hard choice

Rent to Own, Part II: Protection, options, and finding tenant buyers

In Part I of this series on claims made about Rent to Own, I covered the notion that you can make fast cash and don’t have to worry about tenant hassles.

Today I’m going to tackle the next items involving protection from risk and finding tenant buyers for the deals.

You’re protected by the deposit!

During the presentation mentioned in Part I, the speaker said that one of the advantages of Rent to Own is that you are protected by the tenant-buyer’s down payment. If they bail, you get to keep the property and the deposit.

First of all, you do not get to keep all of the deposit. Not, that is, if you want a lender to fund the deal at buy-out. Anyone who writes an RTO contract saying that 100% of the deposit is non-refundable will not meet the current requirements by the few lenders who will consider RTO contracts. While lenders, or more specifically the insurers, would like to see all of the deposit returned to the tenant-buyer in the event that they walk away from the deal – which any investor knows would be madness; nobody would ever consent to invest under such a condition – the reality is that you do need to make some portion of the deposit refundable if the clients back out.

Second, just how far do you think the deposit will get you if you suddenly have a building on your hands and no paying tenant? The carrying costs alone can chew through the deposit in a hurry, not to mention the Realtor and legal fees involved in a sale.

Some simple math

Add up your mortgage, insurance and property tax payments. Now add in utilities and maintenance costs – someone has to mow the lawn, shovel the snow, heat the place, pick up the mail and generally keep the place clean. What’s that number? That’s the amount that would be coming out of your pocket every month without any income.

Now consider the possibility of damage done to the property.  People who are forced to leave their home behind when they fail to qualify don’t always leave it broom swept and tidy. Nor do they fix the holes, dents, and damage accumulated during their stay. If they blame you for their failure, you might see more interesting damage. How much does it cost to paint the whole house, clean up a heap of junk, repair walls, replace fixtures and undo other damage? Add that to the price tag and see how much of your deposit is left.

How much is enough?

So how much of a deposit should you require? The speaker told us that she gets a “good-sized deposit”. When pressed by an audience member about how much she would require for a $350,000 home, she stated, “I think $12,000 to $15,000 would be a good deposit. That’s a lot of money for tenant-buyers!”

One thing strikes me about that answer: There’s no systematic approach. Sure, $15,000 feels like a lot of money, but feelings should not play a role in real estate investing. You should know precisely how much you need to get for a deal in order to properly protect yourself. In addition, your system should be based on a logical, substantive evaluation of potential costs and risks.

I am also concerned about the assertion that $12,000 to $15,000 is a lot of money for tenant-buyers. I agree that for many people, saving thousands of dollars for a down payment is difficult.  The harsh reality, however, is that home-ownership is expensive. If you have little money going into a purchase, you will not be well-prepared for the inevitable costs of repairs and maintenance. What will you do when the furnace needs to be replaced? Also, the less you have going into an RTO arrangement, the more you need to save on a monthly basis in order to have the down payment required by the lenders at buy-out.

Remember, you’re not looking to have your program match every tenant-buyer’s needs; you’re looking for tenant-buyers who fit your system’s requirements. You’re better off saying no than compromising your requirements and adding to your risk.

A deposit certainly provides a measure of protection, but it may not be sufficient protection.

So many plan B options!

Another plus presented in favour of Rent to Own is the fact that there are multiple exit strategies. If the original tenant-buyers fail to purchase the house, there are multiple options for the investor including finding another set of tenant-buyers, keeping the house as a rental, or selling the property. Let’s consider all three of these options.

Find new tenant-buyers

It’s true that you can try to find new tenant-buyers for a property, but your success rate will depend on a couple of factors. First, it can take a while to find people who will love the house enough to want to rent to own it. Most RTO practitioners, and authors, will tell you that this house-first approach has a lower rate of success than using a tenant-first approach (i.e. find tenant-buyers and have them pick their own house). We have replaced tenant-buyers twice in my business, but it took several months in both cases, and only one of the replacement tenant-buyers was successful.

