By Anthony J Cordato © Copyright Sydney 2012
There are many reasons why vendor finance is popular with buyers and sellers, and why vendor finance has been popular for the sale and purchase of real estate in Australia for many years.
These topics are covered in this introduction:
- Why do buyers and sellers choose vendor finance?
- Why are Instalment Contracts, Rent to Own and Deposit Finance popular forms of vendor finance for buyers and sellers?
- How has Vendor Finance been used for over a century for the sale and purchase of Real Estate in Australia?
- Vendor Finance as an investment strategy
Why do buyers and sellers choose vendor finance?
Vendor Finance (also known as ‘seller finance’) is offered by a seller (a vendor) to finance the sale of real estate to a buyer (a purchaser).
Buyers
The buyer who buys with Vendor Finance is taking the first step on the path to home ownership.
The buyer who chooses vendor finance is usually looking for a home to live in, but can also be a business looking to buy a shop, factory or office for their business, or is looking to buy as an investor.
Buyers choose the form of vendor finance that meets their needs.
Sellers
The seller who chooses vendor finance is usually looking to sell their property for a better price than they are able to sell the property using the standard cash sale. Selling on terms therefore provides a better outcome than selling for cash because it makes the property more attractive to potential buyers.
Selling for cash means the sale of a property in the standard way, with a deposit of 10% of the price payable at the time the Contract for Sale is entered into; then waiting 30/42/60/90 days (depending in which part of the country the property is situated); until the remaining 90% of the price is paid – from bank finance. The sale is therefore dependent upon bank finance.
Selling on terms means the sale of the property on vendor finance terms, where the seller can mould the terms of the sale to fit in with the buyer’s needs. The vendor finance terms are set by the seller to suit the seller’s needs, as well as the buyer’s needs. Significantly, the sale is not dependent upon bank finance.
In short, by using vendor finance, a seller receives two benefits; the first is that the seller sells the property more quickly than if offered at a cash price because the property is attractive to more buyers, and because the price does not need to be discounted for a quick sale, because terms are being offered.
Sellers choose the form of
vendor finance that meets their
needs.
Why are Instalment Sales, Rent to Own and Deposit Finance popular forms of vendor finance for buyers and sellers?
Why are Instalment Sales popular with sellers and buyers?
For the seller, the reasons why Instalment Sales are popular are –
- the seller receives a
fair sale price because they
are providing vendor finance
- the seller can qualify
the buyer themselves and
allow them to move in
quickly
- the seller can set the
income to be received from
the buyer so as to exceed
the mortgage payments the
seller must make to their
financier, until the buyer
is ready to ‘cash out the
contract
- the seller passes on the
obligation to pay for
maintenance and repairs to
the buyer from the date the
buyer moves in
- the seller continues to
receive rates notices and
insurance premiums
assessments (because the
title to the property
remains in the seller’s
name) but is reimbursed for
outgoings, such as council
rates, water rates and
insurance premiums by the
buyer from the date the
buyer moves in
- the seller is no longer
liable to pay land tax (in
some States) – neither is
the buyer liable because of
the owner-occupier exemption
- the seller retains the
title to the property in
their own name – the buyer
has an equitable interest
until they ‘cash out the
contract’ – only when the
buyer pays out the price, is
the title to the property
transferred into the buyer’s
name.
- the seller can continue to depreciate the property and obtain tax benefits until the buyer ‘cashes out the contract’ and the title to the property is transferred into the buyer’s name.
For the buyer, the reasons why Instalment Sales are popular are –
- the seller is able to
set vendor finance payment
terms to suit the buyer,
rather than the buyer
needing to fit into the
straightjacket of a standard
home loan offered by the
banks – for example, the
seller can offer low
payments to start,
permitting extra payments to
be made
- the payments are
structured like a bank loan
– as principal and interest
repayments usually over 30
years
- the buyer can move in
immediately the seller’s
background checks are
completed
- the buyer has the
freedom to improve the home
and keep the increase in
value, because the purchase
price is fixed up front and
never changes
- the buyer can refinance
or sell the property at any
time, and pocket the profit!
