By Anthony J Cordato © Copyright Sydney 2011
Contents
In this introduction, I cover why buyers and sellers choose to use vendor finance and how vendor finance has come to be used for the sale and purchase of real estate in Australia.
These topics are covered:
- Why do buyers choose vendor finance?
- How do each of the three forms of vendor finance meet buyer’s needs?
- Why do sellers choose vendor finance?
- How do each of the three forms of vendor finance meet seller’s needs?
- How has Vendor Finance been used for over a century for the sale and purchase of Real Estate in Australia?
- Illustrations of Vendor Finance
- Vendor Finance as an investment method
- Documentation for Vendor Finance
Why do buyers choose vendor finance?
Vendor Finance (also known as ‘seller finance’) is offered by a seller (a vendor) to finance the sale of real estate to a buyer (a purchaser).
Vendor Finance is often the first step on the path to home ownership.
The buyer who chooses vendor finance is usually looking for a home to live in, but can also be a business looking to buy a shop, factory or office for their business, or is looking to buy as an investor.
Buyers choose the form of vendor finance that meets their needs.
How do each of the three forms of vendor finance meet buyer’s needs?
Buyers have three forms of vendor finance to choose from, namely Instalment Sale, Rent to Own and Deposit Finance –
(1) Instalment Sale
- If the buyer’s needs are
to buy a home and be able to
move in straight away, then
an Own Your Home – No
Bank Loan needed
advertisement will appeal to
the buyer.
- In this case, the buyer
has chosen the form of
vendor finance known as the
Instalment Sale also
known as Terms Finance.
Instalment Sales are
documented in the form of
Instalment Contracts which are
also known as a Terms
Contracts. Instalment
Contracts are recognised as
legally valid throughout
Australia (except in South
Australia) and New Zealand.
- A buyer who chooses an
Instalment Sale will be
buying the property in the
usual way, with one
significant difference -
instead of the buyer needing
to look around for a bank
loan to pay for the price
for the property, the seller
finances the price for the
property along the same
lines as a bank would
provide. That is why it is
called vendor finance.
- There is no mystery
about the many reasons a
buyer might choose the
Instalment Sale form of
vendor finance. These
reasons include:
- having a deposit which is too small for a loan;
- not having a savings history with a bank for a loan;
- not having a permanent job for long enough for a loan;
- needing to have a job history of 12 to 24 months to qualify for a loan;
- being self-employed – running your own business;
- needing to re-establish after a financial set-back;
- needing to wait for 2 years to pass after a black mark has been placed on a credit file,
before being accepted as a good credit risk by the banking system;
- not liking the banking system – prefer to deal with someone they can talk to.
- The Instalment Contract
is mostly along these lines
- the buyer pays a deposit
and then pays weekly,
fortnightly or monthly
instalments to the seller.
The instalment amounts will
be set to pay the price for
the property over 25 or 30
years, just like a bank loan.
- The buyer is encouraged
to replace the vendor
finance by taking out a bank
loan at the 3 year mark
(rather than taking
advantage of the 30 year
term) because bank finance
will be cheaper. Vendor
finance is offered at a ‘low
doc’ interest rate which
means that the interest rate
payable is set at a 1%, 2%
or even 3% above the best
interest rate offered by a
bank for a home loan
product. The seller will use
the interest rate payable on
their mortgage over the
property as the benchmark.
- The great advantage that
a buyer has when choosing to
buy with vendor finance is
that the buyer can move in
straight away, compared with
buying in the usual way with
a bank loan, which can often
take two to three months.
- When the buyer moves in
under an Instalment
Contract, they become
responsible to pay for
council rates, water rates
and insurance, and also are
responsible for all
maintenance and repairs.
This is exactly the same as
buying in the standard way
with a bank loan. Usually,
the amount to be paid for
council rates, water rates
and insurance is calculated
and reimbursed to the seller
(because the rate notices
are issued to the seller)
and paid along with the
price instalments.
- There are embellishments
on this form of vendor
finance, such as U fix,
you own, U profit which
is suitable for 'handyman' buyers who
have trades skills and who
can renovate houses. They
trade their time and skills
for a price credit, which
works for buyer and seller
by improving the value of
the house.
- For more information on Instalment Sales go to the Instalment Sales tab
(2) Rent to Own
- If the buyer’s needs are
to find a home without
necessarily wanting to buy
straight away, but be able
to move in straight away,
then a Rent now, buy
later advertisement will
appeal to the buyer.
- In this case, the buyer
has chosen the form of
vendor finance known as the
Rent to Own. Rent to Own
is also known as Rent to
Buy, Rent 2 Buy, Rent 2 Own,
Rent and Buy and Lease
Options. Rent to Own is
recognised as legally valid
throughout Australian and
New Zealand.
- A buyer who chooses rent
to Own will gain the
advantage of living in the
home or operating the
business from the property
for a good period of time,
before committing to the
purchase of the property.
It’s try before you buy!
