Opinion Needed for a Potential RTO Tenant in Alberta

clumsyn1nja

Phil Wong
REIN Member
Nov 3, 2014
47
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Edmonton
#1
Hello Everyone,
I've recently acquired a new client wishing to do an RTO with me and as this is my first RTO deal, I was hoping I could get a second or fifth opinion on my prospect.

My client went through a divorce several years back while he was in a lower paying job and his credit tanked hard as a result. He has since found a much better paying job (grossed $185,000 per his 2015 T4) and has started paying off his debts and improving his credit. His credit score currently sits at 610. His credit report shows a few past due statements but the latest was back in 2013. His pay stubs, references, and employment checks out. He appears serious about this as he wasted no time in getting me his financial documents.

He has $17,000 ready for an initial option payment. The caveat is that he wants to limit his monthly rental cost to $2000 per month. Based on this, and dividing it by 0.006, gives him a price limit of ~$330,000 which he is ok with. As the market is not doing so well in Alberta lately, I decided to charge him an interest rate of 3% annually for a 2 year term giving me a final price of ~$350,000. Including mortgage pay down during that time, I will net approximately $38,000 on the deal so about $19,000 each for myself and an investor if I go that route.

Any thoughts on the matter would be greatly appreciated.

Thank you,

Phil
 

Sherilynn

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Oct 22, 2007
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#2
I would not be doing a tenant-first RTO in Alberta at this time, especially in certain markets that are likely to stay flat or decrease in value. There are a couple of markets with low inventory that could do well, but there is also additional risk with smaller centers. Tenant-first only works in a rising market, so I would wait another year or so before starting one.

If you still want to do one now, you should require a huge option payment, thereby reducing the capital required and allowing a 2% per year markup (not interest rate) make sense. I would still set the markup at 3%, but the deal must make sense at a reduced final price, just in case it comes to that. The huge option payment also mitigates your risk and makes it more likely the person will buy the property.

To really give the deal the best chance of working, you must buy a property below market value because then the property has a much better chance of being worth more than the final price you later charge the tenant-buyer. This sets him up for success. Let your tenant-buyer know you may not be able to buy his first choice of property for this reason.
 
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ThomasBeyer

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REIN Member
#3
... is my first RTO deal, ..
He has $17,000 ready for an initial option payment. ... limit his monthly rental cost to $2000 per month. .. final price of ~$350,000.
Several yellow (not necessarily red) flags:
a) market is likely flat so 350,000 might be too high a price in 2 years on an asset that is 330,000 today
b) while 17,000 down is decent you MUST accumulate enough of a down payment in 2 years to get to at least 10% down for him to qualify .. so this is about 18,000 or $750 (18,000/24) per month .. leaving essentially only $1250 as rent. That seems too low for an asset worth $330,000 .. plus there is utilities .. who is paying that (presumably the tenant) ?

As such, if you want the tenant to succeed you must either
i) increase the monthly payment, or
ii) lower the target price in two years, or
iii) extend this deal to say 4 or even 5 years
 

clumsyn1nja

Phil Wong
REIN Member
Nov 3, 2014
47
2
8
Edmonton
#4
Hello Sherilynn and Thomas,

Thank you for the feedback. I have a question that's I'm not clear on: If CMHC does not get involved in a high-ratio mortgage (so the tenant buyer has 20% down) in two years and he agrees to buy it at that price, does it matter that the price may not appraise to $350,000? The reason I'm asking that is the tenant buyer has a number of stock options through his company and he appears willing to cash those in to make the necessary down payment that's needed on the future price of the property. This should allow me to make the monthly option payments smaller and increase my base rent.

I will do my best to buy the property below market and if it comes to it, I can lower the percentage in two years to 2%. That will still net each JV just over $15,000. This tenant appears very committed though and has already paid me the $500 non-refundable application fee in order to start the house shopping process and my mortgage broker who is familiar with RTOs appears confident given his trajectory that he can get approval by a bank in 2 year's time. I suppose my main concern is how much an inflated house price will affect his ability to qualify for a mortgage if he has 20% down in 2 years time.

Thanks,

Phil
 

Sherilynn

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#5
Greetings.

If the buyer has 20% down (so a conventional mortgage) buying higher than appraised value is still a problem because banks will only finance up to 80% of the appraised value. So the difference would then need to come out of the buyer's pocket.

For example, if the property appraised at $330000, the maximum conventional mortgage would be 80% of $330k = $264000. This means the buyer would need to pay $86000 for a down payment to make up the full $350000 purchase price rather than only 20% of $350000 (which would be $70000). So now either a) the buyer would need to come up with an additional $16000, b) you could carry a promissory note for the buyer to pay the difference over an agreed term, c) you could reduce your price, or d) a combination of these.

One benefit to having 20% down is the buyer can pay for a second appraisal if the first one seems artificially low. We have done this before where the appraiser apparently didn't know how to accurately value houses with legal secondary suites. However, there often isn't much of a discrepancy with a standard single family home.
 

ThomasBeyer

Senior Forum Member
REIN Member
#6
2018 is still NDP led Alberta. Oil might be in the $60s. Some major construction projects will end in Edmonton. Expect AT BEST flat prices for 2 years in AB. As such, don't be too aggressive in your exit price.

