By Rachel Oliver
For many families, the opportunity to rent to own a home is the best way to overcome barriers to homeownership. For real estate investors who want to avoid headaches of being a landlord, this presents a very lucrative opportunity to help, but only when it is done right.
The Ideal Customer
Saving up a down payment for a first home can be challenging. These days, the challenge is somewhat compounded by rising prices of homes and tighter mortgage rules. Almost every family we interviewed for our RTO program tells us that they feel homeownership may be out of reach altogether if they wait any longer. Typically, that is what brings many homebuyers to explore a more creative path to homeownership. These intelligent folks are often very motivated to succeed.
There are four main groups of people who typically need RTO: those who have had unforeseen personal setbacks and need time to build up their credit score; those who are unable to save enough for a sizable down payment while renting; those who would like to make property improvements and profit from equity, rather than pay their landlord’s mortgage; and those who want more stability for the long term but are unable to get a mortgage today.
These are good, hardworking, honest people who just don’t meet the criteria necessary for a mortgage at this point in their lives.
The vast majority of aspiring homeowners who choose to explore RTO are often recovering from a significant personal setback, such as divorce, illness, or job loss, so they have low credit—usually well below the 680 mark. In most situations, these credit-challenged homebuyers have credit blemishes that can be repaired. They just need some time and some guidance. Depending on the severity of their credit issues, these buyers will need to lock into a RTO arrangement for two, three, or four years.
However, a blemished credit report does not necessarily make someone an ideal customer for investors who want to profit with RTO properties. In fact, credit is the third thing we look at. The amount of household income and down payment is much more important.
Determining “how much house” a family can actually afford is the first thing we tackle when qualifying RTO applicants. A modest income usually allows the family a chance to rent to own a condo or condo town home. Naturally, people with higher incomes can afford to look at detached homes in the more desirable areas. Some people can even afford to buy a property with a finished basement that might generate rental income. When we qualify families for our RTO program, we stress-test their income to ensure it supports the monthly payments (consisting of rent and down payment credit) on the type of property they want. We also validate that they can comfortably cover utilities, maintenance, and repairs. Families who qualify for our RTO program are happy to take on the full responsibility of maintaining the property they choose to rent to own. They embrace the responsibility of looking after anything that needs to be fixed, big or small. Out of the 140 RTOs we have done, only one family had a major issue—their furnace broke down one December. They looked after the repairs without hesitation, as they had some wiggle room in their monthly budget.
The second thing we evaluate is the family’s skin in the game. In many cases, our RTO applicants have saved up between $10,000 and $30,000. For example, a couple with bad credit, $75,000 annual household income, and $14,000 saved for a down payment would be an ideal candidate to rent to own a house valued at $369,000 today.
Show Me the Money (Note: For simplicity’s sake, we’ve rounded the numbers.)
Profits on RTO properties come from two areas: monthly cash flow and future sale. Often 40% of profits comes from the cash flow and 60% from the future sale. Let’s review a real-life example of a RTO property in Ontario that a young couple fell in love with after looking at about 15 houses. In this situation, about $22,000 of the RTO profit is generated through cash flow over 36 months. Approximately $33,000 will come from the future sale to the tenant-buyer, in 2019. Let’s take a closer look:
In 2016, this single-family detached home in a commuter-friendly neighbourhood was purchased at fair market value of $369,000. The couple had $14,000 saved up for the down payment. The initial down payment is an essential element, since it is used to determine how much of the monthly payment will go toward the overall down payment credit.
The first step was to establish the future purchase price. Using a conservative approach to analyzing the appreciation rates in the area, the future purchase price was locked in at $414,000, which the couple agreed to before the house was purchased. Once the future purchase price was established, we determined the down payment credit the couple needs to have when they complete the RTO program. We strategically structured this 36-month RTO to enable the couple to accumulate a down payment credit of $36,000 (about 9%). To determine the monthly down payment credits for this couple, simply subtract their initial down payment of $14,000 from the future down payment of $36,000. Divide that number by the length of the RTO and you’ll end up with a monthly down payment credit just over $600.
In our experience, families who accumulate a down payment credit ranging from 8% to 10% can easily qualify for their own financing at the end of the RTO term, and the purchase process goes more smoothly for everyone involved. More importantly, on the investor side of the equation, it means peace of mind, because we end up earning the profits we projected.
Key to Success
First, buyers need to be emotionally and financially invested. Homebuyers who go house hunting and fall in love with the house they want to rent to own are much more likely to succeed in a RTO arrangement. Coupled with a substantial initial down payment, your customer is well invested in their ability to meet their commitment—essentially, to pay on time and to work on their credit. Our extensive research and experience shows that zero down payment RTOs usually do not work out. We accept applicants who have at least $10,000 down, and find they are very motivated and complete the RTO successfully.
As an investor, if you truly want the process to be successful, accept that you’re entering into a three- to four-year relationship with your RTO customer. Many customers are entering a RTO arrangement with a renter mentality, and they may need your support to make a smooth transition. If you leave the lines of communication wide open and come from a place of helping your customers get ahead, there may be fewer bumps in the road. We do not view RTO as a transaction but, rather, as a relationship.
If you do RTOs right, they can be very lucrative. We see as much as 25% return on investment per year. For us, and many other investors who invest through us, RTO is as much about helping families get into homeownership as it is about making money—that’s truly what makes RTO such a great investment strategy on both sides of the equation.
Rachel Oliver is an active member of REIN and an REIA. She is a full-time investor, international bestselling author, speaker, and coach. Determined to escape the rat race, Rachel found financial freedom with the lease options/rent-to-own investment strategy. She is a founding partner of Clover Properties, best known for helping investors generate passive income and profit with purpose and integrity, all without the hassles of being a landlord. Rachel lives north of Toronto with two amazing daughters and her husband/business partner, Neil Oliver (affectionately known as “Mr. No”). Connect with Rachel at www.RethinkRentals.com.