We’ve all been there …
You have a few rental properties and you really want to sell one soon so you build more cash in your bank account.
You tried selling your property last year, but it sat on MLS for months because the real estate market was slow.
And when someone finally puts in an offer, it was almost insulting looking at the offer price.
Does it feel like a big challenge to sell your rental property in a slow real estate market?
It doesn’t really need to be so hard. You’re about to learn one of the most effective real estate investment strategies that boosts your cashflow, attracts better tenants and gets your property sold.
How Rent-to-Own works
The primary indication of good real estate investing, in my opinion, is whether everyone involved benefits. This can happen in any type of ethically executed strategy. For example, in standard buy-rent-hold investing, the goal is for the property owner, the investors and lenders, and the tenants all to benefit.
The benefits to all parties are potentially even greater in well-executed RTO investing. In addition to having a clean, safe place to live, the tenants complete the RTO term as home-owners with improved credit. It’s a very high profit, compared to standard buy-rent-hold, so investors and partners are very happy, too.
Did you miss the Rent to Own: Smart Person’s Guide Part One – Read it here.
Why Tenants are Attracted to RTO
Rent-to-Own deals are designed to solve two specific tenant problems:
Insufficient down payment. Note that some prospective RTO tenants do have enough cash to cover the down payment, but can’t get a mortgage for one reason or another.
In the absence of an RTO investor, the tenant must wait to save up the down payment, and work towards a better credit rating. The RTO investor helps in three ways:
By giving the tenant the opportunity to start building equity in advance of his or her own ability to purchase a house
By helping the tenant be disciplined in putting aside a specified amount of savings towards their eventual down payment
By helping the tenant repair their credit. Most people have no idea how to do this themselves.
The exact structure of RTO deals varies quite a bit among investors doing them, but most include the following elements:
The amount of the deposit required by the investor varies widely, from a flat fee of $2000-$5000, all the way up to a down-payment equivalent of 10-15% of the purchase price of the home. Most commonly, the deposit is credited back to the tenant/buyer when they are ready to purchase the home. The idea is to allow the deposit credit to count towards the down payment.
A very important thing to note is that not all lenders recognize these credits; many of them insist on a cash down-payment. You need to work with a mortgage broker who is experienced in closing out RTOs to make sure that the deal is set up to please the lenders, and knows who the RTO-friendly lenders are. Otherwise, you could end up at the end of your term with the tenant/buyer, and find that there is no way for them to get a mortgage unless you can find the cash to close the purchase.
The point of the deposit is two-fold. First, it starts the tenant/buyer off with a ”savings account” they can’t touch towards their down payment, and second, it makes it more difficult for them to walk away because they have “skin in the game”.
In general, the “rent” includes a savings portion that goes to increase the “savings account” that will be credited to the tenant/buyer’s down payment at the end of the RTO term.
One way to do this – and I find this is easy to explain, both to tenants and to the provincial landlord-tenant authority, if it becomes necessary – is to charge market rent plus an option fee. Knowing the market rent amount for the property is important for both you and the tenant/buyer. Any amounts paid over and above the market rent is credited to the tenant/buyer, and use to build their down payment.
A common misconception some tenant/buyers start with is that the full rent payment will go towards purchase – some even call it their mortgage payment. It’s important that they are very clear about exactly how much of their rent payment is actually going towards their eventual down payment.
When it’s time for the tenant/buyer to buy the house from you, the deposit and monthly option payments are added together and are shown as a credit on the offer to purchase.
This is a standard lease for the province you are in, with clauses added for the RTO. Generally the tenant/buyer agrees to do all maintenance on the property, including paying for materials and contractors, if necessary. Some RTO investors put limits on the maintenance and repair amounts the tenants are responsible for — $500 per incident to some maximum per year, for example.
Note that there are differing opinions about the kind of lease agreement to use, and the right answer is probably different from province to province. If the tenant is trying to get out of the agreement, they may try to take the contracts to their local landlord/tenant authority with the claim that they are a mistreated tenant. (This happened to me with an RTO in Nova Scotia. In my case, the Landlord-Tenant hearing resulted in a ruling that they did not have jurisdiction over the RTO contract.)
The Option agreement generally sets out the following details:
The term and end date. This is the length of time you agree to be in the relationship, often in the range of 3 years. It’s a good idea to get your RTO-savvy mortgage broker to help you with this. He or she will be able to tell you how many years it is likely to take for the tenant/buyer to improve their credit enough to be able to get a mortgage. It may be more or less than 3 years.
The eventual purchase price. Have your realtor help you with this. This is the projected value of the property at the end of the term. The realtor will use the historical appreciation numbers for the neighbourhood, and use his or her crystal ball to make an estimate for what the value will be at the end of the term.
The deposit amount. This is the amount the tenant/buyer is contributing up-front.
The market rent. Your realtor will be able to tell you this amount.
The monthly option fee amount.
Sometimes the Lease and the Option terms are combined in one document.
Recommended: Agreement of Purchase and Sale
In the last few RTO deals I purchased, the deal paperwork included an Agreement of Purchase and Sale for the province the property was in. This agreement was prepared up front, and included all the details of the eventual sale to the tenant/buyer. The close date reflected the end of the term, in the future.
When I prepare the P&S – whether at the beginning or the end — I don’t allow a financing clause or an inspection clause. To my mind, the financing has to already be in place for the deal to finish at the end of the term, so a financing clause isn’t necessary. As for the inspection, the tenant had an inspection at the beginning of the RTO, and any findings in an inspection at the end of the term are most likely caused by poor maintenance by the tenants themselves, so I will not negotiate price at that point.
This is the question I am asked most often by the tenant/buyers (nearly 100%): “What if the house is not worth the full amount we have agreed to when it’s time for me to buy it?”
You need to be prepared for this question. I always say the same thing: If, at the end of the term, the appraised value of the house is lower than our agreed-upon sale amount, either we will lower the sale price of the house to match the appraisal, or we will extend the RTO agreement until our purchase amount is reached. We will decide what makes sense at that time.
Note that their lender will not lend the required amount if the appraised price is significantly lower than the agreed price.
Setting up your first RTO
When you start working on your first RTO, you will quickly learn that finding the house is easy – but finding qualified tenants can be difficult. When RTO investors start advertising for tenant/buyers, they quickly find that most of the people who apply have poor credit, a low-income, and usually no money at all. Over time, the ads can be tweaked and refined to attract your ideal tenant buyer. I know one beginner RTO investor worked on this for 18 months before attracting his first qualified tenant/buyer.
I didn’t want to spend my time this way, so I bought prepared deals, including paperwork, from a company that finds and qualifies the tenant/buyers. I am very happy to let them do the work while I pay a fee for it. Rent-to-own is generally so profitable that the fee is easy to absorb.
RTO investing has many advantages, and a big one is the relationships you can form with your tenants. Most tenants are great people who just need a break, and it feels good to be instrumental in providing that break.
Next time, I’ll talk about the problems to watch out for and how to prevent or deal with them when they do arise.
Onwards and upwards!
Recommended reading from this accomplished author: Rent to Own: The Smart Person’s Guide Part One