- For more information on Instalment Sales go to the Instalment Sales tab
Why is Rent to Own popular with sellers and buyers?
For the seller/owner, the reasons why Rent to Own is popular are –
- the seller/owner
receives a fair sale price
because they are providing
vendor finance
- the seller/owner can
qualify the tenant/buyer
themselves and allow them to
move in quickly
- the seller/owner can set
the income to be received
from the tenant/buyer so as
to cover the mortgage
payments the seller/owner
must make to their
financier, for the duration
of the Rent to Own
arrangement
- the seller/owner cannot
pass on to the tenant/buyer
the obligation to pay for
maintenance and repairs, but
can encourage the
tenant/buyer to renovate the
home by offering a sweat
equity credit
- the seller/owner
continues to receive rates
and premiums assessments
(because the title to the
property remains in the
seller/owner’s name) but can
set the rent at full market
rent, rather than a reduced
rent, and by this means
‘cover’ these outgoings
- the seller/owner remains
liable to pay land tax –
there are no exemptions
- the seller/owner retains
the title to the property in
their own name – the
tenant/buyer has an
equitable interest because
of the option to purchase
- the seller/owner can continue to depreciate the property and obtain tax benefits
For the tenant/buyer, the reasons why Rent to Own is popular are –
- the seller/owner is able
to set the payments terms to
suit the purchaser – for
example, the seller/owner
can agreed to accept a
larger up front payment and
lower ongoing payments
- the payments are fixed
for the duration of the Rent
to Own arrangement – so that
the tenant/buyer can budget
for a long period
- the tenant/buyer can
move in immediately the
seller/owner’s background
checks are completed
- the tenant/buyer has the
freedom to improve the home
and keep the increase in
value, because the purchase
price is fixed up front and
never changes
- the purchaser can
finance or sell the property
at any time, and pocket the
profit
- For more information on Rent to Own go to the Rent to Own tab
Why is Deposit Finance popular with sellers and buyers?
For the seller, the reasons why Deposit Finance is popular are –
- the seller receives a
fair sale price because they
are providing vendor finance
- the seller can rely upon
the lender which lends the
first mortgage loan to
qualify the buyer as being
creditworthy to be able to
afford to pay the Deposit
Finance
- the seller can set the
payments according to what
the buyer can afford
- the seller no longer has
the obligation to pay
council and water rates,
insurance premiums,
maintenance and repairs,
strata levies or land tax,
by selling the property
under standard Contract
terms, because the title
passes to the buyer when the
property is sold
- the seller pays out
their mortgage and no longer
has a loan liability when
the property is sold
- the seller has security for the payment of the Deposit Finance in the form of a Second Mortgage which can be registered, but often a Caveat is registered on the title instead, because a Caveat is simpler and cheaper to register.
For the buyer, the reasons why Deposit Finance is popular are –
- the buyer can buy the
house with a bank loan and a
little cash, without needing
all of the deposit
- the buyer can avoid
Housing Loan Insurance,
which is expensive and which
is only necessary if the
borrower borrows more than
80% of the price on a first
mortgage from the bank or
mainstream lender.
- the seller is able to
set the Deposit Finance
payment terms to suit the
buyer, rather than the buyer
needing to fit into the
straightjacket of a personal
loan offered by the banks
- the interest rate is the
same as a bank loan – and
the payments can be interest
only or principal and
interest, can start
immediately or be deferred
- the buyer has the
freedom to improve the home
and keep the increase in
value, because they own the
home
- the buyer can refinance
the Deposit Finance or sell
the property at any time,
and pocket the profit!
- For more information on Deposit Finance go to the Deposit Finance tab
How has vendor finance been used for over a century for the sale and purchase of real estate in Australia?
Vendor Finance has been used for selling real estate in Australia for a very long time. In fact, for long periods of time banks were reluctant to lend for residential purchases, preferring instead to finance business and investments because they offered better profits.
