In recent years, especially in Western Canada where we live, a lot of real estate investors have found it tough to make the ‘numbers work’ on buy and hold deals. The biggest challenge is finding a deal that you can buy for a price low enough that you can cover all the costs with the rent it will generate.
While home prices sky rocketed over the last 8 years (up to 2008 anyways), rental rates took a slow and steady path upwards.
One of the ways we’ve been able to continue investing in Western Canada and still make money from our investments is to buy properties and then find tenant buyers for the properties. That is, we’ve done a rent to own real estate deal.
The most recent example is from a single family home we purchased in Kelowna, BC.
For our readers that are unfamiliar with how the Rent to Own (RTO) strategy works, here’s a brief summary.
The rent to own strategy is just like how it sounds, a tenant rents your property with the intention (and option) to buy the property at some point in the future (and at a pre-determined price).
To help your tenant prepare for the purchase you charge them a rental rate over and above the market rate with a portion of their rent building up as a rent credit.
For example, if a single family home (3 beds, 2 baths, 2 storeys, good neighbourhood) rents for approx. $1,300 per month as a standard rental unit, in a RTO, the tenant may pay $1,700 per month and $400 of that $1,700 goes towards the purchase of the property (when and if they buy).
Thus, if the renter (known as a Tenant-Buyer) elects to purchase the property after 1 year, they will have $4,800 ($400 times 12 months) towards the purchase of the property. This, coupled with an Option Fee (similar to a down payment) which the Tenant-Buyer (TB) pays to the Landlord at the beginning of the rental period, goes towards the purchase price.
Here’s a quick look:
|Purchase Price for Tenant-Buyer:||$350,000|
|Option Fee from the TB:||$10,000|
|Monthly Rental Credits from the TB:||$4,800|
|Net Cost to TB when they Purchase:||$335,200|
In essence, the TB no longer has to come up with $350,000 when they buy the property, they now have to come up with only $335,200 (plus standard closing costs). And, if the Tenant-Buyer is able to obtain good financing, they may only need to put down a few more thousand to make-up the difference between the purchase price and the mortgage amount. This effectively helps the Tenant-Buyer to get into a home and start building equity right away (it’s like forced savings) instead of having to put aside $500, $600, $700 per month into a crappy (low interest) savings account.
So, why would a renter choose to do this option rather than just saving and buying later or even buying now? Several reasons:
1 – They may not have a large enough down payment today to qualify for the mortgage
2 – Their credit may be damaged and so they need some time to correct it to ensure they can get the best rates and terms available (why pay 10% interest with bad credit today when you can build up down payment credits in a RTO, improve your credit and obtain 5% interest tomorrow?)
3 – They want to get into the home ownership market today because they think houses will be too expensive for them a year or two from now but again, they may not quite have the down payment, credit, or even income to obtain ideal financing today
4 – They may want to “test” being a homeowner. Perhaps the renter has never bought their own home and doesn’t know how much work/costs/time being a homeowner can consume versus being a renter. The RTO strategy gives them a feel for being a homeowner, without having to come up with a ton of cash (for the down payment and closing costs) to buy today.
Now, why would you, the real estate investor choose to use the rent to own strategy?
1 – Helps create positive cashflow on single family homes because you can charge higher than market rents
2 – Essentially locks-in your return should the Tenant-Buyer exercise their option to buy
3 – Little property management required as your TB effectively is the homeowner
4 – Few extra expenses as your TB pays for regular maintenance costs and any upgrades they choose to add to the home
5 – If the TB purchases the home within 1, 2, or 3 years (the standard option to buy term length), you get your capital back and can turn around and invest in something else
6 – Get all the perks of a standard rental property (tax write-offs, principal paydown by your tenants, cashflow) but you also get a built-in appreciation factor (something a standard rental does not have)
7 – If the TB chooses not (or is unable) to buy the property, you retain all the rent credits and their Option fee (they are non-refundable) and your return on investment essentially doubles. You can then turn around and do another RTO with a new TB
8 – Get an immediate return on your cash through obtaining the Option Fee which can often be as much as 50% of the cash you put in
9 – Potential less worry about what the tenants are “doing” to your property as your TB are essentially the homeowners
10 – If you buy smart, little to no work is required to shape-up the house…it’s already in great condition
11 – Feels good to help individuals “get into” the homeownership market
A Look at Real Numbers: Why we chose the rent to own strategy on the home we recently purchased in Kelowna.
Purchase Price: $351,500
Appraised Value: $355,000
2 Year Option Agreement Price: $383,000
Option Fee from the Tenant Buyer: $7,500
Monthly Rent: $2,000
Monthly Expenses: $1,350 (this includes P&I, taxes, and insurance)
Positive Cashflow: $650 per month
So, over the 2 year period, we’ll have earned $23,100 from the Option Fee and the monthly cashflow. In simple numbers, this is a 26% return on our down payment AND it doesn’t include the appreciation built in nor any principal paydown.
Not a bad investment at all, especially considering there will be little we have to do along the way.
One of the things people always say is “What if the tenant doesn’t buy it?”.
It’s a risk (and you should always be analyzing the risk in your real estate deals). But, it’s worth noting that it’s not really a bad thing if the tenant buyer decides not to buy after the 2 year period. At that point we will probably have a bit of maintenance to do on the property and then we will do another rent to own deal on the property. We will get a new deposit, set the new purchase price based on a new appraised value, and we’ll continue paying the principal down on the property with the rent. At that point our return will jump up considerably.
Now, what are the reasons NOT to choose a RTO strategy?
The opportunity to make single family homes cash flow makes this strategy very appealing but it is not for everyone. There are some reasons that a rent to own strategy might not work for you and your goals. Here’s some reasons why:
1 – Smaller population of Tenant-Buyers than regular renters so it may be more challenging to place good, quality TB’s than in a regular rental unit
2 – It doesn’t make much financial sense to pay a property manager to over see a rent to own property given the limited amount of work involved. However, that choice means that it will involved more of YOUR time
3 – If your target market area is in high demand from competitive owner-occupied buyers, you may have more trouble buying good, high quality properties (because there is so much competition)
4 – You have to remember that someone that makes a good renter is not necessarily the same person you’re looking for as a tenant buyer. Your market includes people with bad credit. It also includes people that have gone through some financial challenges because of divorce, job loss or just bad money management. These are people you might not rent to under normal circumstances but you will be considering them as a tenant buyer. Your main concern here is their ability to make the monthly payments. You aren’t as worried about their credit. You want someone that is going to be likely to take good care of the property and can potentially buy it in a few years. You aren’t looking for the perfect candidate that could buy it right now!
5 – If the TB exercises their option to purchase at the pre-set price and property values have skyrocketed since you agreed on that pre-set price, you won’t obtain that large appreciation
6 – It’s still a rental property and somewhat illiquid (compared to stocks, bonds, and other investments).
The Rent To Own strategy is just another tool for your tool belt. It’s not for everyone, but it does make it possible to generate strong cash flow from properties that would otherwise never stand a chance of covering their costs and putting money in your pocket each month.
And the good news is that Rent to Own is really not that different than a standard buy and hold deal.
The tools required to find, buy, place, and manage a rent to own property are similar to a standard Buy and Hold(and so you can apply the principals from one technique to the other quite easily), but this strategy can also give you that “feel good” emotion that comes with helping a prospective homeowner get into the market (and you can profit from that too!).
Published on October 16, 2009