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An Introduction to Vendor Finance for Real Estate in Australia


By Anthony J Cordato © Copyright Sydney 2009

Contents

This article has been prepared to provide a detailed introduction to how vendor finance has come to be used for the sale and purchase of real estate in Australia.

In this introduction, insights will be provided into how vendor finance currently ‘works’ and how it has developed in Australia.

It is an introduction which is intended to provide a general guide. It is not intended to be relied upon as a template for carrying out transactions. Professional advice needs to be obtained before using vendor finance for a real estate transaction.

These topics are covered:
  • What is Vendor Finance?
  • Why Vendor Finance is used for selling Real Estate
  • A Century of use for the sale of Real Estate in Australia
  • The three kinds of Vendor Finance
  • Illustrations of Vendor Finance
  • Vendor Finance as an investment method
  • Documentation for Vendor Finance

Information upon Legislation which applies to Vendor Finance for Real Estate in Australia and the Tax Treatment of Vendor Finance are to be found under separate tabs in this website.

What is Vendor Finance?

Vendor Finance (also known as ‘seller finance’) is finance offered by a seller (a Vendor) to finance the sale of real estate to a buyer (a Purchaser).

Sellers offer vendor finance to a Purchaser to help a Purchaser to purchase a home. Instead of the Bank financing the purchaser, the seller finances the purchaser along the same lines as a bank finances the purchaser. With vendor finance, instead of the purchaser making weekly, fortnightly or monthly payments under a mortgage to the Bank, the purchaser makes these payments under the vendor finance to the seller.

In its simplest form, a Vendor Finance transaction is structured in this way - the purchaser pays a deposit, then makes regular payments over a period of up to 30 years. It is the fact that regular payments are made to the Vendor to pay the price, rather than the payment of a lump sum to the Vendor that makes the arrangement a Vendor Finance arrangement, as opposed to a standard sale.

Vendor Finance is the first step along the path to home ownership. Sellers who offer Vendor Finance offer purchasers the opportunity to build up sufficient equity (a deposit) and a good track record of payments (creditworthiness) to qualify for bank finance at a future time. Usually, after 2 years, and rarely more than 5 years, the purchaser has sufficient equity and a good track record to refinance with a Bank.

Sellers who offer Vendor Finance receive the price they want for the property because they are not selling on the basis of price, they are selling because the payment terms are attractive to the purchaser. They are the opposite of sellers who discount the price for a sale.

In short, by using Vendor Finance, the seller receives two benefits: the first is that the seller sells the property more quickly than if offered at a fixed price because the property is attractive to more buyers; and the second is the price does not need to be discounted for a quick sale, because payment terms are being offered.

Vendor Finance is often referred to as alternative housing finance. It encompasses instalment sales, rent to own and sales with a carry back mortgage finance.


Why Vendor Finance is used for selling Real Estate

Saving the money to pay the price to purchase real estate without borrowing has been uncommon since the 1950s because of the high price of real estate would mean saving for many years, at the same time watching the price rise, adding more years to saving time.

The high price of real estate leaves purchasers these days with little choice but to borrow money to purchase real estate. The problem is – where can a purchaser turn if they can’t raise finance from a Bank or Non-Bank lender?

The answer is vendor finance!

Here are some advantages and disadvantages of Vendor Finance:

The advantage of Vendor Finance for both Vendors and Purchasers of real estate are that the sale is not dependent on the Purchaser qualifying for external finance from a Bank or Non-Bank lender.

The advantage of Vendor Finance for Purchasers - because borrowing money is necessary for purchasing real estate, obtaining Vendor Finance from sellers of real estate is a very attractive proposition for Purchasers as opposed to qualifying for Bank Finance, because Vendor Financiers will finance where Banks cannot or will not.

The advantage of Vendor Finance for Vendors in providing Vendor Finance is that the Vendor secures a sale, at their desired price.

The disadvantage for Vendors in providing Vendor Finance is that it ties the Vendor to the property, potentially for some time, and that the Vendor must retain satisfactory security for payment of the price.

The advantage for Purchasers in using Vendor Finance is that the Purchaser can purchase immediately at an agreed price rather than deferring purchase, and receive the immediate enjoyment of the property (i.e. the Purchaser can move in).

The disadvantage for Purchasers in using Vendor Finance is that Purchaser cannot sell or mortgage the property without first making full payment to the Vendor. Also, the money the Purchaser pays may be at risk if the Vendor defaults under its mortgage over the property.

