Don't Shoot the Developer

16 May 12

One issue often raised is whether a developer should have the right to sell management rights to strata schemes.


The “Arrow Asset” decision held that a fiduciary relationship exists between a developer and body corporate and that a developer owes a body corporate a fiduciary obligation not to profit from contracts for the sale of management rights without proper disclosure to the body corporate of the profit. A fiduciary obligation is a legal or ethical relationship of confidence or trust regarding the management of money or property between two or more parties.


Without doubt, everyone I talk to who is “anti developer” believes that the developer rips off owners by selling management rights to their complex and that the developer receives a huge windfall in exchange for tying the body corporate up to long term contracts that involve the payment of excessive fees. The common belief is that the higher the caretaking fee, the more the developer will profit from the sale.


The reality is that it is a misconception and I will explain why.
Management Rights” consists of:
1. Caretaking rights, and
2. Letting rights.


Caretaking rights need no explanation. The caretaking agreement is simply a contract for a defined term between the Owners Corporation and the Caretaker whereby the Caretaker contracts to perform specified duties in exchange for the payment of an agreed fee. The agreement has a start date and an end date and, in New South Wales, the term of these agreements is now limited to a maximum of 10 years (including options).


Notwithstanding common belief, these agreements generally do not have a substantial profit mark-up. In fact, I have seen a number of agreements where the caretaking fee is less than the cost of production. The majority of management rights operators do not make significant profit from their caretaking contracts.


The second (and most important) revenue stream for on-site managers is the letting rights. The granting of these rights costs the Owners Corporation zero as all the letting agreement does is give the on-site manager the exclusivity to operate a letting and/or sales business from the complex. Owners cannot be forced to use the on-site letting agent for the provision of letting services. They remain able to use outside agents or can let their units themselves.


The point I want to make is that the big $$$ being paid for the sale of “off the plan” management rights comes from the projected income to be made from the letting side of the business. As a licensed letting agent, managers receive commissions from owners and generally one week’s rent when a tenancy changes over. In a building with considerable investor owners, this letting income can be substantial. When the business is sold by the developer, the buyer will generally pay the developer a capitalised amount based on this projected net income over a 12 month period (generally x 3 or thereabouts).


In other words, the money is in the letting – not the caretaking.


So what is the developer selling?
Essentially, the developer is harnessing and selling a rent roll that, in the absence of management rights, would be taken up by the various selling agents – without payment to the developer. They are simply directing investment buyers to an on-site manager to look after the rental of their unit. No-one is better qualified to handle rentals in a building than the on-site manager. They live with the tenants they put in and know exactly what is happening at any time. If there are bad tenants, they will be in a position to evict them long before any outside agent will become aware of a problem. They have a financial interest in ensuring that tenants are of the highest quality and the investor owner receives the highest possible return. It is much better for a complex to have one on-site manager looking after the majority of rentals in the complex rather than having numerous outside agents controlling lettings ad hoc.


Why can’t the Owners Corporation receive the money?
It is often put to me that the Owners Corporation should be the entity that can sell the management rights and retain the profit. However, I pose this question:
What gives a particular group of owners at a point in time the right to bind future owners into a long term caretaking contract in circumstances where they receive a one-off payment to the admin or sinking fund – to the detriment of future owners in the scheme?


If a lump sum payment comes in today, Owners Corporations invariably reduce levies in the short term (because of the lump sum payment received from the sale of management rights). That “windfall” quickly disappears and future owners are still bound by the long term agreement but don’t receive the levy subsidy that the original owners received. I find the argument it a bit ironic really.


Summary
Developers make the big dollars but not at the expense of the Owners Corporation. They simply harness and sell a rent roll which they create and which otherwise would be picked up by outside selling agents in fragmented proportions.
 

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