In the second of a two-part series Elizabeth Kerr drills down into the pluses and minuses of rent-to-buy home ownership and investment

In the second of a two-part series Elizabeth Kerr drills down into the pluses and minuses of rent-to-buy home ownership and investment

By Elizabeth Kerr

This week I won’t make much sense to you if you didn’t read last week’s column about rent-to-buy property investment and ownership.  

You can catch up by clicking here.

This week's column is divided into three sections.

These are as follows: 1. The Investor Landlord (IL). 2. The Tenant Buyer (TB). 3. The House.

Investor Landlord:

Why would I invest in Property this way?

The most common question is by far why would you even bother when you could just buy a property and have it rented the traditional way?

The answer is nearly always ‘cash flow’ and could also be any or all of the below:

  1. You can’t support a negatively geared property by topping up the rental payments to pay for the mortgage from your own income.
  2. You need the positive cash flow to balance out another property investment that is negatively geared (but well positioned for rental or capital gains in the future).
  3. You are a bit philanthropic and want to feel like you are using your wealth to the betterment of your community, or
  4. You would like to create a money machine without having to put any money down physically yourself, or
  5. You will use the proceeds to pay off your own personal home mortgage quicker.
  6. You want to grow your property portfolio and supporting negatively geared properties is too risky for you.
  7. You want to help your kids/grandkids into a home and have a contract in place to support the arrangement, which also outlines when/how you will get the money back again.

I’m sure you might think of others but those 7 should cover the majority of situations.

Tax

Some investors will argue that the house was brought with the “option” for a TB to purchase, not the “intention”.

Those waters are muddy but in my opinion, at the time of purchasing the property the IL obviously does have every intention of selling it to the TB, therefore would be expected to pay tax on the sale profits.

The rental credits are probably going to be taxed at the time of receipt as rental income and the expenses are deductible as per a normal investment.   

How much tax you have to pay is really dependent on how your investment is owned and how that ownership entity is structured.

The team at GRA have provided accountancy advice for these types of investments, so, if you have any questions I encourage you to use an accountant who is at least familiar with how the arrangement works.

What happens if the market stagnates or declines?

Okay, good question.

If the market stagnates or declines and the house is not worth the contracted future TB purchase price then it’s nothing to get all worked up about.

Remember the entire investment was arranged so that the TB could secure finance at the agreed future purchase price.

The purchase price has been determined by a conservative forecast in market value, and the rental credits and initial deposit have been set based on achieving that purchase price.

The increase in market value is not crucial to the deal being completed successfully; it’s just nice to have.

The TB probably doesn’t want to overpay for a property and would like to know that the house they are purchasing is of fair market value.

The only thing that could get in the way of this is if the bank did not want to lend to the TB based on the purchase price being too high.

However, people overpay for properties all the time, so all things being equal I don’t think that would be very likely.

If that did happen there are only 2 real options left:

  1. Sell at a cheaper price
  2. Extend the term until prices picked up again and the house can be purchased for the agreed price

Option 1 would work but the IL would forgo some of the end profit.

For option 2 the TB and the IL could decide to keep the rent at the contracted rate and continue to add rental credits to their deposit making the TBs position even better come settlement time again.

The key message here is that variations to the agreement can be made if both parties are agreeable. If they are not agreeable then the contract would have to stand.

Tenant Buyer:

If you’re a tenant buyer why would you bother?

Well that’s a lot easier to answer:

  1. You have enough of an income to service a mortgage but without a deposit you don’t have a shit-show of getting finance from a bank.
  2. You might live and work in a high growth area where house prices are increasing faster than you can save for a reasonable deposit.
  3. You might be new to NZ, new to your job, self employed or have run into a few credit issues (and have learned your lesson!!!).

A few other things you might want to know:

  • If you are a TB, ideally you will feel good about your job and be prepared to stay employed for the term of the contract.  
  • This is a private contract between you and the IL and you are not covered by the same rules governing a standard Residential Tenancy Agreement, because you are not a standard tenant. If you fail to pay your rent there will be a clause in the contract whereby the IL can ask you to leave and you will not get any of your initial deposit or rental credits returned. (See ‘Your Emergency is Not my Problem)
  • Your KiwiSaver cannot form part of your initial deposit for the house because you aren’t taking ownership of it yet, but you can use it at settlement to purchase the property, subject to KiwiSaver rules of course. (In the meantime might as well max out those contributions then, eh?)
  • Depending on how much the property has increased in value there is nothing to say that you can’t take ownership of the property then sell it straight away to someone else and pocket the profits as your own.
  • This is just my personal thought - being trusted as a tenant buyer is actually a privilege that you really need to own as your challenge. There are many ways an IL could invest their money and so banking it on you is not something to be sneezed at. Try your dandiest not to let Hedonic Adaption creep in or take on any consumer debt during the term.  

The House:

  • Now this is really important. It’s unlikely the deal will be for a designer home on the North Shore, or even a relatively new home.You see, the deal only works up to an initial house purchase price of $450k. If you go higher than that at the start then the weekly rent including rental credits starts pushing over $1000 per week, which is unachievable and not really sustainable for most people.
  • It works best if the TB can go house hunting for themselves. Ideally you want them to fall in love with the house and really take personal responsibility for it. They should have a vision for what they are prepared to take on and what renovation work would be within their comfort zone. For instance moving a TB into an old draughty villa, with no building experience, is not going to be a win-win; however, a good solid brick house might be just perfect for their skills, enthusiasm and expertise.
  • The house needs to be an “investment grade” house so that should the TB go AWOL the IL isn’t left with a lemon and can at least re-tenant the home easily. So the basics still must be upheld – near public transport, schools, shopping, and easy access to the city/amenities etc…etc…

How is this investment facilitated?

