The news in Ottawa about Rent to Own is all bad these days. Every media outlet is laying out the details of the pounding that investors are taking in the fiasco with Golden Oaks. Commentary ranges from bad to awful. So what’s going on here? Are all Rent to Own operators inept at best or crooks at worst? Is the whole thing really a scam and a very bad idea for investors?
The answer to the above questions is an emphatic NO! However, Rent to Own does attract more than its fair share of bad operators. Investors, like tenant-buyers, need to do their homework before entering into a deal. That’s true of Rent to Own and it’s also true of any real estate investment. When there are that many zeros involved in an investment, you need to do your due diligence properly.
But where do you start? How do you know what to look for? Unless you’re a savvy investor who has been around for a long time and done numerous deals, do you really know how to do your due diligence?
The purpose of this blog post is first and foremost to arm investors with the information that they need in order to evaluate rent to own deals and companies before investing. Rent to Own can be a very powerful tool to grow your income in the short- to medium-term IF, and only if, the deal is put together properly from beginning to end. Every step is critical to ensure success at the end.
The following is a list of the 5 Key Factors you want to consider before becoming an investor and putting both your money and your credit on the line.
#1: Who is offering the deal and what is their reputation?
In my blog post aimed at Tenant Buyers, I began with the same question very simply because the people who put together the deal will determine whether or not it has a hope of succeeding at the end. I cannot emphasize enough how important it is to move beyond the smooth talk and the claims of the people putting out the deal. Because there is no professional oversight in this industry, anybody can claim to be a Rent to Own expert. They put up a website, call themselves the Leading Rent To Own Company in Ottawa and voilà, they’re a so-called pro. You need to dig beyond the surface to see if there is any substance to the claims being made.
Google is your friend here. Do a search on the company and the people behind it. If you find evidence of a complaint, that doesn’t necessarily mean that there is a problem but it should cause you to dig further. Another thing to consider is the way deals are presented: Does the RTO company sound desperate? Are they offering all sorts of incentives to get you to jump in?
For a full list of the things to consider, read my first post addressed to Tenant Buyers.
#2: Do the projected returns set off any alarm bells?
In an ideal world we would all love to earn 20%-30% on our money. Wouldn’t that be great? But ask yourself, how often do you see those kinds of returns in legitimate investments?
The higher the projected return, the more questions you should be asking and the more alarm bells should be ringing. If the returns go above 20% in today’s market of roughly 3% average appreciation, then ask yourself just exactly how you’re going to get those kinds of returns. Those numbers are simply not credible and a good spreadsheet will prove it.
In real estate, there are only three ways to make money: Appreciation, cash flow and mortgage pay down. The latter is fixed; it’s not something you can manipulate beyond choosing a longer or shorter amortization, and you don’t get much of it in a two or three year deal. However, appreciation and cash flow can be manipulated and they do make the biggest difference to the returns so let’s take a look at both.
The fastest way to make money in a Rent to Own deal is to crank up the appreciation rate. That gives you a higher house price at the end and pads your returns. There’s just one problem: If the final house price is unrealistic it will not appraise which then means that the lender won’t support the full value of the house. Guess who will have to pay the difference? The tenant-buyer. Do they have the extra money kicking around to make that happen? No. Will they be happy with that outcome? Absolutely not. They’ll be furious, as they should be.
It is completely unethical to set up a deal with a buy-out price that has little hope of going through. These kinds of deals rob the tenant buyers of their deposits plus accrued option credits and they leave the investors in a difficult position: They now have to sell the house for a lot less money than they were anticipating. They will incur Realtors’ fees to get the job done which will further lower their returns. Add to that some repair costs to ready the house for sale and the result is a big financial mess.
So when you’re evaluating a deal, look for the appreciation rates used to determine the final value of the house. Then call a Realtor and ask for the last five years’ worth of stats for that particular house type in that specific real estate zone. Have a look at the Year-to-Date stats for the same house type and zone. Are the projected appreciation rates in line with the stats? If not, walk away.
MONTHLY CASH FLOW
The second best way to make money in a Rent to Own deal is to cram in as much positive cash flow as possible. While it’s true that you shouldn’t buy a property that has negative cash flow unless you’re certain that you can turn it around very quickly, it’s also true that the monthly costs for the tenant buyers have to be fair and sustainable.
We have seen deals where the monthly cost was determined by using a multiplier. That is, you take the purchase price of the house and you multiply it by a number (the latter varies by the company) and out comes the monthly cost.
The problem with this type of approach is that the monthly amount is not justifiable beyond saying “that’s just how we do it”. In order for the Rent to Own deal to be credible, the numbers have to be credible. What is the breakdown of costs: mortgage, property taxes and insurance? How did they calculate these numbers? Where is the positive cash flow coming from? Is the monthly rent (not including the savings portion) at least in line with the true costs of the house or local market rents? If not, why? Will the amount be a rip-off for the tenant buyer or is it justifiable in a credible way?
