Question - Lease Options versus Instalment Contracts

Hi tony

I was studying up on the week end about lease options vs instalment contract

I was wondering if you can shed some light on this topic

Personally I like the instalment contract idea because it's more concrete to the buyer

But from all the property online forums I have been reading, they all seem to prefer the lease options, and some "gurus" even don't recommend them anymore
mostly from what i can gather it's because it's much easier to evict if something goes wrong on a lease option compared to instalment contract
so all the major "gurus" are recommending lease options as the way to go

Do you see any major problems with instalment contracts going bad?

it would seem the main concern they have is in regard to equity in the deal from the tenant buyer point of view
eg it has been 5 years into contract ..they have paid off $40,000 and property has gone up $40,000...and now default
do they have any equity in this property?

thanks

Answer

Hi,

Lease Options versus Instalment Contracts is always an interesting topic of discussion. I can contribute these thoughts -

1. There is usually more up front money available from a purchaser who wants to buy a property now, under an Instalment Contract, than from a tenant purchaser who wants to rent now and buy later under a Lease Option. If you think of the up front money as security against a default, then Instalment Contracts usually win out because there is more money = more security.

2. In some states, such as in Queensland, Lease Options are commonly used, while in states such as NSW, Instalment Contracts are commonly used. I am not sure what to attribute this to, but it could be that home purchasers in Queensland are more 'try before you buy' than home purchasers in NSW who are more buying to later re-sell for capital gain. The retail confidence level might also provide an explanation - when economic times are buoyant, purchasers will prefer Instalment Contracts; when economic times are poor, purchasers will prefer Lease Options. In South Australia, Lease Options must be used because of a ban on Contracts where the price is payable by more than 4 instalments.

3. The Residential Tenancy Tribunal can be used to evict tenant purchasers under Lease Options. The procedure is cheap and simple, but not much faster than the Court procedure used for Instalment Contracts. There is a problem in Queensland, and in some parts of NSW that Residential Tribunals will not hear eviction cases where there is an Option attached to a Lease. In states such as Victoria, the Government has expressly given the Residential Tenancy Tribunal the right to hear eviction cases where there is an Option attached to a Lease. Evictions under Instalment Contracts are processed through the Courts, which is not cheap, but relatively smoother because the Courts do not have a hearing date unless the purchasers defend the claim - which they rarely do. There is always a hearing date in the Residential Tribunal.

4. Issues of equity in the property can be solved if they arise by cutting a cheque. Usually, the purchaser is substantially in default, and there is little equity if you offset the arrears.

Kind Regards

Question

How secure is a buyer in an instalment contract or a rent to own?

Buyers often ask - what happens if the owner defaults on the mortgage whilst an instalment contract or rent to own is current, can that buyer lose his money? Does he have security?

The buyer understands that the bank would have first bite as they have 1st mortgage, so the question is - what security does the buyer have?

Answer

The same answer applies regardless of whether we are talking about Instalment Contracts or Rent to Own.

The short answer is –

So long as the buyer makes the payments, the bank loan will be paid, because the buyer's payments are made into the bank account from which the bank loan payments are debited. There will be no default on the mortgage if the bank loan is paid.

The buyer should always secure their rights under the Instalment Contract by registering what is known as a Caveat upon the title to the property. A Caveat will protect the buyer by giving the buyer rights to the property immediately after the bank's mortgage.

The long answer is -

1. Provided the buyer is paying the instalments on time, then the owner has sufficient money to pay the mortgage on time, because these vendor finance arrangements are structured so that there is always more money coming in from the buyer, than money going out to pay the loan payments. Because there is money left over, there is no incentive for the owner not to pay the bank because that would ‘kill the golden goose’.

2. Because the instalments are usually more than the mortgage loan payments, the situation has positive cash flow, and so there is no contribution necessary from the owner to pay the mortgage loan payments. Contrast the situation of negatively geared properties, where the owner must contribute the shortfall between the rent and the mortgage loan payments.

3. If an owner becomes bankrupt, the owner’s financial affairs are in the hands of the trustee in bankruptcy. The Official Trustee in Bankruptcy usually takes no interest in the Instalment Contract or Rent to Own because they are considered as an asset of the bankrupt estate which they cannot sell. This is because the bank is effectively in control of the property by virtue of holding a first mortgage. Although bankruptcy is a technical default under a mortgage, banks are not known to rely upon this default to exercise their power of sale under the mortgage, provided the loan payments keep being made.

