Elizabeth Kerr looks at how everyone can have their property cake and eat it too using a Rent-To-Buy approach to property investment and ownership

Elizabeth Kerr looks at how everyone can have their property cake and eat it too using a Rent-To-Buy approach to property investment and ownership

By Elizabeth Kerr

Here’s the conundrum…You have money to invest in property, but the market rents are not enough to cover all the expenses, and your income is already stretched enough as it is, leaving nothing left over for topping up a rental property investment. So what do you do? 

What if I said you could have capital gains AND positive cash flow in the one investment?

In this next two-part series I take a look under the hood of the modern, dressed-up version of the old rent-to-buy property investment method.

It’s not as straightforward as your typical property investment purchase but once you get your head around the nitty-gritty you will see it could be the equivalent of having your property cake and eating it too.

“Lights, Camera, and Action”….!

Enter Stage Left: Landlord Investor: This is the person who owns the house and has the intention of selling it to the tenant buyer. (Sometimes known as ‘Option Giver)

Introducing from stage right: Tenant buyer: This person lives in the house, pays rent and has the intention of buying the house from the landlord investor. (TB or ‘Option Taker’)

One upon a time, in a land just like this, Rent-to-Buy property investments (known as 'Wrap' investments) got a bad rap (no pun intended) because they were highly stacked in favor of the Landlord Investor and left the Tenant Buyer quite vulnerable to loosing a lot of money and being rendered homeless.

In a best-case property investment the process might go as follows:

  1. Investor buys house.
  2. Tenant moves in and pays enough rent to cover all of the expenses of the property and pay down the investor's mortgage.
  3. Over time the house increases in value.
  4. Landlord either lives off the passive income or sells the house for a capital gain.

The old style Wrap property investments went a bit like this:

  1. Investor buys house
  2. Tenant pays a deposit (not always) and weekly payments at a rate of the Investor Landlords choosing.   For example if the Investor organizes bank finance at 6.00% then the payments might be 8% over the term of the loan – typically 25 – 30 years.
  3. The Tenant Buyer pays for all renovations and maintenance on the property.
  4. After 25 years the house would no longer be carrying a debt, via the investor with the bank, and would be transferred into the tenant’s name.

This is all good in theory but the biggest problem in this scenario is the time period. 25 years is a very long time. Who is to say the landlord doesn’t have a change of circumstance, a terrible gambling habit, or gets eaten by a shark? What happens when interest rate changes, or a natural disaster renders the house unlivable?

On the flip side, studies show that the average home buyer will stay in their home just 13 years before selling again. Who is to say they, the tenant buyer, won’t have a change of circumstances and need to find a new home? What if they lose their job? Beholden to 25 years is quite unrealistic. Lawyers especially hated these deals as more often than not an agreement that held so much promise at the beginning ended in tears and they were the ones left mopping it up.

But now some clever investors have used their experience and come together to offer a fandangled approach for rent-to-buy schemes that are evenly weighted between the Landlord Investor and the Tenant Buyer and, most importantly, last typically no more than five years.

SCENE 2: Lights dim. Spotlight on Katie sitting on a wet rock.  Her shoulders are slumped.

KATIE: (sadly) “I’m never going to own a house… I can’t save quickly enough… Maybe I should just focus on marrying Prince Harry instead”?

This is how it works. Let’s take my favourite fictional friend Katie, who still has not been able to save enough for a 20% deposit, but has been keeping her expenses low, therefore has an excellent income, which would easily cover a monthly mortgage payment.

Katie is frustrated that she cannot get her foot into the property market because she doesn’t have a deposit. She is diligently saving but it appears the longer it takes for her to save, the further out of reach her purchase seems to get, due to the increase in asking prices for houses. She has $25,000 saved, but 20% of a $450,000 price is $90,000 so, clearly, she has a way to go.

She approaches a rent-to-buy company via a lucky lunchtime Google search.

Enter Stage Left: Rent to Buy Company: This company facilitates the transaction between the cash flow rich Tenant Buyers and the equity rich Landlord Investors. (Otherwise known as Rent 2 Buy, R2B or The Company)

RtoB Company notices Katie sitting on the rock and moves towards her.

RtoB Company: (comforting) “There is always another way to skin a cat me dear”.