1870s – 1920s
In the land boom years of the 1870s and 1880s which were fuelled by the gold rushes and boom time exports of wool and wheat, property developers subdivided land for sale to meet demand. Some blocks of land were sold to buyers who build homes upon the land; other blocks of land were sold to property speculators who purchased the land for re-sale at a profit.
Then as now, bank finance was not freely available to buyers on vacant blocks of land, because banks were not comfortable with recovering their money if they lent on vacant house blocks of land.
Therefore, in the 1870s and 1880s, to sell their land property developers offered vendor finance terms which were typically ¼ of the price as a deposit, ¼ of the price after six months, ¼ of the price after 12 months and the final ¼ of the price after 18 months. Interest was payable at 6% p.a. on the outstanding amounts.
In the early 1890s, many banks collapsed as the weight of property speculation and the great drought took their toll. Variations appeared to the vendor finance model. For example, here is a plan of subdivision at Blacktown, near the railway station, dated 1895.
You will notice that the land is for sale, not at a price, but on vendor finance terms being a £1 deposit, followed by 24 monthly instalments of £1 each. The total terms price was £25 for the land, and it is safe to say that the cash price would have been less! But more importantly, the property developer was able to sell the land because they offered terms to suit the buyer’s pocket, in a climate where no bank loans were available.
1901
In Phillip Street Sydney, James Edward Hogg authored a book of Conveyancing Precedents and forms for use in New South Wales and other States and Colonies in Australia. Included was a precedent instalment payment clause, for vendor finance of real estate, which I reproduce –
Instalments. The purchase money, with interest thereon, or on the unpaid part thereof, at £-- p.c. p.a. from the – day of ---, shall be paid by – equal half-yearly instalments of principal amounting to £-- each, payable on the – day of -- & the – day of – in each year, the first to be paid on the said – day of --, with the addition to each instalment of the interest on the portion of the purchase money remaining unpaid, ….
Another vendor finance precedent in the book is for the conveyance of property following upon the exercise of an option to purchase contained in a lease – the title of the precedent is –
CONVEYANCE of a REVERSION EXPECTANT on a LEASE to the LESSEE, who purchases under an OPTION OF PURCHASE given him by the lease
1900 -1927
Between 1900 and 1927, the practice of selling land on vendor finance terms was widely used and accepted, with land in Sydney suburban locations such as North Sydney, Chatswood, Hornsby, Centennial Park, Randwick, Potts Point and Heathcote advertised for sale on terms.
The vendor finance terms were typically 1/5 th (i.e. 20%) of the price paid as a deposit, followed by 4 equal annual instalments of 1/5 th (i.e. 20%) each. Interest was payable at 5% pa on the outstanding amounts.
1927
With this high level of vendor finance activity, it is not surprising that the profits from vendor finance came to the attention of the Federal Commissioner of Taxation, and that a legal dispute arose.
In 1927, the High Court of Australia considered the tax consequences of two forms of Vendor Finance, in the legal case of:
The Federal Commissioner
of Taxation -v- Thorogood
which is reported in: (1927)
Volume 40 Commonwealth Law
Reports at page 454.
The facts were:
James H Thorogood carried on the business of buying land, subdividing it into allotments and building houses on them, selling these as house and land packages.
Thorogood sold some house and land packages where he ‘funded’ the whole of the price with seller finance on terms consisting of - a deposit paid in cash which was paid to Thorogood, with the balance price payable by instalments over several years. These sales were documented by a Contract for Sale, which continued for several years, with Thorogood retaining the legal title to the property in his name until the Contract for Sale was completed by payment of the final instalment. Today these are known as Instalment Contracts.
Thorogood sold other house and land packages where he ‘funded’ a part of the price with seller finance on terms which consisted of - , the purchaser paying a deposit to Thorogood, an external financier funding a large part of the price secured by first mortgage, which was paid to Thorogood, with the balance of the price payable funded by Thorogood, who took as security a second mortgage over the property. These sales were also documented by a Contract for Sale which was completed in the normal time. Legal title to the property was transferred immediately to the buyer. The documentation for the seller finance took the form of a second mortgage in favour of Thorogood which was registered, ranking after a first mortgage from the external financier. Today these are known as Deposit Finance arrangements.
