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What if values go down?

thejules

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I am close to signing up my first Tenant Buyer, they are concerned about what happens if the value isn't there in 36 months. This came across from the tenant buyer as an objection to putting down 5% option money on the option agreement.
So what happens if the value isn't higher than when I purchased this property?
 

Sherilynn

Real Estate Maven
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First and foremost, tenant-first Rent to Own only works in a rising market. You must be reasonably confident of the future of your local market.
Second, get a higher option payment. I realize this is counter intuitive for your tenant, but the higher the option payment, the more flexible you can be on the final price. If you have a 15% option payment, you can use a much smaller markup than you can with a 5% option payment and still get the same ROI. Plus, you can have a larger refundable portion of this larger option payment, so the tenant isn't risking additional funds. (Of course, our refund only applies if the tenant exercises the option and can't get financing, but a low appraisal would fall in this category.)

To answer the objection, we inform or potential clients about the benefits of a higher option payment, and we tell them we handle such situations on a case by case basis to come up with a solution that works for everyone. Usually, that satisfies them and we don't have to give specifics.

If the value isn't there, you have a few choices:
  1. renew at the same price. Keep in mind the ROI will decrease because you now have similar profit over a longer time, but it could still work if the mortgage paydown is high. Also, there is no guarantee the appraisal will work next time.
  2. reduce the price to match the appraisal. This means lower profit and ROI, but the deal's done and you have a happy buyer. Note: always build a cushion into your deals to accommodate such situations. We prefer to take the hit ourselves and leave the JV partner's ROI in tact.
  3. split the difference with the buyer. Reduce the price and make payment arrangements for the shortfall. This is our usual method of handling the situation because it creates as much of a win-win as possible.
  4. seller financing for the full amount. If the tenant buyer has 20% down (or close to it), you can sell to them using Agreement for Sale with Seller financing. Then the appraisal doesn't matter. This is a great solution if your buyer has the cash available.
 

neill

Airdrie, AB
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Oct 22, 2007
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An uncertain (aka flat or dropping) market really reveals the main issue with tenant first strategy, versus picking up a property below market value and having an option price that has a better chance of being supported at time of exercise of the option to purchase.

We just had a tenant buyer get approved and funded on a mortgage where the appraisal came in $30k (!) below their option price. She had a bit of extra money down from RRSP, but certainly not enough to make up the difference. We ended up taking a note payable for the difference, that will be secured against property, leaving a fair portion of our profit locked in to "drip" out over the next five + years. It still felt ok, as we got enough funds at sale to give us a return today - the rest is gravy over time.
 

thejules

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Neill, I don't understand? If the appraisal came in $30000 below thier option price, wouldn't the tenant buyer have more than enough to close? & wouldn't you be at risk of having to refund some of thier option money?
 

neill

Airdrie, AB
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Sherilynn, can you expand on your comment of more down, same ROI please?

I did some quick scratching on a scrap of paper:
$400k purchase price today
$20k option payment (5%)
=$60k net required for downpayment from investor (working w/80% LTV).

If you mark it up 6% of year one, the price is $424k. $24k profit / $60k net investor down pmt = 40% ROI net.

Plus mortgage paydown.

In the same scenario, if the tenant puts up the 15%:
$400k
-60k option pmt
=20k required from investor for net down payment.

To achieve the same 40% ROI, that yields a gain of $20k x 40% =8k

Plus mortgage paydown of the same amount.

What am I missing here? Who is going to do that much work to make a mere $8k, with all the same inherent risk in an RTO?

With all due respect, I would submit that the same $24k markup would yield a reasonable dollar profit, with a crazy ROI. And dollars drive our business, not percentages.

Illustrated in the extreme: If the TB puts up 75k upfront, then I only need to mark up the house by $2000 to achieve 40% ROI...
 

neill

Airdrie, AB
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Oct 22, 2007
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Hi Jules:

310 option price (we knocked $10k off from $320 when the market stalled at $300 a year ago in the same complex)

Appraisal - first one was $270. We requested and got a second one at $280, still below more recent comps of 290-95)

We received:
$266 from first mortgage
$9k in upfront and monthly option credits
$7k from RRSP and TFSA,
Leaving us $27k short

The $27k will get paid out at approx 400/mo over the next six years, although the TB will work with us to increase pmts as her budget allows...
 

Thomas Beyer

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Be realistic on future value and in Alberta that is down 5-10% to 2017 then up 3-5% so flat at best for a three year target.

Don't be greedy.

The takeout price can be a formula such as a minimum price, say 5% below today's value , to a maximum price, say 10% above today's value, or appraised value or 5% above tax assessed value.

Many RTO deals make sense even in a flat market as you collect more cash upfront and more cash every month.

Canada just elected a high tax, very high energy cost, lower net wage and generally anti-business government in both Albert and the federal level and that does not bode too well for residential real estate prices!
 

Sherilynn

Real Estate Maven
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Sherilynn, can you expand on your comment of more down, same ROI please?

Of course I wouldn't reduce my profit to the point I reduce my ROI to 20%. That would be daft! ;)

Here's an example of a deal I did with a 14% option payment:

Purchase price $372804
Option payment $52000
Net investment required $24061
Because I had the cash available, I decided to do this deal without a JV partner. I also offered only a 30% refundable portion (as compared to my standard 20% refundable), so there was a lot of security in the deal.

Markup 2% per year for 2 years, then rounded up to an even $390000 for the final price.

My net profit after 2 years = $45718, for an ROI of 126.4% per annum.
If I had a JV partner on this, his 50% share would have been $22859 for an ROI per annum of 63.2%

I'd say that's worth doing. And it's a true win/win:
  • the markup is achievable even in a slow market, thereby helping to ensure a successful purchase
  • the tenant-buyer gets a heck of a deal if the market increases at an average rate of 4% or so
  • I get crazy ROI
  • and if I had wanted a JV partner, who wouldn't jump at 63% ROI with a huge chance at success?
 

neill

Airdrie, AB
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Oct 22, 2007
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472
Hi Sherilynn - thanks for the share.

Can you elaborate a bit more pls?
I see:
390
-372.8
= 17.2 lift in property.

Two year deal = approx 10-11 in typical mortgage paydown for 30 year am.

Was there 8k per year from rents on top of mortgage paydown? Massive cashflow if so - congrats!


The other concern of course is that in a declining market, 372 in two years would be more like 340 based on ~5% price drop.
 

Thomas Beyer

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Markets go up, on average with inflation , but never in a straight line.

They might go up higher than inflation with immigration, falling interest rates and/or too low a supply and down with job losses, rising interest rates, emigration, falling net wages or excessive supply.

A two year outlook in Alberta is at best flat, likely slightly falling.
 

Sherilynn

Real Estate Maven
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Oct 22, 2007
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2,803
Hi Sherilynn - thanks for the share.

Can you elaborate a bit more pls?
I see:
390
-372.8
= 17.2 lift in property.

Two year deal = approx 10-11 in typical mortgage paydown for 30 year am.

Was there 8k per year from rents on top of mortgage paydown? Massive cashflow if so - congrats!


The other concern of course is that in a declining market, 372 in two years would be more like 340 based on ~5% price drop.
Yes, net cashflow is $654 per month on this property (on top of mortgage paydown).

Even if we sell the property for what we paid for it, our profit would be $30k and total ROI would be over 60% per year.

(And our ROI is actually even better because a month after the purchase we got a $6000 GST rebate which reimbursed a good chunk of our net investment.)
 
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