This article will explain how these advantages and disadvantages are dealt with.


A Century of use for the sale of Real Estate in Australia

Vendor Finance for real estate has a long history in Australia.

In the land boom years of the 1870s and 1880s, property developers subdivided land and sold the land to purchasers to build homes upon the land and to property speculators who purchased the land for re-sale. Property developers offered terms to sell the land, typically ¼ of the price as a deposit, ¼ after six months, ¼ after 12 months and ¼ after 18 months, with interest payable at 6% p.a. on the outstanding amounts.

By the early 1900s, the practice was widely used and accepted, with land in suburban locations such as North Sydney and Chatswood advertised for sale on terms.

In 1927, the High Court of Australia considered the tax consequences of Vendor Finance, in the case of:

The Federal Commissioner of Taxation -v- Thorogood.

The facts:

James H Thorogood carried on the business of buying land, dividing it into allotments and building houses on them, selling these as house and land packages.

In some sales, a deposit was paid in cash with the balance price payable by instalments over several years. In these sales, Thorogood “funded” the whole price as seller finance. These sales were documented by a Contract for Sale, which continued for several years, with Thorogood retaining the title to the property in his name until the contract was completed by payment of the final instalment.

In other sales, the Purchaser paid a deposit, paid a large part of the price using external finance secured by first mortgage, with the balance of the price funded by Thorogood, taking as security a second mortgage over the property. These sales were documented by a Contract for Sale which was completed in the normal time. Title to the property was transferred immediately to the Purchaser. 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 an external financier, to secure the balance of the price owing to Thorogood.

In both cases, interest was payable on the balance price owing to Thorogood.

The dispute:

The Federal Commissioner of Taxation assessed Thorogood to pay income tax on the whole price in the year the Contract for Sale was entered, even though considerable portions of the price were payable in future years. Thorogood objected and contended that he should pay tax only on the portions of the price that were actually received in the tax year in question.

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 (Report found in: (1927) Volume 40 Commonwealth Law Reports at page 454).

For our purposes, the important point is that the legality of both forms of Vendor Finance was accepted by the High Court.

For the current tax position, see the tab on ‘Tax and Vendor Finance’.

The use of Vendor Finance fluctuates according to social and economic conditions and the availability of Bank and Non-Bank finance.

  • In the 1950’s and 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 provide loans for the purchase of blocks of land for housing.
  • Therefore, in the 1950’s and 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 terms finance. Once the land was paid for, they would borrow the money to build their home from a Bank.
  • In the 1960’s, 1970’s & early 1980’s, many young couples would purchase house and land packages from builders, using terms finance. In those times, a Purchaser would need to demonstrate a 12 months savings record and have a 25% deposit to borrow from a Bank (the Banks in those days would lend up to 75% of the value only). Generally after one year, the builder would “cash out” the terms finance Contract, by transferring the Contract to their financier, who might then provide normal mortgage finance to the Purchaser until the purchaser was able to refinance with a Bank.
  • From the mid 1980’s to date, the deregulation of the banking system has resulted in an increasing availability of mortgage finance from Banks and non-Bank lenders (up to 95% of valuation with minimal savings record). As a result, terms finance has been used relatively rarely for sales of property. However, it is interesting to note that it has been used continuously for sales by the NSW Department of Housing to its tenants since the early 1970’s, with 40 year terms on a 25% deposit being common.
  • Recently, there has been a tightening of loan approval conditions, and an unsatisfied demand for Vendor Finance has become apparent. It is found amongst purchasers with low deposits, purchasers who have their own business or trades and purchasers whose credit rating is impaired, who do not qualify for Bank or non-Bank Loans.

    Vendor Finance is recognised officially by the Australian Government as a means to purchase a home. In the 2006 Australian Census, question 56 was -

    Is this dwelling: Being purchased under a rent/buy scheme? 1.2% of Australians ticked “yes”.

The three forms of Vendor Finance

The decision of Thorogood describes two kinds of Vendor Finance namely:

  1. Instalment Sales Finance or Terms Finance: In this form of Vendor Finance, the property is sold at an agreed price, but instead of the price being paid up front where the price is funded with Bank finance, the Vendor agrees to accept payment of the whole of the price by instalments, over a period of time.

    The key elements are that the Vendor fully funds the price by setting up an instalment payment arrangement or plan in the Contract; the Purchaser takes possession once the Contract is entered into; and the title (i.e. ownership) remains in the Vendor’s name until the final instalment is paid (or the loan is refinanced).

