Last month, my business partner and I sent out an announcement saying that we are no longer accepting rent-to-own deals. The reaction has been interesting. Several of our referral partners told me privately that while they are sad we are no longer offering that service, they aren’t surprised. Others wondered why we stopped. Aren’t rent-to-own deals lucrative? Don’t they provide an important service in the marketplace for both investors and tenant buyers? Several companies are still gung-ho on them so what’s our problem?
Here is the full scoop on why I don’t believe that rent-to-own makes sense for me in this current environment.
The numbers don’t lie
In any real estate investment, there are three ways to make money: positive cash flow, mortgage pay-down and equity appreciation. In a rent-to-own transaction, equity appreciation represents the lion’s share of the profits for investors. When there is little-to-no appreciation, there is little-to-no profit. When I started doing RTO deals eight years ago, the appreciation rates were somewhere between 4-5%, on average. That means that a property purchased at $100,000 back then would be worth roughly $112,000 after three years, assuming a 4% annual appreciation rate. That’s a total increase of 12% without even factoring in the mortgage pay-down (paid for by the tenant buyers) and positive cash flow. With such strong returns, investors were understandably keen to participate in these deals despite the inherent risks.
Fast forward to 2016 and the market conditions in the greater Ottawa area are very different. Some areas are showing a loss in value, with several others showing flat or negligible appreciation. Traditionally solid, stable areas are having a hard time when it comes to home values. That’s terrible news for investors. Why would you take the risks built into rent-to-own deals if there is little appreciation?
Ah, but first you need to know that there is little appreciation. Some purveyors of RTO deals are still using highly-inflated appreciation rates that have no hope of being borne out at the time of buy-out. What that means for the investor is that the value they claim the house will have in two, three or four years won’t bear any resemblance to the appraised value provided by the tenant buyers’ lender. That’s a big problem.
The banks don’t care about your inflated values, they care about their appraised values. The only way to solve that problem is to:
- harm the tenant buyers by maintaining the option (i.e. buy-out) price, thereby forcing the tenants to stay on indefinitely until the house prices rise, or abandon their savings and the home; or
- work out a compromise with the tenant buyers in which you reduce the price a bit, thereby reducing your returns, and obliging the buyers to take out a second mortgage for the difference between your buy-out price and the appraised value, which tenant buyers can’t always afford; or
- accept the appraised value and walk away with little profit after years of work and hassle.
Any way you slice it, it’s a lose-lose proposition for everyone involved in this scenario.
The only way to ensure that projected house values are realistic when deals are presented is to work with an independent (i.e. not tied to the deal), reputable realtor who can show you the appreciation rates for a given property type in a given zone (do not accept city averages; they are neither useful, nor applicable). We have amassed appreciation rates for multiple zones in the greater Ottawa area, and we have come to the conclusion that at best we can only use 2% appreciation rates in some places, while avoiding many others. The upside has been considerably reduced.
If you’re an investor taking on a deal in an area with little appreciation, you’re taking on a lot of risk that you cannot control. Is that the wisest choice for your funds?
Mortgage insurance is a problem
This past summer I was invited to speak with representatives from one of Canada’s mortgage insurance providers (i.e. the people who insure high-ratio loans) to discuss policies related to rent-to-own. The mortgage broker who set up the meeting wanted the insurer to see that there are indeed companies doing rent-to-own ethically, professionally and thoroughly. We wanted to show them how their policies undermine our ability to do our job. After a couple of hours going over their policies, discussing why and how they posed major challenges for companies trying to do rent-to-own well, and showing them that some requirements were untenable, the insurance representatives agreed that this is a tricky situation. They understand, but realistically it would require a massive undertaking to make substantive changes to their policies. It’s just not worth their while.
What does this mean for RTO investors? It means that in order to meet the insurers’ requirements, you have to expose yourself to even more risk. My partner and I have developed a work-around for some of the major risk points, but it’s becoming increasingly difficult to work with insurers.