KATIE: “Really?  I don’t have to live with my parents forever?   Tell me more….”

After very thorough reference testing and credit checks for Katie, she is taken through the R2B process and sent away to seek legal advice. After talking with her lawyer and thoroughly understanding what commitments are required of her and from the Investor Landlord, she is eager to get started.

SCENE 3: Sunday afternoon. Busy open home in a pleasant neighborhood.  Katie enters house clutching a set of guidelines. (Supplied by the company to follow when choosing a home)

A few months pass and she eventually sets her heart on a three-bedroom, one-bathroom 1970s house, 30 minutes drive from her workplace. It needs a bit of work but she can see it has great potential.

It is on the market for $455,000.

She lets the company know she has found a house and they work hard with the real estate agent and the Landlord Investor to see if they can purchase it whilst satisfying all conditions needed for a rent-to-buy deal to be successful.

SCENE 4: Investor Landlord & Katie stand outside of 1970’s house. They are shaking hands jovially together.

The key to setting up a rent-to-buy deal for success is for the Landlord Investor to purchase the property at, or below the market value. The house is appraised at $455k in its current condition, and the RtoB Company secures it for the investor to purchase for $450k.

Remember that Katie had saved $25,000 so gives $20k to the Investor Landlord as her deposit and decides to keep $5000 behind for emergencies and some small renovations she wants to do to the house.

The Landlord Investor secures finance with a bank for $430k at 5.99%, interest only, locked in for five years.

After taking into account the costs of rates and insurance, the investor landlord is socked with a weekly cost of $576 per week for five years.

Katie pays to the Investor Landlord $835 per week. (Don’t spray your coffee on this… stick with me next week whilst I explain why that is cheaper than you might think).

Katie and the Investor Landlord agree that Katie will purchase the property from the landlord for $530,000 in five years time. There are factors that enable her to be able to do this:

  1. Market growth. If the value of her home increased by just 5% each year then in five years time it will be worth approximately $574k. However, she will be buying it below value at that time at an agreed price of just $530k. That is a $44k saving, or 7.2% below market value.
  2. Weekly rent credits. Katie pays $835 every week in rent and every week the investor landlord holds in reserve $200 of that which is then credited back towards the sale price of the house when it comes time for Katie to purchase in five years time.  
  3. This money essentially becomes part of her deposit for the home along with the initial deposit she paid at the start of the deal. So, now her home purchase becomes a $574k house, which she is buying for just $530k - less her initial $20k deposit and less her rent credits of $52k. 
  4. The amount that she has to hand over to the Investor Landlord at the end is just $458k on settlement.
  5. But wait there is more….. Kiwisaver first home deposit withdrawal. Over this time Katie has been paying her rent regularly AND paying the maximum into her Kiwisaver account. By the time she is ready to make her purchase she has an additional $22k, which means the loan she needs is just $436k for a house worth $574k. No bank in its right mind is going to say ‘no’ to giving Katie a mortgage for that deal.

Landlord Investor Numbers might look like this:

Registered value for House $455.000
Initial House Purchase $450,000
Landlord Investor – Interest Only Mortgage at 5.99% $430.000
Weekly Cost to landlord $576
Weekly cost to Tenant Buyer $835
Sale price to Katie $530,000
Less Katie’s Deposit -$20,000
Less amount held in credit towards TB purchase price -52,000
($200 per week)
Amount required to pay out Landlord Investor $458.000
Amount required to pay off mortgage with the bank $430,000
End Profit for Landlord Investor $28,000
Total Profit for Landlord Investor over 5 years. $95,315

Tennant Buyer numbers might look like this:

2020 House valuation $575,000
2020 Purchase price $530,000
Less Initial Deposit on House - 20,000
Less Rent credits -52,000
Less Kiwisaver contribution -22,000
Mortgage required $436,000
(Equity) ($139,000)

SCENE 5: Katie carries boxes into her new house… she looks around with a satisfied smile and dusts her hands.

Lights dim.

End of First Act.

Intermission.

As you can see there are a lot of numbers and a lot of variables to stitch a deal like this together. Tune in next week to learn more.