4. Banks do not like to call loans in default because they then need to provision the whole of the loan as a doubtful loan, and to reduce their profits by that amount. Calling a mortgage in default also means the bank will need to go through the mortgagee sale process for no reason, if the payments are being made.

5. As a practical matter, if the owner goes bankrupt and the bank wants the loan to be repaid, the bank will be prepared to offer a mortgage to the buyer provided that the buyer has demonstrated a good track record of payments and sufficient equity to support a loan, or when the buyer builds up that track record of payments and builds up equity – usually 12 to 24 months.

6. The buyer should protect their position by registering a Caveat on the title to the property, and should do so, so that when the bank searches the title the buyer's name will appear, and the bank can contact them. When a bank does so, it is often to put into place a direct debit authority from the buyer’s bank account to the loan account the bank has set up, directly, by-passing the owner.

7. Instalment Contracts and Rent to Own arrangements are only the 'first stepping stone on the path to home ownership', and the buyer will be expected to refinance within the banking system within 2 to 5 years. When the buyer does so, they eliminate their risk that the owner may go bankrupt.

Question - Flips and stamp duty

Hello.

In the near future I will be requiring your services. However I would like to ask when using the exchange of Contract in Real Estate transactions here in NSW. What are the provisions with Stamp Duty does it apply to the full sale price? I would like to start using this type of strategy of making quick cash. Who can I contact to find out more information and what forms if needed, will I need. Thank You.

Hope to hear from you soon.

Kind regards

Answer

Hi,

Stamp Duty is payable on Contracts for Sale of Land, calculated at the purchase price, as from the date of exchange of Contracts.

Therefore if you purchase the traditional way, using a Contract for Sale and sell the traditional way, using a Contract for Sale, then you will pay stamp duty on the first Contract for Sale and the purchaser will pay stamp duty on the second Contract for Sale, on the price.

The way to get around the payment of stamp duty on the first Contract for Sale is not to enter into a Contract for Sale. Instead, you enter into an Option to Purchase from the Owner - i.e. an option to enter into the Contract for Sale. Stamp Duty is payable on Options on the option fee paid, rather than on the price, and so the stamp duty payable is minimal.

To on-sell the property, you enter into a Sale Option, rather than a Contract for Sale, and nominate the purchaser to enter into a Contract for Sale directly with the Owner. Because there is only one Contract entered into, then only one lot of stamp duty is payable, and that stamp duty is payable by your Purchaser.

Kind Regards
Tony

Question - Can vendor finance be paid out early?

Can vendor finance be paid out early legally if vendor and buyer agree?

Answer

Hi,

Yes, vendor finance can be paid out early. At any time in fact, just like a Bank Loan can be paid out early. Often there are early repayment fees, if repayment is made not long after the vendor finance was entered into.

Kind Regards
Tony

Question - I have a tenant who wants to buy the house which has been for sale, but has not sold. How do I set it up?

Hi

I own a property in *****, NSW, which is currently rented. The tenant is keen to buy the property but can't get finance.

I'm keen to sell the property, which has a mortgage of about 180k (floating) and is worth 230-240k.

Can you please advise us the best option for me to sell it within one to two years time to the tenant?

The property is currently managed by a real estate agency, through which I try to sell the property recently without success. Do I have to pay commission on sale amount if I make a rent to sell agreement? I’m planning to stop the rental management by the real estate agency soon and manage it myself.

Your advice is much appreciated.

Thanks and Regards

Answer

Hi

Your proposal to sell the property to the tenant fits the Rent to Own vendor finance arrangement perfectly!

If you can agree on the following ground rules with your tenant, then I can prepare the legal documentation -

1. Why can't the tenant get finance? If it is insufficient deposit, then the tenant will need to put aside extra money each week to build up a deposit. If it is poor credit history, then the tenant will need to agree to be 'on their best behaviour' for 2 years to clean up their credit history.

2. To obtain bank finance, the tenant needs to build up the deposit money to usually 10% of the price by a combination of up-front money - a minimum of $5,000 paid to you (often it is $10,000), and ongoing payments of $150 to $200 per week (depending on how much needs to be built up).

