Top 10 Questions At CRE CONVENTION – 5&6 - Posted by David Finkel
Posted by David Finkel on July 04, 2002 at 15:44:26:
CRE Convention Top Ten Question #5 and #6: How do I calculate the price I sell my property to my tenant buyer to when I am selling on a rent to own basis? ANd how do I use “rent credits” when selling on a rent to own basis?
I got this question from a lot of people at the convention. When I went to write up the answer I realized I had already answered it before on the discussion board so I am reposting the question, the answer, the follow up questions and answers. I hope you find them useful for helping you sell your properties more effectively?
This is a long answer, but I hope you find it useful. It comes out of our second book, How to Make Big Money Investing In Real Estate Without Tenants, Banks, or Rehab Projects:
When you are creating your pricing for your properties it is important to balance the your desire to make the most money possible with your need to keep your workload low. What we mean is that if you get too aggressive with the pricing you will have to work very hard to move the property. If you are not aggressive enough with your pricing, then you lose out on part of your profit. Here is the simplest way we know to explain exactly how you come up with your pricing on your Rent to Own properties.
First, here are a couple of the background facts for this deal so we can make this role played scenario go smoothly for you: The house you are selling is valued at $245-250,000. The market rent for a 4 bedroom house like this one is $1,500 per month. The area has been appreciating at between 4-5% for the past two years. You agreed with the seller on a four year lease option where you pay a monthly rent of $1,400 per month and an option price of $225,000. You got the price down by using the negotiation strategies you learned in Section Three.
In case you forgot how to get the seller to lower their price, here is how the conversation probably went:
You the Investor: What were you asking for the property?
Investor: And what did you realistically expect to get?
Seller: Around $240,000
Investor: Oh, $230-240,000? OK.
Seller: Not $230,000, I expected to get at least $240,000.
Investor: Oh, Ok? A question for you, if a real estate agent came to you and said they could guarantee you a sale at the full $240,000 would you let them sell it for you at that full $240,000 or you?d what, probably turn them down?
Seller: No, I guess I?d let them sell it just to be done with this.
Investor: Oh, that makes sense. Then their 6% commission would be?
Seller: Roughly $15,000.
Investor: OK, so that means that bottom line you would be getting?
Seller: I?d get $225,000. (BINGO! See how you let a few powerful questions lower the price by $25,000!)
Let?s take this information and create your pricing for the property. Your goal is to find a price for your tenant buyer that is below the anticipated future value of the property but high enough above your price so that you make a healthy profit. In our example we are going to sell the house on a two year Rent to Own.
First, you take the highest current value of the property and label that the current value of the house. Remember, properties are valued by how much other comparable houses have sold for, and it is impossible to put an exact dollar amount on any given house. Since you are selling with great financing in place you should always start your current value of the property at the highest justifiable comparable property. In our example that means the current value is $250,000.
Next you calculate what the house would be worth at the end of the two years at it?s current rate of appreciation. In our example the market was appreciating at between 4-5% so again we choose the higher end of that range. In this case we use the 5% rate of appreciation. A key point here is that you do need to be realistic on your rate of appreciation. If you talk with five different real estate agents in an area and they tell you the rate of appreciation for that area is: 4%, 4%, 5%, 5%, 12%, you need to use some commonsense that the 12% is not accurate.
To calculate the projected future value of the house, simply multiply the current value by 1.rate of appreciation as a decimal. In our example, multiply the $250,000 house by 1.05 to give you a one year value of $262,500. Because you are selling this house on a two year Rent to Own you need a two year value. You get this by taking the one year value and again multiplying it by 1. rate of appreciation as a decimal. In our example we take $262,500 and multiply it by 1.05 to come up with a two year value of $275,625. (See Figure 5.5)
Now we just need to choose a price that is below this two year projected value, above your option price of $225,000, and still a great deal for your tenant buyer. We recommend $259,980 for this house. (We could have been real aggressive and gone after a price like $269,980, but this is your first deal so we thought we would make it easier for you to sell. You can be more aggressive on the pricing of your next property!)
Next, we need to decide what rent to charge your tenant buyer. You start by charging the market rent. In this example the market rent is $1,500 so you start your rent for this property at $1,495 (which is the prettier way of writing $1,500.) Then you use an idea called ?rent credits? to bump up the amount of rent you are collecting. A rent credit is when you credit your tenant buyer with a portion of his rent towards his purchase of the property. For example, if your tenant buyer pays you $1,600 a month in rent you might credit him with $150 per month off the purchase price. This is your way of both helping your tenant buyer get a great deal and helping yourself get a larger cash flow out of the property. Remember, if your tenant buyer decides not to buy, you keep all the extra rent.