In both cases, interest was payable on the amount payable and owing to Thorogood.
The dispute:
The Federal Commissioner of Taxation assessed Thorogood to pay income tax on the whole price payable under the Contract for Sale in the year the Contract for Sale was entered into, even though in both cases, payment of part of the price was deferred until future years. Thorogood objected to the tax assessment and contended that he should only pay tax on the parts of the price for which payment was deferred until in future years in the future years in which payment was actually received.
The decision:
The High Court did not decide the dispute - it decided only that it was possible to take either view of the tax consequences of the transaction, depending upon the facts, and in particular, whether the taxpayer was in the business of providing vendor finance.
For our purposes, the important point is that the legality of both forms of vendor finance was accepted by the High Court of Australia.
For information on the current tax position, go to the Tax Treatment of Vendor Finance in Australia tab
1950s – early 1960s
- The use of vendor finance continued to fluctuate according to social and economic conditions and the availability of bank and non-bank finance.
- The supply of housing real estate became scare towards 1950, unable to meet the demands or veterans from World War II wanting to settle down an raise a family, as well as the large numbers of migrants coming to Australia wanting to do the same. This drove up the price of building materials and housing, which meant that saving the money to purchase real estate without borrowing was no longer feasible. But who was to provide the finance? Answer – the vendor!
- In the 1950’s and early 1960’s, land for housing was subdivided and sold on vendor finance terms of up to 5 years, with instalments paid monthly. The reason vendor finance was used was that the banking system did not usually provide loans for the purchase of blocks of land for housing.
- Therefore, in the 1950’s and early 1960’s, most young couples looking to build a home would purchase a block of land to build a home upon, from a property developer ‘off the plan’ in a land subdivision, using the terms finance form of vendor finance. Once the land was paid for, they would borrow the money to build their home from a bank.
- An example, here is a newspaper advertisement for the sale ‘off the plan’ of housing block land near Kiama south of Sydney, dated 1957, where terms were offered.
You will notice that terms are offered over 3 years.
- In 1961, there was a
credit squeeze and many land
subdividers went broke,
leading to a tightening of
the law applicable to vendor
finance. Laws were passed in
many of the States to
restrict vendor finance. For
more information go to
The Law tab
- In the mid 1960s, the
Commonwealth Government
decided to make it easier
for banks to lend for
housing, and so bank finance
became more readily
available.
- These two events led to decline in the use of vendor finance.
1970s – 1980s
- In the late 1960’s,
1970’s & early 1980’s, home
builders became major users
of vendor finance to sell
house and land packages to
young couples.
- In those times, to
obtain bank finance to
purchase a home, a buyer
would need to demonstrate a
12 months savings record and
have a 25% deposit because
the banks would only lend up
to 75% of the value of the
home.
- Home builders therefore
sold house and land packages
on an Instalment Contract,
with payments mirroring a
bank loan. This enabled to
builder to obtain finance to
build from their finance
company. After twelve
months, the builder would
“cash out” the Instalment
Contract, by transferring
the Instalment Contract to
their finance company.
- Generally after twelve
months, the bank would be
satisfied that the payments
made by the buyer
constituted a satisfactory
payment/savings record, and
so might then provide
standard mortgage finance to
the Purchaser to pay out the
finance company.
- It is interesting to note that the NSW Department of Housing has had a policy to use the Instalment Contracts form of vendor finance to sell houses to its tenants since the early 1970’s, with 40 year terms on a 25% deposit being common. The same policy has applied in other States, such as South Australia.
Mid 1980s to date
- In the mid 1980’s the
Commonwealth Government
deregulated the banking
system, which resulted in an
influx of foreign banks
offering housing finance.
- From the mid 1990s until
the Global Financial Crisis
(the GFC) in 2008, non-bank
lenders, also known as
securitised lenders, sourced
loan money from the money
markets especially in the
USA and went from 0% of the
home loan market to 20% of
the home loan market.
