When purchasing a commercial property, the advertised income is often a key factor in the buying decision. Two common arrangements used by developers and sellers to support that income are rental guarantees and lease backs.
While the terminology may sound interchangeable, these income support arrangements operate very differently and carry different levels of risk. Understanding the distinction is important before committing to a purchase.
What is the difference between a rental guarantee and a lease back?
A rental guarantee is a promise by a seller or developer to supplement rental income if the property does not achieve a specified rental return.
A lease back is a lease agreement where the seller (or a related entity of the seller) becomes the tenant and pays rent under legally enforceable lease terms.
The key difference is that a rental guarantee is generally a contractual promise to make up a shortfall, while a lease back creates a landlord and tenant relationship supported by a formal lease.
What is a rental guarantee?
A rental guarantee is commonly used in new developments or recently completed commercial projects.
For example, a seller may advertise a property as delivering an 8% return and agree to pay the owner the difference if the property generates less income during a specified period.
Rental guarantees can provide comfort to purchasers by reducing income uncertainty in the early stages of ownership. However, they do not necessarily mean there is a tenant in place generating that income.
The guarantee is only as strong as:
- The terms of the agreement;
- The financial position of the party providing the guarantee; and
- The mechanisms for claiming any shortfall payments.
Important questions to ask the seller include:
- How is the guaranteed income calculated?
- What expenses are deducted before the guarantee applies?
- How long does the guarantee last?
- What happens if the guarantor becomes insolvent?
What is a lease back?
Under a lease back arrangement, a seller-related entity enters into a lease of the property which usually commences immediately on or before settlement.
This entity becomes the tenant and pays rent to the new owner.
Unlike a rental guarantee, the income is supported by a formal lease that typically sets out:
- Rental payments;
- Lease term;
- Option periods;
- Outgoings arrangements; and
- Default and enforcement rights.
For investors, a lease back can provide immediate occupancy and cash flow from settlement.
The value of the arrangement, however, depends on the quality of the tenant and the lease terms. A long lease from a financially strong tenant offers greater security than a short-term arrangement with a tenant of uncertain financial strength.
Which arrangement provides more security?
There is no universal answer, but a lease back is often viewed as a more solid approach for a buyer as it is supported by a conventional lease structure.
That said, the real protection comes from the substance of the arrangement rather than its label.
Buyers should focus on:
- Who is making the payments;
- Whether they have the financial capacity to meet their obligations;
- Whether any security is being offered;
- The duration of the arrangement; and
- The legal rights available if payments stop.
What this means for you
Rental guarantees and lease backs can both enhance the attractiveness of a commercial property investment, but they are not the same thing.
A rental guarantee is generally a promise to support income. A lease back creates a landlord-tenant relationship supported by a formal lease.
Before relying on projected returns, buyers should look beyond the headline figures and understand exactly what is driving the income stream, who is responsible for making the payments, and what legal protections exist if things do not go to plan.
Obtaining legal advice and conducting thorough due diligence before signing a contract can help identify risks, clarify obligations and ensure the arrangement aligns with your investment objectives.
Further reading
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