    The Contract period is usually 20, 25 or 30 years, but generally the Purchaser will pay out the amount outstanding under the Contract as soon as they are able to refinance with external finance, which is usually between 2 to 5 years afterwards. The Purchaser pays interest at a rate of between .5% and 3% above the interest rate the Vendor is paying to their Bank on their loan.

    The Vendor keeps their existing loan on the property. This form of vendor finance is sometimes referred to as a ‘wrap around mortgage’ because the Vendor gives the Purchaser a mortgage which is for a greater amount and is at a higher interest rate than their own mortgage. It is called a ‘wrap’ for short.

    This form of Vendor Finance is documented by an Instalment Contract.
  2. Mortgage Carry back Finance: Traditionally, especially for the sale of farming properties, the Vendor loans the greater part of the price to the purchaser under a mortgage back finance arrangement. The Vendor transfers the title to the property to the Purchaser, and takes a registered first mortgage as security for the balance price that is due and owing. The Vendor is said to carry back the price that is not received on the property transfer, and this is therefore known as first mortgage carry back finance.

    First Mortgage carry back finance is what solicitors usually have in mind when the expression “vendor finance” is used because it is the form of Vendor Finance that is closest to their experience.

    The way that mortgage carry back finance is used by vendor financiers these days is to finance the deposit, and for the Purchaser to obtain Bank finance for most of the price.

    This form of Vendor Finance is known as second mortgage carry back finance or deposit finance, because the deposit is funded by the Vendor.

    The key elements of second mortgage carry back finance are that an external financier funds most of the price The external financier takes a first mortgage security. The title to the property passes into the purchaser’s name immediately. The Vendor funds the shortfall between the price and the external finance (that shortfall is the unpaid price which is often 10% to 20%) and takes a second mortgage over the property as security for payment. Usually the Purchaser has a small cash deposit, and so the Vendor Finance is usually less than 20%. The Vendor Finance may also cover purchase and loan expenses, such as stamp duty.

There is a third form of vendor finance, as follows:

  1. Rent to Buy (Lease Option) Finance: In this form of Vendor Finance, the Vendor allows the Purchaser to build up the deposit, by paying extra money, over and above paying the rent on the property.

    The way it works is that the Vendor rents the property to the Purchaser under a normal residential tenancy agreement. At the same time, the Purchaser pays more than the market rent, with the extra, credited towards the deposit payable if the purchaser decides to go ahead and purchase of the property. The right to purchase is contained in a separate document, called an option, in which the Vendor agrees to sell the property to the Purchaser for a fixed price.

    This form of Vendor Finance is useful where the Purchaser is not sure whether or not they wish to purchase the property, it is a ‘try before you buy’ arrangement.

    The right to purchase is found in an option to enter into a Contract for Sale, at an agreed price. There is an ‘up front’ payment, after which time, part of the rent payments or ongoing payments under the option are credited against the deposit payable under the Contract for Sale, if the purchaser takes the next steps and proceeds with the Contract for Sale. The Purchaser enters the Contract for Sale by ‘exercising’ the option, using the payments credited as the deposit. Until the option is exercised, the Purchaser rents the property under a Residential Tenancy Agreement.

Illustrations of Vendor Finance

These three simple illustrations are of the three common forms of Vendor Finance for a house. Assume a house is to be sold for $250,000, and is capable of being rented for $240 per week.

Illustration 1 – an Instalment Sale or Terms Sale

The house is sold with a deposit payable of $10,000, and with the balance price of $240,000 payable by 1,560 instalments of $425 per week over the next 30 years. For this example, the instalment amount is comprised of both principal and interest, and the interest rate is assumed to be 8.5% per annum. The Purchaser moves in immediately, also paying $35 per week to reimburse all rates and, insurances. The Purchaser is also responsible for maintenance. This example is a terms sale or an instalment sales form of Vendor Finance because the price payable under the Contract is payable by instalments.

Illustration 2 – Rent to Buy or Rent to Own (Lease Option)

A Purchaser rents the house at $260 per week for three years, at the same time putting aside a little extra ($125 per week) which is paid to the Owner along with the rent, making the total payment $385 per week. Over 3 years, the ‘extra’ paid totals $19,500, which together with an up-front option fee paid of $5,500, adds up to $25,000. The $25,000 represents a deposit of 10% credited as paid towards the price of $250,000. Therefore, at the end of the three years the Purchaser is in a position to use external finance to pay the balance price of $225,000, which represents 90% of the price. If the purchaser requires further time, the option can be extended.