As for the option money you want to charge your tenant buyer, there is a simple formula that goes: AMAYCG. (?As Much As You Can Get!?) Typically you?ll collect between 3-5% of the value of the property as a non-refundable option payment from your tenant buyer. In our example you would be fine with an option payment of $10,000 (but wouldn?t complain if someone volunteered to give you $15,000.)
This is how you create your pricing for your properties. Ultimately the only way to know if your numbers are good is to have real buyers come through the house. If you aren?t getting people to say yes they want the property, there is something wrong with your pricing or the house shows poorly.
KEY POINT: Most tenant buyers are NOT buying price, they are buying monthly payments they can afford and an up front payment they can handle.
Now lets go back and learn how to talk through the numbers with your potential tenant buyers, John and Sarah. We are going to be using the sample ?Rent to Own? worksheet you see in Figure 5.6.
You the Investor: Do you know how the Rent to Own program works?
John: A little bit, could you explain it to us though.
Investor: Sure, you simply put down an up front payment which will all go towards your purchase of the house if you buy. Then you rent out the house. You have a set price you get up front that you can buy the house for at any point over the two year lease. It?s kind of a one sided agreement. I have to sell it to you at the agreed upon price but you don?t have to buy it. You have the option to buy or not buy. It?s up to you. Depending which option you choose, a portion of your monthly rent gets credited towards your purchase of the property. Did I make sense there Sarah?
Investor: OK, let me go through the pricing with you. The house is currently valued at $250,000. As you probably know, houses in this area have been going up in value at about 5% each year. If this house goes up at just this same 5% it will be worth $275,625 at the end of the two years. We set our price at below this to give you a large chunk of that future growth and to build in a profit for us as investors. Does that make sense?
John: Yes it does.
Investor: The price you have is just $259,980 which is over $15,000 less than the projected future value. You have three options to choose from. Option one is with a rent of $1,495. If you choose this option then none of your rent goes towards your purchase of the property. Option two is if you pay an extra $100 per month in rent, you?ll get $150 per month credited off the purchase price. Over two years that?s $3,600 of money being saved up to help you buy the house. And option three is for you to pay $200 extra per month. With this option you get $400 per month credited off the purchase price. Over two years that?s $9,600 credited towards your purchase. [Point to the Rent to Own Worksheet] How much up front money did you have to work with again?
Investor: Oh, $9-10,000?OK. [Using the Range Technique]
John: I guess we could manage $10,000.
Investor: Let?s just use that number for the moment as I go over how this works for you. As you can see your final price left to pay on option one is $249,980. Your final price left to pay on option two is $246,380. And your final price left to pay in option three is just $240,380. That?s over $35,000 less than the projected two year value! Did I explain that OK?
Investor: Well John, which of these three options is most comfortable for you?
John: Hmm? what do you think Sarah?
Sarah: I think we should choose the second option. I like the idea of the rent credit, but I am not comfortable paying more than $1,595 per month right now.
Investor: OK Sarah, how about you John?
John: I?ll go along with Sarah and choose option two.
That?s how you walk your tenant buyers through the numbers. When you are talking them through the numbers make sure you go slow and let them be faster with the math then you are. It is important that you maintain the good feelings you have worked so hard to create earlier in this process. We recommend that if you have a calculator handy, let them work the numbers (with you telling them exactly what buttons to push along the way!)
Here was a follow-up question that was posted to this message by ?Tim?:
I have a couple of questions on your techniques/methods.
- Do you always support offering the credits going towards the purchase price, and not the down payment?
Using your method of going towards the purchase price, you do get around the limits lenders might impose for above rent monies going towards the down payment; but you do risk the T/B’ers not having the down payment ready to go when it is time to excercise the option.
Do you change this depending on the T/B’ers credit check or discussions with them or do you stick to only offering the credit to the purchase price and not the down payment?
2) Your example is stating a 5% increase over the past 2 years for each year, yet for this example you are only going to set it up with a 4% total, which is really low compared to your normal figure you use after they complete their first deal. If someone dealing with a $100k home, and not $250k, your 1st time deal maker scenario looks like they will sell the house for only $4k more than they are buying it for over a 2 year period. I don’t want to even think about neighborhoods where the house values are only $50k.Have you considered adding wording to your chapter that the percentage is not cut and dry, or something to that effect? Just because the market is rising 5% each year for that neighborhood, there are no guarantees it will continue at that pace.