In the first instance, the new tenant-buyer also bailed and we ended up selling at a loss (after Realtor fees, legal and carrying costs – that’s one of the two failed deals to which I refer in my previous post.)

The second time, we were lucky enough to find a great family who wanted the house that had been vacated, and they’ve been doing well since then. They are on track to buy out within the year.

With respect to the second of our two failed deals, we tried to find new tenant-buyers but we weren’t successful. We offered incentives and marketed the place heavily, but after three months we couldn’t keep paying the carrying costs out-of-pocket. We had to sell the place.

I also want to address the ease with which you can find RTO tenant-buyers. There was a suggestion at the presentation that you have to look at roughly ten applications to find a good one; thus, a 10:1 ratio. In ten years of putting together successful RTO deals, we have never been able to reach a 10:1 ratio. It was more like a 30:1 ratio, and that number was climbing when we decided not to accept any more RTO clients. That’s a lot of time spent sifting through potential applicants and doing due diligence, even with minimum requirements clearly stated.

You might wonder if the issue was the source of our applications? In our case, they came from online ads (few), our website (moderate number), Realtors (very few) and mortgage agents (most of our applications). Regardless of the source, most applicants did not meet our system’s requirements, which were established to mitigate risk and prioritize tenant-buyer success.

Discussions with fellow RTO practitioners confirmed our own experience that “good” tenant-buyers are hard to find. If you’re having much better success, and managing a smaller ratio, I’d love to hear about it. But bear in mind that in order to assess the success of tenant-buyers, you need to evaluate the rate of completed files (i.e. those that have ended in a successful buy-out).

If you don’t manage to find new tenant-buyers, you can always turn the RTO property into a rental, right?

Keep the house as a rental property

The success of this approach will depend entirely on the type, size, location, and price of your property. If the tenant-buyer selects the house, as is often the case in Rent to Own (and as was the case in my own business), then keeping the property as a rental might not be doable for all the reasons I’ve just mentioned: too expensive, wrong location or property type to attract renters, etc.

Julie Broad, author of More Than Cashflow: The Real Risks & Rewards of Profitable Real Estate Investing, explains why she and her husband found it more profitable to pay under-market prices for rental properties and then find tenant-buyers versus using a tenant-first approach. In their case, they knew perfectly well that the properties would do well as rentals. If they failed to find tenant-buyers, they would resort to renting as a Plan B, and they succeeded because they built their system around a sustainable exit strategy. They already had a portfolio of buy-and-hold units, so adding another one to the mix was not unwelcome.

If we’re going to say that renting is a viable option in the event that RTO fails, we have to add the caveat regarding the details of the purchase at the outset. These will determine the viability of turning your RTO property into a rental.

Sell the property

Over the past ten years, I’ve received calls from several people who entered into Rent to Own investments and subsequently found themselves in a pickle. In some cases, the tenant-buyers didn’t even last a full year before bailing on the property. The investors faced losing a good chunk of money because there had been little appreciation since their purchase and virtually no mortgage pay down to offset the costs of selling the place. After Realtor and legal fees, plus the carrying costs, they would be in negative ROI territory.

There are a number of factors to keep in mind when it comes to using the sale of your property as a Plan B:

  • Is the property in a desirable location?
  • Does the property appeal to a wide demographic? The more people who want that sort of property, the better your chance of a quick sale.
  • What are the average Days On Market for listings in the area in question? If that’s a large number, you might end up paying significant carrying costs before the property sells.
  • Has there been sufficient appreciation to cover the Realtor’s and the lawyer’s fees? If the deal goes south in the first year, or if property values flat-line (or worse, decline), there will be no appreciation to bank on.
  • How many costs will the non-refundable portion of the deposit plus option credits cover?
  • Has there been any damage to the property that will require an investment of time, cash and effort?
  • What’s the time of year? Selling a house in April is considerably easier than selling a house in December, regardless where you live.

I have a colleague who successfully sold a property vacated by a tenant-buyer, leaving her with a good profit, but this property was in a city with very strong appreciation. The market in which you invest will play a large role in the viability of a sale post tenancy.

Next up: Rent to Own, Part III: Scalability issues and Done For You deals

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