Qualifying and finding the down payment cash is much harder if appraisal comes on below the ask price, with or without CMHC.
 
Last edited:

clumsyn1nja

Phil Wong
REIN Member
Nov 3, 2014
47
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Edmonton
#8
Well, I've been exchanging a few more email with the client and there must have been some miscommunication earlier but I was wrong about the 20% down. He's confident he can get 10% but 20 is a bit of a stretch. I'm trying to negotiate with him to either increase his initial option payment or allow an increase in the monthly rent so more can go towards his down payment in the event he doesn't save as much as he thinks he can.

So based on what you've both told me, I've come to these possibilities.

Best case scenario: prices go up 2% per year with all else being the same, the investor and I each net just over $15,000.

Worst case scenario: prices stay flat and we each only net $8,700.

Unfortunately, the ball's already rolling so a bit late to turn back now and with this being my first RTO deal, I think it'll be a good learning experience. At least I'm not losing money. I will however, have to let my investor know to expect the worst.

So Sherilynn and Thomas, in your opinion, what would you have done differently and what should I look out for on my next deal?

Thanks,

Phil
 

Sherilynn

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Oct 22, 2007
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#9
It isn't too late to back out unless you are already unconditional on a property.

If $30k total profit is your best case scenario, then I can almost guarantee $17400 total profit is NOT your worst case scenario. Your worst case scenario is likely zero profit (meaning you would be working for free) with your investor potentially losing some of his capital due to a combination of months of holding costs and reduced sale price if the tenant walks.

In a rising market, I wouldn't start a deal that net less than $30k, and in a rising market you have plans B, C, and D if the RTO fails. But this is a flat market, and it sounds like you may have no cushion against errors or bad circumstance, so I would probably not be doing this deal.

At the very least, will the chosen or target property make a good regular rental if the RTO fails? Will it cashflow? Is the investor prepared to change strategies to accommodate a failed RTO?
 

clumsyn1nja

Phil Wong
REIN Member
Nov 3, 2014
47
2
8
Edmonton
#10
Yes, I have informed my Realtor who has some experience doing RTOs himself, to steer tenants towards properties that will cashflow on their own if all else fails. That's another thing I will be talking to my investor about.

Thanks Sherilynn
 

ThomasBeyer

Senior Forum Member
REIN Member
#11
Only you can determine what your time is worth, what the compensation is for taking on a mortgage (i.e. risk) and what the risk of default or failing is.

Write down and analyze these options:
a) TB (tenant buyer, not Thomas Beyer) executes as planned - market up 10% in 3 years
b) TB executes as planned - market up 5% in 3 years
c) TB executes as planned - market flat in 3 years
d) TB fails within first year and leaves graciously
e) TB fails, trashes the places, goes on a drinking or drug rampage, doesn't leave and doesn't pay and needs court order to be evicted

Also analyze options a) to c) if TB cannot qualify ie needs a bit of help cash wise to get a mortgage, say cannot get CMHC mortgage with less than 20% down, so you need to bridge to 20% in csh (say via second mortgage or personal loan). I am working with a fellow in Vancouver right now through that very scenario.

So 8 options to analyze.

RTO can be very profitable if done well, but like anything profitable in life it is easier than it looks. Grey hair comes from experience.
 
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Richard May

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Mar 5, 2016
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#12
Greetings.

One benefit to having 20% down is the buyer can pay for a second appraisal if the first one seems artificially low. We have done this before where the appraiser apparently didn't know how to accurately value houses with legal secondary suites. However, there often isn't much of a discrepancy with a standard single family home.
Hi Sherilynn, how much success have you had with having a second appraisal done? Was the bank willing to accept the second appraisal?
The reason I ask is that I just had a condo appraised and it came in much lower than expected and we had to abandon the refinance that we were attempting. My broker let me know that the bank will generally play it safe and go with the lower of the two appraisals. If you've had success with second appraisals (or anyone else has) I may attempt a second appraisal. (I am taking into mind your last line but i'm being hopeful!)
 

Sherilynn

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#13
It is highly unlikely a second appraisal would be helpful in this case. Appraisals for refinance are always more conservative than appraisals for purchase, so you should expect the appraisal to be lower than what you would get if you sold the property.

As for which appraisal is used, many banks will average the two appraisals. In rare instances where you can demonstrate the first appraisal was somehow erroneous, the bank will use the second appraisal. It is safer to ask the bank directly what their policy is rather than rely on generalizations.
 
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Richard May

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Mar 5, 2016
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#14
It is highly unlikely a second appraisal would be helpful in this case. Appraisals for refinance are always more conservative than appraisals for purchase, so you should expect the appraisal to be lower than what you would get if you sold the property.

Makes sense, thanks!

As for which appraisal is used, many banks will average the two appraisals. In rare instances where you can demonstrate the first appraisal was somehow erroneous, the bank will use the second appraisal. It is safer to ask the bank directly what their policy is rather than rely on generalizations.
☺ that's easy enough, if you want to know, just ask! Why sometimes we dont just think of that, thank you!