RTO option credit and lease rate and contract issue

[DavidLi]

Hello folks, Can I borrow your brain for a sec? I read through Mark`s book "Investing in Rent-to-won property" twice, but still can not figure out the following three questions. 1) based on page 122, the monthly option credit is 20%. I am wondering if it is possible for us to choose other numbers, say 15% or 10%? what are criteria to choose this number? 2)same page, lease rate. when we calculate the lease payment, Mark uses lease rate in the range of 0.8%-0.95%. Why pick this number in this range? and what factors will effect us to choose the big number or small number?

3) Mark recommends us to sign two contract with the renter/buyer. one is lease agreement, which will be shown to the bank to prove there is a tenant living there and offering me a positive cash flow, the other is occupancy agreement, which is the contract between investor and tenants. It doesn`t matter how to use these two agreements, they are a binding documents between renter and investor. Both agreements have a common item: how much the renter will pay per month, which is called rent in lease agreement and called occupancy payment in occupancy agreement.

Let`s take the number as example for simplicity. House purchase price: $210K with 20% down, 4% rate 35 yrs amortization. property tax $120 per month, insurance cost $35 per month. Let`s wipe off all other costs. Based on the book, the occupancy payment is lease payment. Let`s choose 0.85% as lease rate, then the occupancy payment will be $1785, but based on the theory of the buy-and-hold, the monthly PIT cost will be $895, take the other factors in, the reasonable market rent will be roughly $1200 - 1300.

so my question is are we using $1200 - 1300 as rent when we sign lease agreement and using $1785 as occupancy payment when we sign occupancy agreement? If we use different nubmers, then which one will be legally accepted? The renter/buyer will not give us a hard time to justify if we put different numbers in the different agreement? just because one is for bank, the other for us and renter. Don`t forget both docs are legally binding us. All the clauses in them apply to us.

Any comments are welcome!!!

David

 

[AndyLuchies]

Let me give you my answers 1 at a time:

1) If you go too high on this, the tenant cannot afford to pay his monthly rent.
If you go too low, the property appreciates faster than he pays it down...i.e. he is worse off in the end than in the beginning. I imagine Mark would say that there`s nothing magical about 20% but it tends to be a good balance between something that the tenant can afford, and something substantial enough to put a dent in the future purchase price.

 

[AndyLuchies]

2) There`s lots of considerations with lease rate. Here are the main two that affect my thinking...
First, what payment can the people afford per month. Of course you`re going to want to keep it below 40% of their income, and generally speaking the lower the payment the better for the tenant.
HOWEVER, the investor needs to have a deal that makes it worth his/her time and effort. If the payment goes too low, there`s no profit in this. Again, I imagine Mark would say there`s nothing magical about 0.8% - 0.95%, it just happens to work out to a great balance between tenants` general limitations, investors` needs, and fair market numbers in most areas.
Of course, if rent is substantially higher than your number and the tenant is used to higher rents, you can raise the number a bit, conversely you may have to lower it in certain markets.

 

[AndyLuchies]

3) As far as I understand (and what we follow in our contracts) the numbers don`t change from one contract to the next. The lease agreement is a legal document saying these people are paying $1785 in rent each month or they`re kicked out. Period.

The occupancy agreement and option to purchase states Whats required to remain in good standing on this lease, and shows that of the $1785 paid in rent each month, $400 (or whatever you decide) will be credited towards their dp when they buy. (however it should not say that only 1385 is really rent with 400 credits, even though that is assumed).
The rent never changes number from one contract to the next as far as i understand, its always the total monthly payment. The credits only come into play IF they uphold their agreement and decide to exercise their option to purchase.

If it turns out, that you`re charging too high (their monthly rent minus their credits are WAY higher than market rent) then you lower your monthly payment, calculate the new 20% credit and see how the numbers work out. If it still cashflows decent, go with the new numbers. Ideally the monthly payment minus the monthly credits should be same or slightly less than market rent. One way to fix this is simply give more credits to the tenant, eg. if market rent is 1300 and tenant is paying 1785, give them $600 credits each month. It will still cashflow great, and if tenant can afford those payments, he will be racking up dp for his eventual purchase, everyone wins!!!

Mark is providing his basic calculations. The skill lies in using those calculations as an anchor from which you build each individual RTO deal based off tenant`s situation, local market numbers, investor`s needs, etc.

 

[GaryMcGowan]

Great Answers Andy,
At the end of the day you make the numbers work so it is a win win. On the monthly credits we have used 10% in some cases because the clients could not afford a higher monthly payment but they provided a higher down payment. If you are happy with numbers and the clients are happy with the numbers then you have succeeded with providing the right opportunity.

