Thursday, October 12, 2017

Rent to Own Example - Double the money in 3 years

I attended a wealth building MeetUp today that covered 5 ways of building wealth in real estate:

  1. converting a single home into a legal duplex
  2. buy & hold 'first-time home buyer' type of property
  3. rent to own
  4. multi-unit properties, and
  5. commercial real estate.
I found all of the material helpful, but rent to own strategy was presented in most detail, so I wanted to summarize it here.

Key benefits of rent-to-own for real estate investors:
- Tenants care about the house and are happy to maintain and/or improve it
- Tenants pay 15-25% more than the market rent monthly, which gives better cash flow
- Tenants provide a non-refundable deposit of 8-15K (3-5% of current house value)
- There is a pre-defined exit strategy with good ROI
- If tenants can't or chooses not to purchase the house at the end of the lease term, landlord keeps the deposit and the house.

Here is how rent-to-own typically works
  • Tenant and landlord sign a standard lease agreement for a rental property. This agreement is governed by Landlord and Tenant board rules, so all typical regulations apply and can be used by the landlord/tenant in case of any issues (ex., landlord can evict a tenant for non-payment).
  • Tenant and landlord enter into a separate 'Option to Purchase' agreement outlining an exclusive option for the tenant to buy the rental property at a preset purchase price at the end of the lease. Typically, the term of the lease is 3 years and buy-out price is calculated at 5% annual appreciation of current market value.
  • Tenant pays a non-refundable fee up front This fee is the price for the opportunity to buy the house in the future. It's called "option money" Typically, the fee is 3-5% of the current property price. 
  • Tenant pays rent plus a 15-25% mark-up on top. The extra money is kept by the landlord as a credit towards future purchase. 
  • Landlord puts the tenant in touch with a mortgage broker, who works with the tenant on improving his/her credit history over the course of the contract. This way tenant has a better chance qualifying for a mortgage when the time comes.

Example:

Current market value of the house: 400K
Current market rent: $2,500 / month

Tenant pays up front: 3% of 400K = 12K (option money)
Tenant pays monthly:  $2,500 + 25% = $3,125 (includes credit money of $625 / month)

Lease duration: 3 years
Preset purchase price: 400K + 5% * 3 years = 460K
Credit accumulated by tenant:  $625 * 36 = $22,500 

Note: $22,500 is 4.9% of the purchase price of $460K, so the tenant is in a very good position to qualify for a mortgage with 5% down and become a home owner.

If tenant doesn't purchase the house, landlord will keep $12K of option money and $22,500 of credit money.

Suppose tenant chooses to purchase the house. Assuming the landlord originally bought the property for 400K with 20% down, 2% closing costs, and 3.5% 5-year fixed mortgage with 30-year amortization, he/she will receive:

Principal paid by tenant: ~20K 
+ Preset appreciation: 60K
+ Net cash flow during three years: say, $200 * 36 = $7,200
- Less: mortgage discharge fees of 3K.

Total: 84.2K profit. 95% ROI (more than 30% annual return).

Per above, rent to own strategy is worth considering on my path to 50 doors.