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.
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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.
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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.
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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.