Buying property in a hotel and placing it in a rental pool is gaining popularity among investors. But you can come dangerously unstuck if you aren't alert to the ploys of cunning developers, writes Angelique Arde.
Investors who bought units in five-star hotels in Cape Town a few years before the 2010 Fifa World Cup thought they would be laughing all the way to the bank for years to come. But for investors who bought into the Cape Royale, the experience has been anything but amusing.
Last week, the hotel's body corporate was placed under administration amid allegations of gross mismanagement, financial irregularities and conflicts of interest involving the developer, who is simultaneously the single biggest owner of units, the chairman of the body corporate and the sole director of an entity that performs some of the functions of a managing agent (see "Cape Royale's body corporate goes under administration after trustees fail owners").
Meanwhile, the owners of units in another plush Cape Town hotel, the Pepper Club, have engaged a firm of attorneys, because the trustees have failed to appoint a managing agent who has a valid fidelity fund certificate and have refused to allow the owners to inspect the body corporate's service agreements.
Ordinarily, hotels are financed and wholly owned by property investors and then managed by hotel management companies. But it's not uncommon for developers to divide hotels into sections (under the Sectional Titles Act) and sell the rooms in the form of units.
Typically, you, as an owner of a unit, are given the option to place your property in a rental pool so that you can share in the net rental income generated by the hotel from letting the rooms to guests. The upside of this is that the properties in the rental pool are managed by a hotel management company, so you don't have the hassle of finding tenants and maintaining the property, as you would if you were an ordinary residential landlord.
But what you may not realise is that although you share in the risks of the hotel, you do not always share in all of its profits. You share only in the profits of the rental pool, and often it is managed by a rental pool management company that is distinct from the hotel management company. This means that by the time you get your share of the profits, other entities - over which you have little or no control - have taken their cut.
What you should know beforehand
Cape Town-based attorney and consultant Anton Keet says that when contemplating buying property in a hotel to place in a rental pool, you need to consider:
Transparency
Ascertain how much disclosure you will given about the operating income and expenses of the hotel, not the rental pool management company.
"A rental pool agreement is between owners in the body corporate and the rental pool management company, which is usually controlled by the developer.
"The developer, through the rental pool management company, will have the right to appoint a hotel management company. It is not uncommon for the developer to own the rental pool management company.
"What you often find is that there are several levels and layers of costs between the hotel - where profits are generated - and the unit owner, who is supposed to receive a portion of the profits. The rental pool management company will be entitled to a percentage of the revenue of the hotel, as a fee, on top of the management fees that will be charged by the hotel management company.
"In effect, this means that they (the developer/rental pool management company) take their income from the revenue line of the hotel. So whether or not there's profit is irrelevant - as long as there's revenue, they derive benefit, while you, the owner, might not." Keet says that very often this drives the rental pool into a loss-making position.
Expectations
Although you, as an investor, buy a title to property, you will not be able to use the property for most of the year, Keet says.
"The property is accessible to you, but usually for no more than 20 or 30 days in the year, depending on the terms of your rental pool agreement. Many people forget that they are effectively buying a share of the income stream attributable to their unit. While the investment is in the form of a fixed property, it's nature is actually more that of a share."
Keet says that often the procedure you must follow to enjoy the use of your property is cumbersome, and there is a direct cost to you when you do have access to it. "This is not always clear in the rental pool agreement."
The line may be blurred between what expenses constitute part of the sectional title levies and what are rental pool/hotel operating costs, Keet says.
"Often, the developer will be in a position to move some expenses that should strictly be rental pool/hotel expenses to the body corporate. In this way, levies subsidise the hotel operation, but the owners don't get the benefit of increased profits from the hotel. So it's a double whammy: the owners are paying ever-increasing levies, but they don't get profit distributions," he says.
How the levies will be determined
You, as a member of a body corporate, are entitled to know how the levies will be calculated and also whether the developer will pay levies while he is an owner of units in the sectional title scheme. A provision to this effect is often incorporated in the body corporate's management rules.
You must find out the levies that owners must pay for the first two years so that you will know what your financial commitment will be.
"If you are buying through a bond, it's not enough to simply compare the promised rental pool distribution to a bond repayment. Financing such a property increases your exposure to risk," Keet says.
Feasibility studies
Keet says you should beware of basing your decision to buy on the strength of feasibility reports presented by the developer. These reports may contain projections of a yield of six or eight percent on your investment.
Often, a developer will commission a hotel management company to conduct a feasibility study based on market conditions and location, Keet says.
"That [study] will often be massaged by the developer so that it looks more attractive to prospective owners. Ask to see the feasibility study done by the hotel management company itself. You may find projections of an operating loss in the first two to three years, which is to be expected. In the past, there's been a lot of latitude taken in terms of forecasting, especially in the first five years of the operational life of a hotel," Keet says.
Guarantees
Beware of "guarantees", Keet says. "Often, there will be a guaranteed yield for the first two years. The cost of this will be included in the purchase price - in other words, the developer is paying you some of your own money back. Logically, it is the only conclusion. There's no such thing as a free lunch, and after the guaranteed period has ended, it's not inconceivable that the yields will drop, or disappear completely."
The reputation or track record of the developer
Ask the developer to refer you to other hotel developments that he has undertaken and then ask unit owners in those developments what their experiences have been, Keet advises.
Before you buy property in a rental pool structure, you must ask your accountant or auditor to analyse the numbers presented by the developer, and ensure that your attorney studies the sale and rental pool agreements, he says.
Via IOL Personal Finance
