Property prices have soared in Sydney and Melbourne over the last few years, dashing the prospects of homeownership for many residents of these cities.
This has led some, like Your Investment Property reader Jodie, to consider alternative ways of getting into the property market.
“I’ve recently discovered a rent-to-buy scheme here in New South Wales,” Jodie wrote.
“My husband and I don’t have a house deposit, which would enable us to enter the property market. They are asking us to pay 30% more rent, including the cost of stamp duty, as the deposit for a five-year term prior to the house being sold to us at a fixed price (determined now).
“Would this be something to avoid, or could this be a feasible option of homeownership eventually? Thanks, Jodie.”
I can understand why Jodie is looking into this type of arrangement. In principal, if all goes well, it’s fine. But generally speaking, in rent-to-buy arrangements it doesn’t always go well, because there are many complexities involved.
I am not a big fan of rent-to-buy property schemes, for a number of reasons.
It’s not like when you’re buying a property in the standard way, with legislation and contracts in place that are watertight and that protect both parties, the buyer and the seller.
As the buyer, you are more vulnerable in a rent-to-buy situation. To start with, the buyer’s name isn’t on the property title, so there’s less security.
Also, if you’re making extra payments and one month you’re late, you might find that this has voided the whole contract and you have lost all the money you paid.
That’s not really great protection, and it’s not the ideal way to move up the property ladder, is it?
Furthermore, your situation could change, even if you have the best intentions in the world and believe that in a few years’ time you will be able to afford the loan for the property purchase.
While you may meet the current lending criteria today, as we’ve seen recently, lending criteria can change – a lot. APRA has toughened up the mortgage market in the last few years, and there could be further changes to come.
As the buyer, if you find that you can’t get the finance to settle the purchase in five years’ time, then all the money you have paid to the seller could simply disappear.
The other thing to consider is the situation of the investor or landlord. If the landlord misses a mortgage repayment, what happens to the property?
At this point we start to enter legal territory, which is why I asked my friend Sean Ryan, partner at the boutique property firm FBR Law in South Australia, to weigh in with his legal viewpoint.
Peter Koulizos walks us through the pros and cons for both the buyer and the seller.
The good news is that he does have a solution for those wanting to buy!
"If you find you can’t get the finance to settle the purchase … all the money you’ve paid could simply disappear"
Sean says that in Melbourne, Sydney and Brisbane there is a fairly active rent-to-buy market. But in SA there are considerable restrictions around rent-to-buy schemes. “It’s so highly regulated in SA that people don’t tend to pursue it, although that’s not to say it doesn’t occur,” he says.
“There’s no doubt that these arrangements can work and they have their place. They really can fill a void for those – like your reader Jodie – who are struggling to get into the market.”
So what is the legal process like for entering into a rent-to-buy arrangement?
“It’s complicated if you don’t know what you’re doing,” Sean says. “If the two parties involved don’t get advice, and instead try to put it together themselves, it could lead to disaster.
“I’ve seen a lot of these types of arrangements go wrong, predominantly where parties create the agreement themselves, based on an internet template. They get a little bit of knowledge and off they go. It is much more complicated than that.”
A genuine win-win Sean says a rent-to-buy arrangement can genuinely be a win-win, offering upsides for both parties.
“The model has two parts: the rental part and the ownership part,” he explains. “The rental takes the form of a standard residential lease, under which the homeowner rents the property to the buyer/tenant and the tenant pays market rent. That is fairly straightforward.
“The second part is the ownership component, which is achieved by offering a sale option. It permits the tenant, at their discretion at some point in the future, to say, ‘I want to buy this property at the pre-agreed price’. The seller is then compelled to sell on those terms.”
In exchange for this arrangement, Sean says, the tenant pays an upfront option fee and an ongoing fee.
"In my opinion, rent-to-buy schemes seem to be heavily weighted towards the owner/investor"
“Practically, this means that, on top of the rent, the tenant could be paying, say, a $100 per week option fee for the duration of the agreement. The option fee goes towards the final purchase price; the payments are effectively instalments towards the deposit, so that at the end of, say, three years, those weekly payments of $100 have built up a deposit.
“This enables the tenant to do then what they can’t do today – that is, go to the bank and say, ‘I have the ability to buy this property. I have the deposit’. They have also locked in a price that was set three years ago, and hopefully the property has gone up in value during that time, so notionally they have built up some equity.”
Sean points out that from the owner/investor’s point of view, there’s the benefit of having
a long-term tenant in place, someone who is invested in the property and therefore more likely to treat it well.
“After all, they are saving to buy it!” he says. “You’re getting market rent paid, plus you’re getting extra cash flow through the weekly option payment. While the owner/investor does have to credit those option payments towards the purchase price in the end if the tenant buys, they get to keep that money if the tenant never buys.”
The risk faced by the tenant is that, if in three to five years’ time they can’t get a loan to buy the property, they will have thrown away $100 a week for all those years.
The other big risk is that the owner/investor could default on their mortgage repayments and the bank could exercise its rights of sale under the mortgage.