 

[JoeRagona]

Gary and Andy know what they are talking about, I will just lend an experience to this:

With regards to the monthly rent, you should analyze the property as a pure buy and hold WITHOUT the option credit in place to see if it will cash flow should the tenant default on their option. This happened to me on my first RTO and it DID NOT cash flow for what I needed.

Andy is providing two leases (contracts) but in an alternate way than I. My lawyer suggested two separate leases also, but if they default on the `option` lease, they are allowed to still occupy the unit without having to kick them out. Circumstances change and you may end up with a decent tenant instead of trying to re-rent or RTO.

Everyone does RTO differently and I guess much of the decision is based on how you can apply to the LTB to collect should the payment default.

I have spent the better part of a year fudging with spreadsheets to manipulate all sorts of different scenarios to make it win/win based on Mark`s first numbers you speak of. My analysis always takes into consideration the tenant`s TDS and GDS ratios both beginning and end. If you are doing this correctly, you MUST have the tenant`s best interest in mind - it`s not only for your increased cash flow.

 

[JoeRagona]

Andy,

I`m wondering if your formula works at the LTB level since they do not want to even `hear` about option credits. As far as I understand, if you have leases that are structured with option credits, you would have to go to small claims court to collect any monies - including back rent.

Correct me if I`m mistaken..

 

[DavidLi]

Hi Folks,


Thank you very much for your sharing your knowledge with me. I am greatly appreciated for that.


I don`t know what housing market situation is in Ontario, but in Calgary, it is brutal. Just as the other REIN members said you won`t see a positive cash flow property in Calgary unless you put down at least 35% D/P. Calgary is the homeowner town with high appreciation rate.



Still let`s take the number as example for simplicity.

$380K is just for single two storey house with 3 bedrooms upstair and 2.5 bathrooms, one bedroom + one full bathroom + entertainment room in basement, regular double garage, size: 1500 sq.ft. That is the situation here. samll lot.




Math tells us: based on the assumption 35% D/P ($133K), 5% rate, 35 yrs, then mortgage payment: $1,238.51, property tax: $140, insurance: $50, PIT cost totally is $1,428. If count in all other factors in(18%), the rent must be at least $1,685, plus some profit in, so the rent should be around $1,850-1,950. but the market tell you $1,700 - 1,800 is the best you can find.




Let`s take monthly credit 20% towards D/P, 2yrs term with 5% as deposit, so the lessee total monthly payment will be $2,040 (rent: $1,700 + 340 credit). At the end of the term, all the credit collected for the lessee will be taken away from your pocket. The only thing we can get is just the tiny cash flow monthly profit ($150 - 200) + appreciation value (6%) during the two years. That is all we can get.



If we use 0.70% as lease rate to calculate lease payment, then it will be as high as $2,662, taking off 20% as monthly credit $532 to $2,130, which will be the actual "traditional rent" payment. It is way too higher than the market rent $1,700. I guarantee that you will scare everybody away. How can we justify that and make the renter/buyer convinced that the balance $430 is reasonable and he / she is willing to pay for that?



If we use 0.55% as lease rate, then the lessee total monthly payment will be $2,090, which makes a little bit sense ($1,700 + 390 credit - 18.7% of $2,090). but another question comes out - why is there a big difference between the reasonable rate 0.55% and 0.8% in the book? if 0.8% is still reasonable, then I think there must be some other convinceable charge behind and it didn`t show in the book. Do you folks have any ideas about other reasonable charges except monthly credit, which can convince the renter/buyer to pay the extra $430 per month based on the above situation?




Based on your experience and market situation, what lease rate do you use to calculate the lease payment? It seems like it doesn`t work out at all if I use 0.8% to calculate lease payment in Calgary.



thanks a lot for your great response.



David



[email protected]


DWL Contracting Ltd.

"where quality begins"

 

[TomNamestnik]

David,
If I can add to the great feedback from Andy, Gary and Joe, here is how I handle the lease option amount:
20% is usually in a good ball park figure, but you can reduce or increase in order to get their DP to the amount they will need to get the deal done at the end. For example, if the client will be looking to qualify with 10% down, I always make sure that their initial deposit plus monthly options add up to 11.5% of the purchase price. This will cover the down payment and the closing costs resulting in a lot less pressure on the tenant to save the extra $$$.

Tom Namestnik
Lease2OwnNiagara.com
Visit Lease2OwnNiagara on the web

 

[markl]

Hi All,

As Andy has pointed out the numbers I use are based on trial and error and working backwards from the returns that we wanted to generate.

What type of returns are you looking to generate? We are working in the Alberta market and people are agreeing to .0085 of the purchase price.