- During this period of
between mid 1980’s to the
mid 2000s, increasing
availability of home loan
finance from the banks and
the non-bank lenders made
vendor finance shrink to a
rump of what it was. By the
mid 2000s, driven by
competition, loan finance of
up to 95% of valuation with
minimal savings record was
available to the employed
and the self-employed.
- In the 2006 Australian
Census, the Australian
Government Statistician
included
Question 56 -
Q Is this dwelling: Being purchased under a rent/buy scheme?
A 1.2% of Australians ticked “yes”.
The answer to this question underestimates the houses financed with vendor finance because it is restricted to rent to buy and instalment sales and because these last a short time – often 3 years, and are used as a stepping stone to bank finance.
The question was repeated in the 2011 Australian Census.
- The GFC has seen the
demise of the non-bank
lenders and Basel II has put
the shackles on bank
lending, leaving the 18% of
the home lending market that
the non-bank lenders had
serviced, without finance.
- Some of this 18% of the
home lending market will not
exist due to a decline in
demand for housing, but as
for the rest, represents an
obvious market for vendor
finance.
- In summary, there is an unsatisfied demand for vendor finance which has become apparent amongst buyers with low deposits, buyers who have their own business or trades and buyers whose credit rating is impaired, who do not qualify for loans from the banking system.
1 July 2010
- On 1 July 2010, the
National Consumer Credit
Protection Act came into
force. This Act is a
Commonwealth Act of
parliament, and consolidates
the laws governing consumer
credit in Australia. From 1
July 2010, ASIC (the
Australian Securities and
Investments Comission) is
the responsible governing
body.
- This Act covers two
forms of vendor finance,
namely Instalment Sales and
Deposit Finance. It does so
by making them explicitly
subject to the National
Consumer Credit Code.
- The Act also provides
that if a person is engaged
in the business of providing
these two forms of vendor
finance, they must hold a
National Credit Licence.
- For more information on
the National Consumer Credit
Code -
Click
Vendor Finance as an investment strategy
Vendor Finance is gaining popularity as an investment strategy for investors because it generates positive cashflow from residential property.
‘Positive cashflow’ means that the income from the property exceeds the outgoings, be they mortgage payments, rates and taxes, maintenance and repairs. It is the opposite of negative gearing, which is where the owner must contribute to the shortfall in the money available to meet the outgoings from their own pocket.
Vendor Finance is successful as an investment strategy because it meets the demand by Australians who want to purchase their own home, to ‘escape’ from the rental market, but who for some reason are ‘locked out’ of the banking system.
Specifically, the demand by purchasers for vendor finance in Australia is to be found in two situations:
- Where the buyer has
little or no deposit, or
insufficient savings record,
or is not creditworthy
(cannot obtain bank or other
finance) to obtain bank or
non-bank finance. Some
buyers may be creditworthy,
but find it difficult to
deal with lenders. Other
buyers are not creditworthy.
They must repair a poor
credit rating, or have
difficulty proving income
because they are self
employed or have casual or
irregular income.
- Where the property is such that bank or non-bank finance is not easily obtained by anyone. Examples are vacant land (especially outside the Metropolitan Area), acreage, farms, commercial property and unusual property such as boarding houses.
Using the Instalment Sale or Terms Finance Strategy for investing
Instalment Sale or Terms Finance, which is colloquially referred to as a “wrap” is a strategy used by investors to sell a residential property to generate positive cashflow from the property. The investor purchases the property using external finance, and then privately finances a purchaser to purchase the property, on terms, giving rise to a “wrap around” financing, commonly known as “wrapping”. The term ‘wrap’ was coined by US and US based investors, and has been used in Australia since 1999.
The outstanding advantage for an investor of using the “wrap” strategy is that the investment return from the property is strongly cashflow positive from day one. This is achieved by setting a level of instalments payable by the buyer which is greater than the amount of the investor’s payments to their Bank. In addition, the investor passes responsibility to the buyer to pay the outgoings, consisting of rates, taxes, insurance premiums, and the responsibility for repairs and maintenance. Using this technique, investors can achieve returns on residential real estate investment comparable to the returns achieved on commercial real estate investment.