  • Why would Katie want to enter into such an arrangement?
  • Why would an investor want to do this?
  • How this arrangement is facilitated – Contracts & Contacts.
  • Tax – “yes you do have to pay it”!!!
  • Can I do this with my current tenant?
  • I’ve found a  five-bedroom, four-bathrooms, and triple garage in Mission Bay – will that house work?
  • And of course… how does this help my money machine?

If you have any questions or comments on Rent-to-Buy investing or on any column that I have written please email me at Elizabeth.Kerr@interest.co.nz.

We welcome your help to improve our coverage of this issue. Any examples or experiences to relate? Any links to other news, data or research to shed more light on this? Any insight or views on what might happen next or what should happen next? Any errors to correct?

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29 Comments

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Generally a rent to buy will have a surrender clause, that if the tenant doesn't keep up the higher rent of payment they surrender some or all of their accumulated deposit. watch for this make sure you're ok with it.

Most tenants don't understand rent to buy. I had an offer once, they wanted to pay _less_ than the market rent rate, less in fact that the mortgage payments I had for 60% equity level. And they were serious and very insulting when I said that the rate wasn't even going to cover my current loan payments!
When I pointed out that the whole idea behind rent-to-own was that the _higher_ rent rate was to build up equity towards a deposit, and to fix a price today, I got accused of all sorts of nastiness.

What happens when the property value falls?

You are supposed to assume this was the conservative option,
"If the house price ONLY goes up by 5% per year"
What?

There are people....the go I'm from the Government.....I'm here to help you.....maybe have a child and get paid parental leave and housing accommodation supplements seems to work for many of breeding age.........believe me the offers of sympathy and compassion for the plight of the people will pour forth from the mouths of the pretentious who led the charge to trouble promising to disentangle you from your plight.

Same as the rest of the country, you either have a contract which states an accepted price, or you have put in the contract a scaling factor for price changes...normally if the existing owner can't put in a "goes UP with capital gain" clause you won't be able to put in a "goes DOWN with capital loss"

See comment further down the list.

:)

I just love the simple minds and the childish mentality of the mind games at play.

Read my lips.

Negative equity is rife.

Houses not only go up, they go down. (So do Xero sum investment schemes).

That is why Interest Rates were forced down to prevent even more mortgagee sales

Compounding the problem by over charging the next mug is classic.

Ouch!

There are many strategies/deals that can be done but it depends on how inventive people can be....

LVR's have done nothing more than increase house prices and I warned along with others that this would be the outcome!!!......house price increases are another instance of the RBNZ snookering itself........I am firmly of the belief that the one organisation RBNZ should not be left in charge of both financial stability and inflation targeting!!! The journalists aren't seeing the issues because they are focusing on the wrong things e.g. a NZ advertisement in Singapore.

The old adage Fear and Greed drive markets still stands.....and our very own RBNZ is showing one of these traits in big doses.

Interesting article Elizabeth. Why is it that we seldom see these sorts of 'rent to buy' offerings from being advertised? If the numbers outlined above were a realistic example, then why aren't more landlords getting behind this rent to own scenario? Am I missing something? Or is it that the future rent demands from these tenants are off putting? Or are people just too weary of these types of deals that its too hard to find clients........?? Thoughts??

Its a technique to open an expensive market to lower income people.

eg no deposit interest free terms on whiteware and brownware

I understand - but why don't we see buy to own schemes being advertised/promoted? Very little on the web also.......

There isn't a standard place to advertise such a deal.....sometimes you will see them on trademe advertised as a rental. It's not until you open them up and read the detail that you see it as a rent-to-buy. It's no use advertising under 'For sale' because that's the wrong market. Otherwise if you google rent to buy or rent2buy you will see companies who specialist in the matching up of investors and tenant buyers.

Hi Cowboy... not lower income... just low deposits. Still need to have a good income but for some reason saving for a deposit has gone awol.

Hi Tito, i don't know for certain but i imagine it's partly a supply and demand thing. Supply of equity rich and STABLE property investors who are interested in this approach AND understand the many variables of property investment (or are prepared to learn) is in high demand but low supply I'd say, Therefore it's no use advertising for tenant buyers if there are no investors around. So it's a delicate balance and i think that could be one reason.
As for the client side... yes id say finding tenants who have a good income and aren't drowning in consumer debt could be rarer still..... It wont work for them if they have too much debt which would stop a bank lending to them regardless of how good the purchase price/their deposit is.
Tune in next week for more details about the nuances for such a deal....