- There is no mystery
about the many reasons a
buyer might choose the Rent to
Own form of vendor finance. These reasons include:
- Low savings – insufficient to make up a deposit;
- The fact that the price is fixed up front;
- Not being sure whether they would like to live in the area;
- Not being sure whether the house is suitable;
- Need to establish a good track record of payments to prove eligibility for a loan, to
overcome black marks in credit;
- Need time to find a steady job;
- Need time to establish a steady business;
- Like the idea of not having to move, and making the same payments, for a period of
2 or 3 years.
- It is called Rent to Own
because it combines two
activities, namely renting
and owning. The renting part
is in a renting agreement
which is called a
Residential Tenancy
Agreement, and the owning
part is in an Option, which
is called a Sale Option.
- A buyer who chooses Rent
to Own finds it very easy to
understand the Rent
part because they are
probably renting already. So
they understand the renting
part and know what a
Residential Tenancy
Agreement looks like. What
also helps is that
Residential Tenancy
Agreements must be in a
standard form to comply with
Residential Tenancy Laws.
Note before these Laws, they
were known as leases, and
are still known as leases
for shops, factories and
offices.
- A buyer who chooses Rent
to Own finds it easy to
understand the to Own
part if they have rented a
TV or a motor car because
they work along the same
lines. The buyer rents for 2
or 3 years, then chooses
either to return the TV or
motor car to the person they
have rented it from, or to
pay what is known as the
residual to buy it. So if
the buyer chooses to hand it
back, they can walk away and
not be responsible to pay
anything more.
- The payments made under
Rent to Own are split into
normal rent payable under
the Rent part, and
the extra amount into what
are known as option fees
payable under the to Own
part. The total amount of
the payments is set
up-front, and so is the way
in which the payments are to
be split between the Rent
and the to Own.
- The payments which are
made under the Rent
part are rent. Usually there
is a small rental bond paid.
- The payments which are
made under the to Own
part are option fees and are
payable under the Sale
Option. This is the vendor
finance part. The Sale Option has
two kinds of option fees.
The first kind is the
upfront option fees, which
are paid before moving in.
The second kind is the
ongoing option fees, which
are paid over time. Both
kinds of option fees are
credited against the price,
if the buyer decides to buy.
The ability to credit the
option fees against a price
which is fixed up front is
the vendor finance. Because they represent
payment for the opportunity
to buy, they are not
refundable.
- Usually, the buyer is
given 2 years, extendable
for a further 1 year, to
decide whether to go through
with the purchase. At any
time, and definitely before
the end of this period of
time, the buyer must choose
to purchase or to move out
of the property. The buyer
need not wait until the end
of the period of time to go
through with the purchase -
what lawyers call exercising
the option - they can go
ahead at any time.
- The seller can help the
buyer to build up the
deposit by introducing price
credits for improvements to
the property. The
improvements are agreed and
the price credits are agreed
in the Sale Option. This is
called 'sweat equity' and is
a valuable part of this form
of vendor finance.
- For more information on Rent to Own go to the Rent to Own tab
(3) Deposit Finance
- If the buyer’s needs and
indeed desires are to buy a
home and be able to move in
straight away, and all they
lack is enough deposit, then
a House for Sale –
Deposit Finance available
advertisement will
appeal to the buyer.
- In this case, the buyer
has chosen the form of
vendor finance known as
Deposit Finance. Deposit
Finance is also known as a
Second Mortgage Carry-Back.
Deposit Finance is
recognised as legally valid
throughout Australian and
New Zealand.
- A buyer who chooses
the Deposit Finance form of
vendor finance will be
ready to buy the house –
ready in every way including
being able to qualify for a
bank loan straight away. All
that stands between them and
the house is that they do
not have enough deposit. The
seller is willing to bridge
the gap between the small
amount of deposit the buyer
has, and the amount that the
bank is willing to lend.
The gap is bridged as a
vendor loan. And that is why it is called
vendor finance.
- From this form of vendor
finance, the buyer must qualify
for the bank loan. The bank
loan might be ‘low doc’
which is up to 80% of the
value of the property, or
85% or 90%, or for
commercial property, 70%.
The bank will take a first
mortgage over the property
as security for the loan.
The buyer’s bank must not
object to the Deposit
Finance – buyer’s banks
object less if they lend no
more than 80% of the value /
price.
- The Deposit Finance is
documented by a Loan Offer,
a Mortgage and a Caveat,
which are standard loan
documentation used by
providers of Second
Mortgages. Usually the
interest rate will be the
same, or similar to the
buyer’s loan with the bank.
But the term of this vendor
finance will be shorter
– and the instalments will
be interest only, or
principal and interest, with
a balloon payment at the end
of the term.
- For more information on Deposit Finance go to the Deposit Finance tab
Why do sellers choose vendor finance?
The seller who chooses vendor finance is usually looking to sell their property for a better price than they are able to sell the property using the standard cash sale. Selling on terms therefore provides a better outcome than selling for cash.