There is a contract in place between the IL and the TB. There are all matter of clauses in here and it is required that both parties seek legal counsel before signing BUT the clauses that matter the most (in my opinion) are as follows:

  • TB fails to pay within X number of days of monies being due – the IL can ask the TB to leave and keep the initial deposit and rent credits. (So you don’t want to stuff it up)
  • Cosmetic changes are fine, but big renovations need the IL permission first. (That means putting in a German sauna and an outdoor smoke-house might not exactly add value to the property. But you are welcome to do this after you have taken ownership if you really want to)
  • The IL will take care of the rates and insurance for the TB until they take ownership, as this is their responsibility as property owner.
  • Additionally the contract should state what happens if the TB or IL want to get out of the contract early, or what should happen if they can’t settle come time to transfer the ownership over.

Money machine?

Everything I write about usually comes back to the money machine and this week is no exception.  A money machine is something that spits money at you, which you can use to fund your lifestyle without the need to work (unless you wanted to).   Does R2B property investment qualify? Yes and No is the answer. Yes – during the term of the contract the rental credits are yours to do with what you want to. No - in that they will run out at the end of the term so it’s not sustainable.

Having said that, being able to invest using your equity in a property (not having to put forward any cash of your own earning) is a relatively “easy” investment and the return can add some value to your portfolio if it is managed well. But it is a reasonable commitment, and one that shouldn’t be taken lightly, by either an Investor Landlord or a Tenant Buyer.

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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Great hit lists. Nicely written and presented.

Another reason for becoming a TB, is meeting a want-to-be IL (based on the first list).

The House also tends to be in the lower end of the spectrum because if one has the resources to Rent-to-buy a more expensive property then there is usually a good opportunity to save-and-buy a cheap property, pay it down fast, and then use that to buy outright, in the traditional manner.

One would expect that the only reason for a high end buy is one of opportunity (to get The One House (to rule them all)) but often if such a place is for sale it is because the property owner wants to release/realise some of the equity in a hurry, which is the exact opposite dynamic to a rent-to-buy dynamic. ie the owners equity (and borrowing capacity) is still locked into the existing property.
Which is why you seldom see RtB. .

That and the risk because just as the Tenant isn't covered for the Residential Tenancy Act, likewise neither is the Landlord afforded the meager protections of the Act and Tribunal. If the tenant looks like they're going to be short on payment they could damage or even burn the place to the ground and the Owner or Landlord have to take them to full court, and have little assurances, as the courts (a) tend to dislike such agreements because of the way they work, the "complexity", that they're actually daring to have private contracts, and a constant suspicion that someone must be trying to rip someone off, (b) have a poor general record of handling civil cases, (c) will be exceeding expensive once both parties lawyer up, (d) if your tenant couldn't pay the rent...good luck trying to get damages money out them...

Thanks Cowboy.
I hope you aren't talking from personal experience re A to D.... :)

Found it out doing due diligence from someone who had been there. Fortunately they only suffered damage about twice that of the saved "deposit", the difficulty they said was that the TB doesn't see why they should foot the bill for insurance against such an event.

You keep conveniently forgetting the fact that no bank would lend the investor a home loan if servicing a negative geared property is an issue (as the way banks calculate serviceability assumes that you have the income to top-up – they only use around 70% or so rental income and have a 1.5%-2% floating interest rate buffer calculated on principal+interest even though investors mostly use interest only loans).
This means I’d rather buy a negatively geared property, rent it out and bank the capital gains tax free than run these dodgy schemes (It’s also the more profitable way as I had already proven the maths in my last post!).

Exactly... so if serviceability is an issue then this approach would be a viable alternative. I think it's prudent to clarify all that we don't have a Capital Gains Tax... discussions on this refer to the profits being taxed according to your individual taxable circumstances.

You keep continuously missing the point!
If serviceability is an issue, this is not a viable alternative!
Even though banks include 70% rental income, their calculations always assume that you must be able to service the loan on a principal + interest basis with a 1.5%-2%buffer which means this "alternative" becomes negatively geared according to the bank and therefore no loan.
We have a capital gains tax if you have an intent to sell at a profit when you buy. Here, the intent is clearly to sell at a profit and therefore capital gains tax applies!

If that was the case then no one would be able to own more than 2-3 houses before running out of income.

And re the capital gains tax.... We are both agreed that the profits will be taxed because of intent to sell at the start. The rate of that tax can vary according to an individuals tax circumstances. There is no standard CGT in NZ.

Most significant investors already have an established portfolio where rents have significantly risen since they last bought. Many have high non-property incomes FYI.
Here's a statistic that might be relevant: 96.3% of all property investors own 3 or fewer rental properties in Australia, of which 72.8% own just 1 rental!
I'm sure New Zealand isn't very different!
All I'm saying is this "rent-tobuy landlord" would rather just be a "buy-and-hold landlord given banks/loan process assumes negative gearing anyway for both cases.

Perhaps NZ's consumer protection laws are much better than in Aus, or ILs are much more ethical, because these 2 articles paint a very rosy picture. Perhaps you don't have 'middlemen' who take profit off the top and contribute to overpriced properties & so hard for TB to qualify for finance. From a consumer advocates perspective in Austraia, here are some risks here
http://news.domain.com.au/domain/real-estate-news/vendor-finance-under-t...
and here
http://thenaysayer.net/2013/09/11/16/