This example is a rent to buy or rent to own form of Vendor Finance, documented as a lease with an option.

Illustration 3 – mortgage carry back

A Purchaser is given assistance to pay up to a 20% deposit of $50,000, by the Vendor giving deposit finance, with the balance funds (80% of the price) loaned by an external financier. The Purchaser pays interest only of $76.92 per week on the deposit finance, calculated at 8% per annum and repays it all at the end of 3 or 5 years out of savings or external financing. This example is a mortgage carry back form of Vendor Finance, which in this example is used to fund the payment of the deposit. It is documented by a mortgage.


Vendor Finance as an investment method

Advantages

Vendor Finance is gaining popularity as an investment method 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 direct 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 method 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:

  1. Where the Purchaser has little or no deposit or has an insufficient savings record.
  2. Where the Purchaser, is not creditworthy and cannot obtain bank or non-bank finance. Some Purchasers may be creditworthy, but find it difficult to deal with lenders. Other Purchasers 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 or have been in their employment for less than one year.
  3. 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. Many Banks will not lend on houses in towns with a population of less than 10,000.

Using the Instalment Sales Finance or Terms Finance Method for investing

Instalment Finance is a method commonly used 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. This is known as “wrap around” financing, commonly known as “wrapping”. The term ‘wrap’ was coined by US and US based investors, and has been used extensively in Australia since 1999.

The outstanding advantage for an investor of using the “wrap” method 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 Purchaser which is greater than the amount of the investor’s payments to their Bank. In addition, the investor passes responsibility to the Purchaser 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.

Using the Rent to Buy Method for investing

Rent to Buy 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 purchaser over and above the normal rent. Usually, the cashflow is not as strong as the cashflow on a “wrap”, because the Purchaser has not committed themselves to the property to the same extent as they commit themself under a “wrap”. Purchasers in a rent to buy are equivocal; they are thinking ‘rent now, purchase later’ rather than ‘purchase now’.

Refinancing by Purchasers of a Vendor Finance arrangement

Whatever the form of documentation is used, Vendor Finance is a means to an end, the end being the Purchaser refinancing using external finance. Vendor Finance is only the “the first stepping stone on the path to home ownership”.

Once the Purchaser has built up equity in the property by home improvements, savings or capital appreciation, and has a track record for payments, then the Purchaser is able to refinance the Vendor Finance on more favourable terms (lower interest rates for example).

Therefore although the Instalment Sales documentation is written for a term of 20, 25 or 30 years, in many cases a Vendor Finance arrangement can be for a term of as little as 1 to 2 years, and generally no more than 2 to 5 years. This reduces risks to both Vendor and Purchaser appreciably.

The period of 2 to 3 years for the Rent to Buy arrangement puts a formal time frame upon the Purchaser to purchase the property. The Purchaser has a deposit and a track record of payments, to enable the Purchaser to obtain external finance, should the Purchaser choose to proceed with the purchase of the property. Should the Purchaser decide not to proceed, the Purchaser moves out and the Vendor keeps the payments.

Joint Ventures

Instalment Sales and Rent to Buy 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 “wrapper” as a co-investor under a Joint Venture Agreement, to put a Vendor Finance arrangement into place.

A separate commentary upon Joint Venture Arrangements appears on a tab on this website.

Other investment methods

Other methods 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 methods are difficult to import easily into Australia, because they work in the absence of a title registration system, 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 an assumptive lease option arrangement.

Tenancy in common arrangements, where a vendor and purchaser each take shares in a property also come in and out of fashion in Australia. This investment method 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 methods, generally using options, which are also not examined in this article.


Documentation for Vendor Finance

The Instalment Contract

Where Vendor Finance consists of terms payments or instalment payments then it is known as terms finance and the sales are called terms sales. Terms sales are documented by way of an Instalment Contract.

An Instalment Contract takes the form of a standard Contract for Sale of real estate which has been modified to provide for the payment of the price by instalments, over time.