There shouldn’t be any magic multipliers or mystery numbers in Rent to Own. If you can’t understand the breakdown and it doesn’t make sense to you, then ask more questions and seek clarification. If, after you’ve tried that, it still doesn’t make sense then walk away. Don’t let a high monthly rent lure you into sweeping your concerns under the carpet.
It is worth remembering that real estate is a get rich slow approach. Greed gets people into trouble only 100% of the time. You don’t need to be greedy to succeed in Rent to Own. Leave money on the table for the Tenant Buyers. Ensure that they are happy and successful. The best way to succeed is to ensure other people’s success.
If the promises and the returns seems too good to be true, they probably are. Walk away and look for more reasonable returns. Solid, well-structured Rent to Own deals can yield 12%-16% in this market. Isn’t that better than what you’re getting with your stocks and mutual funds? You don’t need crazy numbers to do well.
#3: What do you know about the Tenant Buyers?
When a deal is pitched to you, here’s a good rule to bear in mind: If the package starts with a lovely description of the house and a line about how nice the Tenant Buyers are, run away!
The real asset in a Rent to Own deal is the Tenant Buyer. The house matters but not until you are sure you have the right candidates for the program. Look at it this way, if you have an ugly house but great Tenant Buyers, you still have a successful deal. Beautiful house but terrible Tenant Buyers? Big problem.
The deal begins and ends with the Tenant Buyers. One of the most important factors that a Rent to Own company should bring to the table is their ability to evaluate clients and to select those who have a very high likelihood of succeeding. Anyone can place an ad and get interested people, but it takes skill, knowledge and experience to be able to sift through all the applicants to find the people who have what it takes to succeed in a Rent to Own deal. Here are some questions to ask:
- Does the RTO company know how to read and evaluate Credit Bureau reports? If they’re depending on an outside mortgage agent to do the heavy lifting, you’re hoping that the mortgage agent will be experienced enough to do the job well. We have worked with a lot of agents over the past four years and here’s the scoop: Rent to Own deals involve working with B files and not all mortgage agents are well-versed in this type of file. They may be the best in the business when working with A clients but knowing how to evaluate B files requires a different knowledge set. Consider also that if the RTO company doesn’t know how to fully read and pick through Credit reports they won’t be able to verify what the mortgage agent has told them. That’s a lot of risk considering what’s on the line. Do you really want to work with someone who doesn’t have a full understanding of where the clients are at and what it will take to get them mortgage-ready at the end?
- What is the client’s credit history? Does their story fit with the story told by the Credit report? Knowing that someone has been through a bankruptcy is not enough. If they say that it’s because of a divorce, you need to know more: What are the specific circumstances that led to the financial difficulties? You need a lot of details before you can fully evaluate a story and a file.
- How recent are the credit troubles? The more recent the difficulties, the less you know about the client’s commitment to fixing the problem. Bad things can happen to anyone, but in a Rent to Own scenario you need to know that the clients have turned a corner and that they are fixing the problems. What indication do you have that this is the case?
- How much do they earn and can they prove it? There are a lot of situations in which people have cash-based or newly-established businesses. Or perhaps they work for someone on the side and get paid in cash. That’s fine, but if they want to qualify for a mortgage at the end of the term, you need to know that the income required to do the deal is provable and will be declared to CRA. You also want to ensure that the deal doesn’t rely on increases in income. Just ask any government worker how secure those are. They’re great when they come through but you don’t want to bet the farm on them.
- Are they using Child Tax Credits or the Universal Child Care Benefits to qualify? If so, will they still be in place when it’s time to get a mortgage and will the lender accept them as income? Do you really want to work with a file that relies on those credits to qualify?
- How much have they been approved for and what are the TDS (Total Debt Service) and GDS (Gross Debt Service) ratios? If the TDS is above 40%, the clients will need a higher Beacon score. Will they realistically get there?
- Has the RTO company put together a realistic credit improvement plan and what plans do they have to ensure that the clients are taking the necessary steps? Is the term appropriate?
- Will the Tenant Buyers have enough savings at the end of the deal? If they are only saving 5% they will be missing the 1.5% closing costs that lenders look for. Ensure that the clients are saving at least 6.5% of the final purchase price.
- What is the deposit? Is it high enough to provide reasonable security in the event that the Tenant-Buyers abandon the house in the early days? Anyone who has been a landlord knows that it doesn’t take much time to do thousands of dollars worth of damage, without mentioning the carrying costs for a vacant building.