Joe in the past we have renegotiated with tenants who wanted to stay but didn`t want to or couldn`t keep up the rent to own scenario. we put them on straight lease and we leave the door open if things change they can go back into the RTO program. For this you need to be in communication with your tenants.

The lease is not structured with an option credit. You have a lease for the full amount and a separate option agreement which comes into play when they exercise the option on the property.

Regards,

 

[DavidLi]

QUOTE (markl @ Apr 26 2010, 01:02 PM) Hi All,

As Andy has pointed out the numbers I use are based on trial and error and working backwards from the returns that we wanted to generate.

What type of returns are you looking to generate? We are working in the Alberta market and people are agreeing to .0085 of the purchase price.

Joe in the past we have renegotiated with tenants who wanted to stay but didn`t want to or couldn`t keep up the rent to own scenario. we put them on straight lease and we leave the door open if things change they can go back into the RTO program. For this you need to be in communication with your tenants.

The lease is not structured with an option credit. You have a lease for the full amount and a separate option agreement which comes into play when they exercise the option on the property.

Regards,

Hi Mark,

Thank you very much for your coming in and giving us some insights.

I checked your website and found your deals are from everywhere in ON and right now you are working in Alberta. It is really wonderful success for you. when we google RTO, there are tons of ads in the internet. What strategies do you use to make you stand out in the woods? A lot of people put ad in kijiji.com or craigslist.com or something like that. We can not follow this practise if we want to survive. I am just starting to try this method for positive cash flow so I am very curious about how you make your success happen. I am also pretty sure a lot of people want to know, besides me. Would you mind sharing some with us? We are learning right now. Thanks, David

 

[AndyLuchies]

QUOTE (JoeRagona @ Apr 25 2010, 10:04 PM) Andy,

I`m wondering if your formula works at the LTB level since they do not want to even `hear` about option credits. As far as I understand, if you have leases that are structured with option credits, you would have to go to small claims court to collect any monies - including back rent.

Correct me if I`m mistaken..

I`m not sure if this has already been answered, but the LTB gets the straightforward lease saying they rent at X amount (total monthly payment). They don`t see the option to purchase, which is the only document containing any mention of credits. (all this is in theory as I`ve never had to go to the LTB, knock on wood)

 

[AndyLuchies]

Of interest to others who may be reading, in response to question 1, there is an alternate way to come to the numbers for a monthly payment and credits if Mark`s %s aren`t working in a particular market (e.g. extremely low area rents).

Simply show your tenant buyers a simple chart and let them choose what they want to do:

Example:

Market rent for similar property as rental: $1200
RTO option 1 = Monthly payment= $1400/mo with $300 monthly credits (Tenant saves $100/mo)
RTO option 2 = Monthly payment= $1600/mo with $600 monthly credits (Tenant saves $200/mo)

I`ve heard of tenants that have asked about an even higher payment than the two offered! And either option gives you great cashflow while the appreciation eats any "loss" sustained by the investor giving the deal.

 

[JoeRagona]

QUOTE (AndyLuchies @ Apr 26 2010, 10:13 PM) I`m not sure if this has already been answered, but the LTB gets the straightforward lease saying they rent at X amount (total monthly payment). They don`t see the option to purchase, which is the only document containing any mention of credits. (all this is in theory as I`ve never had to go to the LTB, knock on wood)


Interesting, I may look at this situation in the future as I had to evict an RTO tenant. The first 3 months they were in, they defaulted on the option payment and bounced back to the lease only portion of rent which is what I collected at the LTB.

 

[MarkTorgerson]

QUOTE (AndyLuchies @ Apr 26 2010, 08:22 PM) Of interest to others who may be reading, in response to question 1, there is an alternate way to come to the numbers for a monthly payment and credits if Mark`s %s aren`t working in a particular market (e.g. extremely low area rents).

Simply show your tenant buyers a simple chart and let them choose what they want to do:

Example:

Market rent for similar property as rental: $1200
RTO option 1 = Monthly payment= $1400/mo with $300 monthly credits (Tenant saves $100/mo)
RTO option 2 = Monthly payment= $1600/mo with $600 monthly credits (Tenant saves $200/mo)

I`ve heard of tenants that have asked about an even higher payment than the two offered! And either option gives you great cashflow while the appreciation eats any "loss" sustained by the investor giving the deal.

Hi Andy

Thanks for your post.
Do you not have to be cautious with starting to give back credits as the seller(investor)? I was under the impression that CMHC will not recognize credits under market rent as part of the down payment when the tenant/buyer is trying to qualify. In example 2, market rent is $1,200 per month but you are in essence only charging them $1,000 ($1,600 less $600). You could go ahead and sign a deal as such, but would your tenant/buyer get the full credits when trying to qualify a few years down the road?