The Documentation for Instalment Sale or Terms Finance
The form of documentation
generally used is an Instalment
Contract. This Contract is in
the form of a standard Contract
for the Sale of Land, with four
modifications. The first is that
the buyer enters into possession
of the property on exchange of
Contracts; the second is that
the purchaser pays a low
deposit; the third is that the
balance price is paid by
instalments (the balance price
is vendor financed); and the
fourth is that the purchaser
pays all outgoings and is
responsible for repairs and
maintenance. The buyer does not
take a transfer of the legal
title until completion, when the
whole of the price has been
paid.
For further comments, see the
Instalment Sales tab
Using the Rent to Own Strategy for investing
Rent to Own is similar in terms of objectives to “wrap” financing, in that the objective is to boost the cashflow return from residential property. The boost is in the form of the payments made by the buyer over and on top of the rent. Usually, the cashflow is not as strong as the cashflow on a “wrap”, because the buyer has not committed themself to the same extent as they commit themself under a “wrap”. Buyers in a rent to buy are equivocal; they are thinking ‘rent now, buy later’ rather than ‘buy now’.
The documentation for Rent to Own
Rent to Own consists of two documents.
The first is the lease, which is technically known as a Residential Tenancy Agreement. Under the law, it must be in a standard form. The rent is paid under the Residential Tenancy Agreement.
The second is the option. Under the law, there is no standard form of option. In most States, a cooling off warning must be attached, and in some States, a contract summary or a full Contract for Sale must be attached.
Refinancing by Buyers of a Vendor Finance arrangement
Whatever the form of documentation used, vendor finance is a means to an end, the end being the buyer refinancing using external finance. Vendor Finance is only the “bridge between the buyer’s position of being unable to obtain bank finance and the banking system”.
Once the buyer has built up equity in the property by home improvements, savings or capital appreciation, and has a track record for payments, then the buyer is able to refinance the vendor finance on more favourable terms (lower interest rates for example).
Therefore although the Instalment Contract is written for a term of 25 or 30 years, in many cases a vendor finance arrangement can be for a term of as little as 2 to 3 years, and generally no more than 5 years. This reduces risks to both seller and buyer appreciably.
The period of 2 to 3 years for the Rent to Own arrangement puts a formal time frame upon the buyer to purchase the property. The buyer has a deposit and a track record of payments, to enable the Purchaser to obtain external finance, should the buyer choose to proceed to buy the property. Should the buyer decide not to proceed, the buyer moves out and the seller keeps the payments.
Joint Ventures
Instalment Sales and Rent to Own have become popular in Australia with Investors because of the high returns achievable on money invested. But often Investors do not have the time or skill to put vendor finance arrangements into place.
Investors often utilise the services of an experienced vendor financier as a joint venture partner under a Joint Venture Agreement, to put a vendor finance arrangement into place.
For more information upon Joint Venture Arrangements go to the Joint Ventures tab.
Other investment strategies
Other strategies have been developed in the USA for property investment, such as purchasing “subject to” an existing mortgage (i.e. taking over the property, subject to the Vendor’s mortgage). These strategies are difficult to import easily into Australia, because they work in the absence of a title registration system. This is in contrast to the situation in Australia, where a title registration system exists. In Australia, the process of taking over a property, ‘subject to’ the existing mortgage is more formal, but possible, using a reverse rent to own arrangement, which is known as a Sandwich Lease Option.
Tenancy in common arrangements and shared equity arrangements, where a vendor and purchaser each take shares in a property also come in and out of fashion in Australia. This investment strategy starts with an investor who provides a deposit for the purchaser to purchase a home, and at the end of a specified period, the purchaser must refinance or sell to repay the deposit. These tenancy in common arrangements are far less attractive to an investor than other vendor finance techniques and will not be examined further.
There are a number of property trading strategies such as sandwich lease options, which use options, which are also not described here because the knowledge needs to be acquired through a learning program.