These are the modifications required to be made to a standard Contract for Sale to convert it into an Instalment Contract:
  1. The price set represents a profit over the purchase price. The price is payable by instalments, instead of a lump sum on completion.
  2. The instalments are payable regularly, either weekly, fortnightly or monthly, and will include interest. The interest rate is usually set at a premium above the interest rate payable on the investor’s loan / mortgage upon the property.
  3. The time between the date the Contract is entered and is therefore legally binding (called “the exchange of Contracts”) and completion of the Contract (also called “settlement” in Australia and “closure” in the USA) may be as long as 25 or 30 years, rather than the 30 days, 42 days or up to 90 days found in a standard Contract.
  4. The Purchaser enters into possession of the property, under a licence rather than a lease, and will be responsible for all expenses as from the exchange of Contracts (i.e. when the contracts are signed and the deposit is paid).
  5. During the continuation of the Contract, the Purchaser must reimburse the Vendor for all Council and Water rates, taxes and other outgoings, the insurance premium, and must keep the property in good repair and carry out all repairs and maintenance to do so.
  6. The deposit is paid by the Purchaser on the entry of the contract. The deposit paid will generally be less than 10% and where applicable, will include the First Home Owner’s Grant. It may itself be paid by instalments, and will be given direct to the Vendor, and not held by a deposit holder until completion.
  7. The Vendor retains legal title until completion. That is, the Purchaser does not have title to the property transferred into their name (and is therefore not the “owner”) until the final instalment of the price is paid or the vendor finance is paid out by a refinance or sale.
  8. Default under the Contract will result in late payment charges. If the Contract is terminated, the deposit and all instalments paid are non refundable and are kept by the Vendor.
  9. The Purchaser can pay out the balance price under the Contract before the due date for completion, but must pay all payments due to that date and an early completion charge.
  10. The Vendor needs to provide a Credit Code Disclosure Statement with the Contract and a Statement every six months to comply with the Consumer Credit Code.
There is no standard form of Instalment  Contract. The form of the Instalment Contract undergoes continuous amendment as new issues arise and as new ways of looking at old issues are found.

The Lease Option

Where Vendor Finance consists of payments consisting of a mixture of rent and option fees, then it is known as rent to buy, rent to own or rent now, purchase later. These are documented by way of a Residential Tenancy Agreement and an option for sale, hence the abbreviation, Lease Option.

The Residential Tenancy Acts in each State have a Schedule which contains the standard form of Residential Tenancy Agreement to be used in that State. In some States, a different form is prescribed for short term leases as compared with longer term leases. The Residential Tenancy Acts prohibit any amendments to those standard forms.

Therefore, all that needs to be done is for the particulars to be inserted, namely the names and addresses of the landlord and tenant, the address of the property, the rent, and how it is to be payable, the term of the lease, the commencing date and the terminating date. Often the bond requirement is omitted.

The option is a separate document to the Residential Tenancy Agreement. The Sale of Land or Conveyancing Acts in each State provide for certain inclusions, but apart from that, the form of the option is left to the discretion of the drafter of the option. There are many precedents for call options available to assist in drafting the 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.

Technically, the option is a ‘call option’. This means that the purchaser takes an option to purchase the property. As a taker of the option, it is up to the purchaser to decide whether or not to proceed with the option, which is technically known as exercising the option. Because options are granted for a fixed period of time, then unless the option is exercised within that period of time, the option will lapse.

The main task of the person who drafts the option is to document the payment of the option fee. It must be documented so that it properly reflects the intention that it be credited as part of the deposit to be paid under the Contract for Sale, which comes into existence when the option is exercised. This credit is colloquially referred to as the ‘rent credit’.

The Second Mortgage carry back

Where Vendor Finance consists of payments consisting of a mixture of principal and interest, then it is known as carry back finance. Because the title to the property goes into the name of the purchaser, the documentation takes the form of a second mortgage, which is to rank after the first mortgage upon the property.

The second mortgage is no different in form from a first mortgage, although some drafters like to add a clause that a default under the first mortgage is to be treated as a default under the second mortgage. Often, but not always, the consent of the first mortgagee to the entry of the second mortgage will be obtained. The consent may be given by letter, or in the form of a Deed of Priority. The second mortgage will either be registered upon the title to the property, or a Caveat will be registered to protect the second mortgage.

Disclaimer: The information and advice contained in this commentary is: (a) general in nature; (b) intended to draw attention to certain items to be discussed with a professional adviser; (c) not intended to provide specific advice; (d) takes no account of particular facts and circumstances; and (e) is not to be relied upon for any purpose.; and (f) is copyright, and must not be used other than for private or educational purposes and is not to be published in any form without the prior written consent of Anthony J Cordato.
Anthony J Cordato and Cordato Partners Lawyers disclaim all liability and responsibility to the fullest extent available at law. Liability limited by a scheme approved under Professional Standards Legislation


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