 

[DavidLi]

QUOTE (MarkTorgerson @ Apr 26 2010, 11:30 PM)
Hi Andy



Thanks for your post.

Do you not have to be cautious with starting to give back credits as the seller(investor)? I was under the impression that CMHC will not recognize credits under market rent as part of the down payment when the tenant/buyer is trying to qualify. In example 2, market rent is $1,200 per month but you are in essence only charging them $1,000 ($1,600 less $600). You could go ahead and sign a deal as such, but would your tenant/buyer get the full credits when trying to qualify a few years down the road?




Hi Mark, see my another post, which may help.



http://myreinspace.com/public_forums/General_Discussion/61-16466-How_bank_say_about_RTO_down_payment_when_renter_exercise_the_option.html







"you will show a letter that states how much credit has accumulated, i.e. how much money will be forwarded by you to the tenant-buyer / his lawyer !" said Thomas Beyer.









David

 

[MarkTorgerson]

QUOTE (DavidLi @ Apr 26 2010, 11:56 PM)
Hi Mark, see my another post, which may help.



http://myreinspace.com/public_forums/General_Discussion/61-16466-How_bank_say_about_RTO_down_payment_when_renter_exercise_the_option.html







"you will show a letter that states how much credit has accumulated, i.e. how much money will be forwarded by you to the tenant-buyer / his lawyer !" said Thomas Beyer.









David




Yes David but there are criterea on what CHMC will allow for credits when qualifying for a new mortgage. The credits allowed will only be the amount over and above market rent. Credits over and beyond that will be disallowed. For example (extreme) you would not be able to lease a house for $3,000/month and give back $1,500 per month in credits when the market rent if $2,500 per month. Again, you can sign a deal as such but your tenant/buyer will not be credited the full $1,500 per month by CMHC when qualifying for a new mortgage.



In Andy's 2nd example, there would be $200/month of credits in question.



There is a certain amount of forward thinking that needs to be done on what CMHC will be looking for when the lease option date comes due. The success of the entire RTO industry should be more geared towards how many deals you can close, rather how many RTO deals you can sign.

 

[markl]

Joe, You didn`t have the full amount of your lease on the lease payments? We do not collect 2 cheques we only get one from our tenants.

Mark - My hypothesis on what CMHC is trying to do is to stop landlords from giving back existing rent to tenants for their down payments. Although I have heard that this is being done right now with no problem. I think CMHC sees it the same way I do if the person buying the property has no money in the game they are more likely to default.

We have also had people ask to pay higher rents and we do reward them for it. If they paid an extra $200 per month I would credit them $300. We haven`t had an issue as the rents themselves have been over market value.

Regards,

 

[MarkTorgerson]

QUOTE (markl @ Apr 27 2010, 08:12 AM) Joe, You didn`t have the full amount of your lease on the lease payments? We do not collect 2 cheques we only get one from our tenants.

Mark - My hypothesis on what CMHC is trying to do is to stop landlords from giving back existing rent to tenants for their down payments. Although I have heard that this is being done right now with no problem. I think CMHC sees it the same way I do if the person buying the property has no money in the game they are more likely to default.

We have also had people ask to pay higher rents and we do reward them for it. If they paid an extra $200 per month I would credit them $300. We haven`t had an issue as the rents themselves have been over market value.

Regards,

Thanks Mark

That is interesting as the feedback I am getting from the lending industry is that CMHC uses the base of market rent and then will only recognize credits over and above this amount. The arguable issue would then be "what is market rent?". I think in the example you have given above, the additional $100 would not be enough to raise a flag with CMHC when the purchase option date comes due.

Have you been able to "close" deals with credits noticeably larger than what is above market rent?

 

[DavidLi]

QUOTE (MarkTorgerson @ Apr 27 2010, 08:48 AM) Thanks Mark

That is interesting as the feedback I am getting from the lending industry is that CMHC uses the base of market rent and then will only recognize credits over and above this amount. The arguable issue would then be "what is market rent?". I think in the example you have given above, the additional $100 would not be enough to raise a flag with CMHC when the purchase option date comes due.

Have you been able to "close" deals with credits noticeably larger than what is above market rent?

Hi Mark, thank you for your further clarification. I phoned CMHC this morning and staff in charge told me we can go beyond the market rent as long as you put the number in the contract. in this case we are talking about, the credit can go beyond $400. that`s what I got in Calgary. maybe there is different rule in ON. just phone CMHC and you will get the answer right away.

Regards,