3. The price of the house is set higher than today's value, to take into account increases in values over time. In your case, if you set it at 10% higher than today's value, then it will work out well if it is a 2 year arrangement.

4. The rent will need to be agreed and fixed for the term of the arrangement. Again, it will need to be higher than current market rent, in this case 15% higher is the appropriate figure.

5. The weekly payments are therefore the total of rent and ongoing payments. They can be paid to the agent, or via a direct debit system called ezidebit.com.au. If paid to the agent, the agent should reduce their commission from 7.7% to 4.4% because the amount payable is higher than the rent.

6. Whether you are liable to pay agents commission on the sales agency agreement if you enter into a Rent to Own arrangement depends on: (a) whether the sales agency agreement covers an option to sell, in addition to a Contract for Sale; (b) whether the sale agency agreement has expired; (c) whether you have terminated the sales agency agreement after it has expired; or (d) if you come to an arrangement with the agent to continue to manage the property during the lease option period (this is the best alternative!).

7. When you have the information, you should complete my Instruction Sheet - Lease Option. You will see that I call the up-front money "up-front option fee" and the ongoing payments "ongoing option fees" in the Instruction Sheet. Please also provide a copy of your current Residential Tenancy Agreement.

8. For further detailed information, go to the Rent to Own tab on the website.

Kind Regards

Tony

Question

Hi Tony,

I want to ask you something about vendor financing.

1) If I have a mortgage on a house and I wanted to vendor finance it, will the bank know about it, if they did find out the whole deal will fall through? Do I have to tell the bank that I intend to do vendor financing? The clients you come across do they mainly have their house motgage free before they do vendor financing?

2) If the wrappee wanted to put a caveat over the property the bank will find out, will they? What if the wrapees lawyer insist they caveat the house?

3) Say if I vendor finance a first home buyer will I have to pay capital gains tax at the beginning of the sale since it is a purchase and I am vendor financing the rest of the term?

4) Say if the wrappee is a first home buyer so I will get the first home buyer grant , do I still ask them for a deposit on top of that and how much percentage of the sale price do I charge them, if so?

5) How much is your fee for vendor financing?

Answer

Hi

The queries about vendor financing –

1) Almost without exception, the houses that are vendor financed have mortgages upon them. The bank usually does not care as long as their loan payments continue to be made on time. If the vendor finance transaction falls over, it does not affect the bank – it only affects you because you will have to pay the Bank out of your own pocket.

2) The purchasers’ lawyers often lodge Caveats against the property. The practice in NSW is that the Lands Office sends a Notice of Caveat only to the Owner and not to the Bank. The Bank learns of the Caveat when they carry out a title search of the property, which they do only if there is a default under their mortgage or if you ask to refinance.

3) The situation differs according to you circumstances. The tax determinations that you will find on my website – tab Tax Issues – state that if there is an enterprise, tax is paid on emerging profits (as received) rather than up front as a capital gain.

4) The First Home Owners Grant is accepted as part payment of the deposit. Therefore if the deposit is set at $20,000, then $6,000 is paid up front in cash and $14,000 comes from the FHOG, which is paid about I month after the purchasers move in.

5) My fee is $1,000 inclusive of everything (searches, GST), per transaction.

Hi Tony, a quick question

Background: Block of land going to be subdivided. House build on front section.

There is no impediment to selling the ‘house block’ on vendor finance terms, before the subdivision is registered.

Goal – wrap front house to then build second house and sell that.

Answer

Legally, you enter into the Wrap Contract, the purchaser moves in and make payments, in the normal fashion. What is different is that completion of the contract (the cash – out) is conditional upon registration of the plan of subdivision. Normally the Contract will provide that the plan of subdivision is to be registered within 6 months of exchange of Contracts.

The approval for subdivision is not received as yet?

To set this up, you should obtain advice from a local surveyor as to the feasibility and cost of the subdivision, and as soon as you exchange Contracts for the purchase of the property, engage that surveyor to prepare a plan of the subdivision suitable for attachment to the Wrap Contract.

Is it possible to wrap the house saying that wrap house and section only is on say 400sqm not 800sqm? Or can we just insert a clause in the Wrap Contract that states they are aware the land will be subdivide during a course of Wrap Contract?

You can either exchange WRAP Contracts for the sale of the house at the front, subdivide the land, and then either sell the land at the back, or build a new house and then sell the land at the back.