The lending environment has changed
It’s one thing to set up a rent-to-own deal but it’s another thing entirely to see it through to a successful conclusion with a buy-out. As an investor, you make the bulk of your returns when the property is sold to the tenant buyers. If the sale doesn’t happen, you’re stuck. If I were an investor today looking at a potential rent-to-own deal, the first thing I would do is ask the presenter how many deals they have successfully carried through to a buy-out by the tenants, and I’d ask for proof (e.g. speak to the investors on the deals).
When I first started years ago, it was a lot easier to find lenders who would work with reputable companies that had proper documentation and a transparent process. Things have changed in the interim. Since 2008, lending requirements have tightened up roughly once per year, leading to much greater risk aversion by the lenders. Today, most major banks won’t touch rent-to-own except on an occasional, case-by-case basis, if they look at it at all. If the tenant buyer has a former bankruptcy or consumer proposal, you can forget about it. For the rent-to-own company, that means having to get awfully creative in order to close out a deal.
My company has successfully closed out dozens of deals over the last eight years, but it is becoming more onerous to do so.
The reality of working with tenant buyers
I have had the privilege of working with fantastic families over the last eight years, and while my experiences with them have provided me with valuable insights, there have also been countless trying moments. The reality is that people don’t entertain rent-to-own unless they’re in a credit and/or cash bind, usually both. You know the Pareto Principle – or the 80/20 rule? A version of that holds true for rent-to-own. In our experience, maybe 20% of the families we have worked with have done what we asked them to in the customized Credit Improvement Plan that we created for them. They made the necessary changes on time and carried through with their commitments.
The other 80% were not fully compliant, and by that I mean that they failed to execute on key parts of their plan. I can’t tell you how often we discovered that clients had made major purchases, in the tens of thousands of dollars, mere weeks before they were scheduled to buy out their home, resulting in qualifying issues. This despite repeated requests to ensure that they not take on any additional debt at any point. My business partner and I had to make significant efforts to get those clients back on track and to convince the investors to give the tenant buyers additional time to sort out their problems. In rent-to-own, delays are the norm, not the exception.
I’m sharing this because if you’ve only been working in rent-to-own for a couple of years, it can seem so simple and awesome. Again, it’s impossible to know how much work is really involved unless you have seen multiple deals through to a successful buy-out or handled a deal that has gone sideways.
If you’re an investor looking at rent-to-own for the first time, you need to understand that the tenant buyers pose the single, biggest risk to the deal, quite apart from the real estate conditions driving property values. The clients say they are motivated, they truly believe that they will follow your advice (assuming you know what you’re doing from a credit repair perspective), and they will sign documents stating in black and white that they will be compliant. And then 80% will fall off the wagon. You can get most of them back on if you’re really committed and prepared to do a lot of work, but it will be quite an undertaking.
The final question
Is rent to own worth the effort? For me, it all boils down to ROE – Return On my Effort, or return on my investment of time. I would argue that time is your most valuable commodity. How do you want to spend it?
I’ve had a good, long look at how much effort is involved in putting together a rent-to-own deal, maintaining it and seeing it through to a successful conclusion, and I have determined that it is no longer worth it for me. I believe in the power of real estate and I love helping people. I will continue to do both and lend out second mortgages, but my primary focus is now on helping women grow their financial literacy and develop their confidence when it comes to money. That feeds my soul. I’d rather help women increase their wealth than bang my head against the brick wall of lending institutions. Families who are facing a credit crunch can follow my work and learn from the free resources that I provide (i.e. blog posts, interviews, free e-books, etc).
My business partner and I still have a handful of deals on the go and we remain committed, as always, to ensuring their success. Once they are done, we’ll be done. Will we ever do rent-to-own again? Possibly, if the conditions change substantively.
To those who choose to continue to do rent-to-own, we wish you well. Just be careful.
Until next time, Survive, Thrive and Grow.