CREATING A WIN-WIN PARTNERSHIP
Rent-to-buys can offer creative solutions to housing affordability problems, says Sean Ryan, partner at FBR Law. “If you’re a handyman you could structure a deal where if you paint the house and upgrade the bathroom, the owner will notionally credit that effort and value towards your deposit. There are many novel ways to move forward,” Ryan says.
“The tenant/buyer will always rank second to the bank,” Sean says. “If there’s an unscrupulous owner, or just one who is in strife, the tenant’s going to come out second best and lose the equity they’ve been building.
“Rent-to-buys are a bit like dating – in the beginning, the two parties are madly in love, thinking this is the best thing for both of them. Then two more years later circumstances change, the tenant defaults on their rent or can’t make their option payment, and tensions develop. This is where a properly structured legally prepared agreement is worth its weight in gold.”
For anyone considering this type of arrangement, legal advice is essential, Sean advises.
“There are solicitors who practise in this area, have a good working knowledge of property, and who have an intimate understanding of these types of agreement. They can help you put the document together.
“While you might spend between $2,500 and $3,500 on having the agreement prepared, in my view that is a pretty good investment, when you consider the likely return.”
BIG RISKS OF RENT-TO-BUY SCHEMES
- Some rent-to-buy contracts are structured so that the buyer loses all payments made and has no claim over the property if you miss even a single payment.
- The seller will usually keep the title in their name until the buyer has paid off the loan. Because the buyer isn’t legally the owner, they have limited rights.
- If the seller is using the payments to cover their mortgage, they could be left vulnerable if the buyer fails to pay their rent or other fees.
- Sellers remain legally responsible for the property until the property title is transferred. This is an extremely risky situation. Think very carefully before you agree to anything.
RENT TO BUY: NEED TO KNOW
- Rent-to-buy may seem like a cheap and easy solution when you need something fast, but be aware of what it will really cost you before you sign up.
- Before entering a rent-to-buy arrangement you must find out if account-keeping fees will be charged, and whether penalties will apply if you miss repayments, break the agreement or pay it off early.
- Watch out for salespeople who pressure you. Don’t sign anything on the spot – always ask for a cooling-off period.
- If you are on a low income, you may be eligible for a no- or low-interest loan to help you reach your financial goals. Talk to Centrelink’s Financial Information Service to see if you are eligible for a special benefit.
Sean has shared a number of insights into rent-to-buys, and I agree that anyone considering this type of set-up needs to seek out qualified legal advice.
In saying that, in my opinion, rent-to-buy schemes seem to be heavily weighted towards the owner/investor, and they’re so complicated that both parties are exposed to unnecessary risks. Many people find themselves in a position where they don’t have a sufficient deposit for a property, so they start considering these creative concepts to get into the market. However, rent-to-buy agreements aren’t the only option available to you.
Following are some other ways you can plan to take your first step on to the property ladder.
• Set a three-year goal
If you can afford to pay the extra money in a rent-to-buy agreement – which in Jodie’s case is an extra 30% on top of her regular rent – then I would encourage you to instead save those extra funds for a deposit on a property purchase one, two or three years down the track.
By having a clear goal of saving for a property deposit, this will give you the motivation to keep saving. It may not be the property you want to end up in, as you’ll have to adjust your taste to match your budget, but that’s OK, because getting your foot on the ladder is the hardest step, and it’s an important one.
I think rentvesting is a better option than a rent-to-buy scheme. Rentvesting allows you to rent where you want to live, and own where you can afford it. From a lifestyle perspective, if you want to live in Bondi and the only way to achieve that in your current situation is to rent there, then go ahead.
However, I must clarify that, from a purely financial perspective, the best option is almost always to buy a property and live in it. No, it’s not going to be your dream home, but you’ll sell it one day and move into your next home. Most crucially, when you sell it, it will be capital gains tax free.
"From a purely financial perspective, the best option is almost always to buy a property and live in it"
If you choose to reinvest when you eventually sell that investment property to leverage into your own home, you will have to pay capital gains tax on your gains.
• Live at home
This is probably the most important point of all: I would encourage younger people who are keen to get into the property market to stay in their parents’ home for as long as they feasibly can, paying minimal board.
Ideally, while you’re there, buy an investment property before you move out, because that will give you a huge leg-up on the property ladder. It’s far harder to build a deposit towards a property when you’re already paying full rent, so take advantage of living at home while you can.
Of course, this is not an option for everyone. But for those who do have this opportunity available to them, it can help create a strong financial foundation to build from. At least you will have your name on a property, and from there you can leverage into bigger and better homes.
For some, embarking on a rent-to-buy property deal may seem like the solution to the housing affordability crisis, but my view is that if you can afford the extra money each week, then surely you have other (less risky) options. With a little discipline, in a short space of time you will be able to put those funds towards a deposit and own your own home sooner.
is an investor, university lecturer and author of several books,
including The Property Professor’s Top Australian Suburbs.
He has been teaching in real estate and investment for 20 years.
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