Jeez...No need to 'Ride em Cowboy' they will likely ban you for making multiple entries into their ledger.

Landlords will not agree to such deals because:
1) we want to retain full ownership (and kick out tenants/renovate etc. at our convenience)
2) we don't want to get into these dodgy schemes and pay capital gains tax (because the intention here is to re-sell)
3) we are liable to the bank anyway (mortgage) and can't trust such "Katies"!
4) we obviously make more tax-free capital gains when a normal tenant pays rent and we negative gear the property at 33% tax rates. Assume $450 per week rent retaining the property for 5 years with negative gearing benefits.
5) why would we landlords ever sell a property below market value ever?

show the maths on (4) using a schedule. I challenge your "negative gearing" benefits (vs those of the tenant)

Here it is:
$450000 at 5.99% interest only for 5 years (there are seriously better rates out there but nvm) + Elizabeth’s $4.195k per year expenses = $599 per week * 5 years = $155750
At $450 per week rent * 5 years = $117000
Loss = $38750
Tax benefits = 33% of $38750
Loss after tax benefits = $25963
Now

Elizabeth says landlord profit for 5 years is $95315 (definitely taxable as resell is intent)
Whereas now: Sale price = $575k and purchase price + costs = $450k + $25,963 = $475,963
Profit = $575k - $475.963k = $99,036 (tax free)

Capital gains tax makes a big difference to the comparison btw!!!!!!!

However, your example shows that you need to be able to support the weekly losses every week. If you couldn't afford those weekly losses and you had plenty of equity but not the spare cash, the next best thing might the R2B scenario...... Am I wrong?

Banks won't lend if you don't have serviceability!

Correct but they will take into account rental income.

If your investment is "rent-reliant", you will not get a home loan!
You need some other source of income too!

You still retain full ownership until the TB settles.
Why would you want to renovate something and move tennants on if they are paying good rent and are happy to do the renovations themselves?
Yes there is capital gains tax... but avoiding paying CGT is not a good enough reason to avoid investing in my opinion.
4) im with Cowboy... show us the results over the same term...
5) because landlord identifies that the benefit of excellent cashflow is more profitable to their entire portfolio over 5 years than negative gearing and selling.

Just think, if you had a deal that gave you an extra $200 in cashflow per week you could use that to prop up a property that is negatively geared in a strong capital gains area so you don't have to use your personal income. just an idea...

:)

Maths proven!
What if Katie is a bad tenant? I can't kick her out!
Capital gains tax is not a good reason to avoid investing but when the alternative is tax free, why not?

I see your maths and I'll come back to you on this in next weeks column.
Define bad tenants in this situation?
I mean that sometimes paying CGT is just the cost of an opportunity.... in this instance positive cashflow and a small bonus at the end.

I believe that this approach would suit investors best when they believe that property values are going to stagnate or decrease over the term of the agreement. That way they can lock in a higher sale price than they would if they attempt to sell at the end of the 5 year term.

All of this is of course contingent on the tenant being mandated to buy at the agreed price regardless of how much the market drops and having the assets to make up the difference between actual sale price and the reduced value of the property when it is sold. The risk of tenants not buying if house prices drop will need to be mitigated by way of a risk premium applied to the rent.

If the TB can't get finance from a bank then yes... The deal will not be able to settle. In this case it could be agreed to extend the term and continue to add to the rental credits and build up a higher deposit. Generally one would not be doing deals like this in the back blocks of eketahuna.... This is for high growth areas where movement is expected.
Also there are two ways to increase the value of the house. Market increase is one and the other is through adding value via renovation. The house would need to satisfy both of these approaches to be considered an appropriate R2B property.

For most asset rich individuals the lower risk alternative to what Elizabeth has proposed is to leverage your seed capital at the same interest rate mentioned above (5.99%) and invest the funds with a managed fund returning 14% pa (Generate focused growth, ANZ One answer aggressive, Milford, etc...).
Assuming monthly compounding for both the mortgage and managed fund the portfolio would be worth NZD 670,763.6454 - 430,000 borrowed = 240,763.6454 of Gross profit. (These are very rough numbers you effectively need to factor in PIR, omit market fluctuations because that is also absent in the house price model above).