- Concerning question 2 above, given that 1st investor has finished their first deal, and now use your figures for 5% each year and set a price at $275k, have you added wording to this chapter about what happens if in 2 years the appraisal is only valued at $255k? What if the 5% that was going in that neighborhood, changes during the option period and is now only seeing a 1% increase each year, a flat period, or even a declining period?
Have you personally used your, past percentages for the neighborhood, to project the future 2 year price, and have to make a decision on whether to sell at the new appraisal price, or no deal is going to happen and you keep all monies collected thus far?
These are not meant to be critical of your methods, you write books, I don’t. But it is something I think should be mentioned and am curious to know how you, as an author, determine what to mention in your course and what to leave out.
Thank you for any replies you care to share.
Here was my reply back to Tim:
Thank you for your thoughtful response. You bring up a lot of good points.
First, ?rent credits? turn into additional down payment at the closing should your tenant buyer exercise their option to purchase. It?s just that if there is no closing (ie: they don?t exercise their option) then this extra is simply rent you get to keep?
(Be careful of calling anything with your tenant buyer ?Down Payment? because you want to make sure all the paper trail calls them a tenant on a lease hold interest NOT a buyer on an equity interest. The difference is that you EVICT tenants and have to FORECLOSE buyers.)
You are correct that if the rent credit given is not for rent paid OVER the market rent for the area they won?t allow it. That is exactly why we have our tenant buyers who want a rent credit pay ABOVE market rent for the credit. We haven?t had a problem with lenders for us giving a $400 per month credit for someone who paid about $200-300 over market rent. (Because market rent is always a RANGE and since we always start our Rent to Own properties at the HIGH end of this range lenders haven?t ever given us a problem.) If we were to offer a 100% rent credit obviously lenders would balk at this.
To make it easier for our tenant buyers when they go for their loan we photocopy and file EVERY check we get from our tenant buyer so we can help them document their loan application. Also, we have them work with mortgage brokers we have established relationships with to make it easier for them to qualify.
As for your comments about using a price that is only 2% higher than the current value. Obviously if the market will support it, I will ask for more. For example, on six of the houses I sold in San Diego over the last period of time, all of them were sold at prices of AT LEAST 7-12% over the current market value.
If you have a house that is worth100k and you picked it up for 100k, then you better be in a hot market or have the cashflow be great or something to make the deal good for you?
If I were negotiating on a 100k house in an average market, I would try to lock it up for 90-92k at the most? If I were negotiating in a bad market I would try to lock up the property for a price of much less. YOU NEED TO BUILD YOUR PROFIT IN WHEN YOU ARE BUYING. The good thing is that depending on the market you are in, motivated sellers will NEED to go along with this too.
If the market I am in is hot, then I will be much more flexible on price in exchange for better payment and longer term?Bottom line is that you need to build your profit into the deal WHEN you are BUYING.
You asked if I considered adding these types of considerations into the book and the answer is yes. I found it very hard to cut back on the volume of what I was writing, but I had a limited space to work with. (You can tell by the lengths of my post on this discussion group that I am a bit wordy)
Finally you asked what happens if the house only increases in value by 1% (to a value of $255k) what then? I can simply keep the tenant buyer?s option payment and find a new buyer. I can renegotiate the price with my tenant buyer. I can give my tenant buyer an extension. I have lots of options.
Usually I am very reluctant to simply kick my tenant buyer out (even if I legally can.) I just don?t feel good about this. If they have been good in the property I?ll typically just give them an extension on their term. (If they have been a bad tenant then I will simply get them to leave.) Example, I had a house in Colorado that I picked up on a 5 yr lease option for $130k that I sold for 160k on a 2 yr lease option. At the end of two years it was only worth $155-160 (not a great deal for my tenant buyer) so I gave them a 9 month extension on their lease option at the same price of 160k. They felt good, I felt good, seller never even knew the discussion took place.
You can do what some investors do and say you?ll get an appraisal down the road and use that for the price (with a min. price stipulated in the contract) or use some other method.
I gave you the cookie cutter we use on pricing about 90% or more of the houses we sell on a rent to own.
Again Tim, thank you for your comments and input. I enjoyed the thought you put into your questions. I wish you much success in your investing.