- Where are they looking to buy? Is it in an area that has strong, stable appreciation rates? Is the house decent enough that you can sell it quickly and easily if the Tenants-Buyers don’t honour their end of the deal? Is it a house type and a location that are in demand? If not, the risks go up. If you’re not sure about an area, talk to a couple of Realtors and get multiple opinions to ensure that you’re not getting biased feedback from someone who has a vested interest in the deal.
If you have any reservations about how well versed the RTO company is in any of the areas above, step back, ask more questions to ensure that you feel 100% certain before proceeding.
#4: How thorough is the spreadsheet?
All professional Rent to Own companies provide a spreadsheet with extensive financial information outlining the breakdown of costs and income. You need to ensure that all of the relevant information is there and that the projections are realistic, not optimistic. Let’s take a look at some of the most important items that should show up on a deal spreadsheet:
- Today’s purchase price and the final purchase at the end of the term. What appreciation rate has been used? Is it credible based on local (current and past) statistics? See above for that discussion.
- Financing. How much of the deal will be financed and at what rates? Will there be a second mortgage and what will this do to cash flow? If there is more than one mortgage, what is the final Loan to Value? If it goes above 90%, you’re taking on a huge amount of risk. As a second mortgage holder you’ve got more risk than the first mortgage holder in the first place. The higher the LTV, the less money there will be to cover your investment if things go south and the house needs to be sold. Proceed very carefully with second mortgages.
- What mortgage rate has been used and is it realistic? Remember that the property will be a rental and many lenders use higher rates for rentals. If a very low rate is quoted, ask who the lender will be and verify that the rate applies to rentals for the term in question. This is also true of insurance rates – they are typically higher for rentals.
- Legal costs. This is one of the areas where we see the most optimistic projections. For a Rent to Own deal, you will have legal costs for the purchase (roughly $1,400 – $1,800 not including the Land Transfer Tax), costs for the sale (roughly $900 – $1,200) and a discharge fee for the mortgage at the end of the deal (roughly $250 – $400). If you do the math, that means that you will pay anywhere from $2,550 to $3,400 for a single deal. If there’s a second mortgage on the deal, you’ll have set up costs of roughly $1,000 plus another discharge fee at the end over and above the other fees. If the second mortgage comes from an RRSP, there will be a set up charge in the hundreds of dollars plus annual fees. You want to ensure that every cost has been properly accounted for because if not, you’ll need to dig into your pockets at the end and that may affect your ROI.
- Appraisal and inspection costs. Who pays for those? Are the numbers realistic? In our experience appraisal fees range from $285 to $400, and inspection fees are around $400 plus tax.
- Banking fees. Where will the rent money go and in whose name is the account? What are the fees for the account and do they come out of the deal? Who pays for the mortgage? Many lenders will no longer accept third party payments which means that investors must make the mortgage payments from their own accounts. How will this be dealt with within the deal? What about the insurance and property taxes?
- Are the property taxes and insurance rates realistic? Has the RTO company accounted for increases in rates over the term? Property taxes rarely remain static and insurance rates always go up more than anyone would like. Has this been taken into consideration?
- Is the RTO company charging any fees and if so, when do they collect them? If they ask for high fees up front, ask why? Set it up so that they win when you win.
#5: Is the documentation professional and thorough?
Real estate investing is not a place for sloppy bookkeeping habits and casual agreements. There is a lot of money on the line in any deal. To fully protect yourself, beyond doing the homework above you’ll want to ensure that every step of the deal is properly documented and that the agreements are professional. Refer to my article for Tenant-Buyers for a discussion of the three key documents.
For an investor, it really boils down to the following: What happens if the deal goes south for any reason? How are you protected? Are you on Title? What skin does the RTO company have in the game? Are they on the line and liable for the expenses as well? Who will sell the house and what will it cost? If a Realtor is involved then there will be fees. Who will provide the funds if repairs need to be made before the sale? Who will pay the carrying costs (i.e. the mortgage, property taxes, insurance, heating and electricity bills)? Who pays if the tenants stop paying the rent?
Even if the agreements are written in a way that you find easy to understand, have your lawyer review them. Ensure that all of your questions are answered. If you don’t like the answers you’re given by the RTO company, then don’t proceed. It’s better to pay a few dollars to avoid a bad deal than it is to save a few hundred dollars at the beginning and pay thousands later on.
This blog post is very long for a reason: There is a lot to think about before you do a Rent to Own deal. There are no short cuts to success. Rent to Own investments are an excellent way of getting solid returns and growing your savings when they’re done properly. These investments offer many advantages to investors, including reducing or eliminating tenant hassles. But again, the deals must be structured properly.
Do your due diligence. Ask questions until you have all the answers you need. If you’re not satisfied with a deal being offered then move on and keep looking. Professional, ethical companies with a good track record do exist and so do great deals.
We welcome your feedback. Please post your thoughts below.