long is the guarantee for?” – if it is only for 1-2 years, then really the market rent is more important.

Why isn’t my bank excited about my investment?

Another major problem with serviced apartments is getting finance for them.

Many lenders have a negative attitude towards them and will lend a lower percentage of the purchase price than a traditional residential investment and in some cases they won’t lend at all.

It’s not uncommon for lenders to have strict criteria regarding the size or location of serviced apartments.

It’s worth how much?

For an investor, there’s nothing worse than finding out that your property has lost value. 

But this is a reality for many owners of serviced apartments.

Because of the long leases, serviced apartments can only be sold to investors – the owner-occupier market is effectively shut out.

This severely affects the level of demand for the product and restricts capital growth.

While there are always exceptions to the rule, generally speaking serviced apartments have poor capital growth.

If they didn’t, why would they need to offer a rental guarantee?

Conclusion

With more and more serviced apartments available, the problem of oversupply will hinder the capital growth of the category.

Also the high rental returns become less appealing the more you investigate the high risks involved.

There are also many other traps to avoid if you are thinking of investing in a serviced apartment.

For instance, what obligations do you have to renovate the property at the end of the lease?

While there have been some successful service apartment projects where all parties in the transaction have profited, in many cases investors who purchased the units have suffered poor returns.

All in all, it seems that serviced apartments are great for hotel operators, tourists and business travellers, but not necessarily for investors.