It looks like the hype about Rent to Own is back.
Housing sales aren’t the only part of real estate that goes in cycles. Ten years ago, everyone was saying that Rent to Own was a scam. A few years later, it was all the rage in the world of real estate investing. Rent to Own “experts” (according to the claims on their newly-minted websites) were everywhere, promising returns in the high double-digits with virtually no risk. Then, when the going got tough, many of the companies disappeared.
Now, RTO seems to have come back into fashion with purveyors making all sorts of claims:
- So much cash flow to be made!
- No tenant and toilet issues!
- You’re protected by the down payment!
- So many plan B options!
- There is no shortage of tenant-buyer prospects!
- You can find companies that will set up and manage the deal; you just put up the money and qualify for the mortgage. It’s so easy!
- There’s no limit to the number of deals you can have on the go at any moment!
I heard more of this sort of thing last week when I attended a meeting for real estate investors in which an RTO expert from another city pitched the appeal of Rent to Own and her “Done For You” business.
After running a Rent to Own company for nearly ten years, I have the following advice for anyone contemplating RTO: Be careful. Ensure that you fully understand what you’re getting into. Rent to Own may be a valuable investment for some people – a much more limited set of people than you think – but it does not live up to the hype.
I am so concerned by some of the claims that I heard last week that I’m going to highlight some issues with RTO and share counterpoints to consider.
Last year, I wrote a long piece about the perils of Rent to Own. This is a follow-up, multi-part blog series to address the contentious claims mentioned above.
Fast, easy cash!
There is nothing easy about Rent to Own. It can be an effective strategy, but it is not simple. As one colleague stated, this is not a beginner strategy; it’s an advanced investment that should be entered into only by people who have a solid understanding of, and experience with, real estate investing.
By the way, most mortgage agents that I’ve encountered don’t like doing RTO deals because it’s a pain in the backside for them. Just ask anyone who has worked on the buy-out at the end and ask them how fond lenders are of RTO. Apart from the fact that most lenders won’t touch RTO deals, they’re a lot more work for the mortgage agents for no extra cash. That’s not exactly an ideal clientele for them.
Back to the main point though: The deal is made or broken on the selection of the tenant-buyer. With the wrong tenant-buyer, you will face headaches, at minimum, and financial losses at worst. The monthly cash flow can be strong if you’ve set up the deal correctly and there are no significant, unanticipated expenditures (e.g. increases in property taxes or insurance costs), and there are no issues with your tenant buyers. If everything falls into place as projected, then the cash flow is strong.
However, there are two things to bear in mind: First, the lion’s share of that cash flow is the savings portion that the tenants are amassing on a monthly basis. It is therefore considered a liability in your hands until the deal successfully closes without a hiccup. This is a case of being careful not to count your chickens before they’re hatched. Yes, you may have the cash in hand, but the bulk of that cash, strictly speaking, belongs to the tenants at buy-out. Are you spending it before it’s credited to them at the end of the deal? Do you have access to it in the event that you need it? (We’ll discuss the refundable vs non-refundable portion in a later post.)
Second, there’s the issue of ethics: Are you one of those people who picks the amount of the savings portion based on what you think you can get, or what you think sounds reasonable using an approach that I liken to using magic formulas? There is a very specific number that lenders look for, and it has nothing to do with what you hope to get or what you think sounds OK. It’s all about lending requirements. For A-lending, you currently need a down payment of 6.5% of the purchase price; 5% for the actual down payment and 1.5% for closing costs. That’s the minimum. The minute you venture into B-lending (i.e. not the major banks or lenders), or you add in issues like self-employment or a past history of credit challenges (which defines most RTO tenants), then you’re looking at 10% to 15% down payment requirements plus closing costs.
As I listened to the presentation about adding on a savings portion to the amount you collect “because the tenant-buyers need to have some savings”, I can only hope that there’s more rigour and substance behind the calculations that did not get mentioned. If not, the system is already in trouble. Who get hurts by this? The tenant-buyers for sure – they get ripped off by paying outrageous monthly amounts or they’re set up to fail at the end – and possibly also the investors.
No tenant and toilet issues!
In order to become a successful real estate investor, one needs to learn to evaluate and mitigate risk in a deal. When it comes to RTO, there are three major risk points, the first of which is the tenant-buyer. Get this choice wrong and you will encounter difficulties.
The presenter I refer to above suggested that the two key points to evaluate with respect to a tenant buyer is the person’s income and their down payment. I thought so too when I first started in RTO. Do you want to know who cost me the most money in a deal gone bad? A couple who earned more than $160,000 and who had $35,000 for a down payment. Worst. Experience. Ever. And yet, by the presenter’s criteria, they would look like rock stars.
Income and down payment are not sufficient. You have to look at the following, to name but a few:
- how they earn their income
- what their employment history is
- when and why they encountered credit difficulties
- what their pattern of spending has been
- what their track record is when it comes to managing their funds
- how they talk about the difficulties they’ve had (e.g. is it always someone else’s fault or do they take ownership of their difficulties)
- how they respond when you ask pointed questions about their past (e.g. defensive? open? honest? evasive?)
- how they maintain their current residence
If you’re relying on someone else to evaluate tenant buyers, you are effectively handing over one of the most important decisions to a third party who, mostly likely, has no skin in the game if something goes wrong. Even if you employ someone to help you with this, you need to do your own due diligence which includes understanding what information you need and what it all means.
The disastrous deal that I mentioned above? That came from a mortgage agent who had “analyzed” the deal before presenting it to us. That person did not fully understand how to evaluate the risk in the deal. There was no malice or ill-intent, just a lack of understanding. That’s the experience that pushed me to develop expertise at reading credit bureau reports. I never again wanted to rely on someone else to evaluate the risk in a file.
As for no toilet issues, you might want to consult a lawyer who is familiar with the residential tenancy act that governs rentals in your province. Here in Ontario, most people offering RTO’s write in clauses to the effect that tenant-buyers are responsible for all maintenance and repairs. We did, and most of the time it worked. Except when it didn’t.
Back to the nightmare scenario referenced above: A major problem developed in the house and the tenant-buyers refused to pay. When we consulted a lawyer who specializes in landlord/tenant issues, he informed us that our clause stating that the tenant-buyers are responsible for repairs likely wouldn’t stand up at the Tribunal; landlords are responsible for maintaining their properties.
For other deals, we’ve had issues where tenants wanted us to make a claim through our insurance because, as they argued, the issues in question are covered under insurance policies. We set high deductibles to discourage frivolous requests, but we nonetheless had situations where we did end up dealing with insurance companies for water in basements, etc. That added a great deal of time and hassle to those deals, not to mention the impact on insurance rates.
It’s worth remembering that it’s what you don’t know that can harm you the most.
Stay tuned for Part II in this series in which I address more of the claims enumerated above.