Selling for cash means the sale of a property in the standard way, with a deposit of 10% of the price payable at the time the Contract for Sale is entered into; then waiting 30/42/60/90 days (depending in which part of the country the property is situated); until the remaining 90% of the price is paid – from bank finance. The sale is therefore dependent upon bank finance.
Selling on terms means the sale of the property on vendor finance terms, where the seller can mould the terms of the sale to fit in with the buyer’s needs. The vendor finance terms are set by the seller to suit the seller’s needs, as well as the buyer’s needs. Significantly, the sale is not dependent upon bank finance.
In short, by using vendor finance, a seller receives two benefits; the first is that the seller sells the property more quickly than if offered at a cash price because the property is attractive to more buyers, and because the price does not need to be discounted for a quick sale, because terms are being offered.
Sellers choose the form of vendor finance that meets their needs.
How do each of the three forms of vendor finance meet sellers’ needs?
These are the three choices, Instalment Sale, Rent to Own and Deposit Finance, that we have examined from the buyer’s point of view. We now examine these three forms of vendor finance from the seller’s point of view –
(1) Instalment Sale
- Sellers who offer vendor
finance by means of an
Instalment Sale, offer
buyers 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 buyer
has sufficient equity and a
good track record of
payments to refinance the
vendor finance with bank
finance and pay out the amount
outstanding under the
Instalment Contract.
Refinancing is also prompted
when a buyer wants to borrow
against the property to fund
an extension, a new garage
or a swimming pool. The
buyer may pay out the
Instalment Contract by
selling the property.
- Sellers who sell with an
Instalment Sale do so to
receive the price they want
for the property. With
Instalment Sale vendor
finance they do
not sell on the basis of
price; instead, they make
the price payment terms
attractive to the buyer.
They are willing to delay
receipt of the price. By
using vendor finance, they receive the
price they want to receive.
They are the opposite of
sellers who sell on the
price, and are often forced
to discount the cash price
for a quick sale.
- Other sellers who sell
with an Instalment Sale
do so because banks are
unwilling to lend much money
because the property is in a
small town or a rural area,
or because the property is a
shop, factory or office.
- Yet other sellers who
sell with an Instalment
Sale like the higher rate of return on
money invested that is
available when they, rather
than a bank, vendor finance
the purchaser.
- Selling with an Instalment Contract form of vendor finance means that the legal title to the property (i.e. ownership) remains in the name of the seller until the Instalment Contract has been paid out. This provides excellent security for a seller in the event of a default – better than a mortgage security which is what banks hold!
(2) Rent to Own
- Sellers who offer vendor
finance by means of a Rent
to Own, offer buyers the
opportunity to build up a
deposit and a good track
record of payments
sufficient to qualify for
bank finance within 2 or 3
years.
- From the seller’s point
of view, they are landlords
renting to the buyer. They
have the responsibilities of
landlords. But they have one
benefit that landlords do
not have, which is that each
payment made includes an extra
amount, namely option fees,
which will go a long way
towards covering the
shortfall between standard
rent and mortgage loan
repayments, and also fund
council rates, water rates,
repairs and insurance.
- Also from the seller’s
point of view the tenant /
buyers are likely to look
after the property a lot
better than if they are just
tenants, simply because they
picture themselves a buying
the property down the track.
They might even do their own
repairs and maintenance,
which tenants used to do
until the current
Residential Tenancy Laws
made this the landlord’s
responsibility!
- If the buyer defaults, the seller can use the Residential Tenancy Laws to terminate the Rent to Own arrangement.
(3) Deposit Finance
- Sellers are able to
offer Deposit Finance to
buyers who qualify for a
bank loan, but for some
reason or other cannot raise
enough deposit.
- Sellers who offer vendor
finance by means of Deposit
Finance, offer buyers the
opportunity to borrow the
part of the deposit that
they have not saved, to buy
the property.
- Selling with Deposit Finance means that the legal title to the property transfers to the buyer, and that therefore the obligation to repay the Deposit Finance needs to be secured over the property. For this reason, the seller in this case takes a mortgage security over the property to secure the vendor finance, which because it ranks after the first mortgage security that the bank holds, is called a second mortgage security. This is acceptable to the sellers because the amount financed is small, and should substantially represent the premium above the cash price for the property.
How has vendor finance been used for over a century for the sale and purchase of real estate in Australia?
Vendor finance has been used for selling real estate in Australia for a very long time. In fact, for long periods of time banks were reluctant to lend for residential purchases, preferring instead to finance business and investments because they offered better profits.
1870s – 1920s
In the land boom years of the 1870s and 1880s which were fuelled by the gold rushes and boom time exports of wool and wheat, property developers subdivided land for sale to meet demand. Some blocks of land were sold to buyers who build homes upon the land; other blocks of land were sold to property speculators who purchased the land for re-sale at a profit.
Then as now, bank finance was not freely available to buyers on vacant blocks of land, because banks were not comfortable with recovering their money if they lent on vacant house blocks of land.
Therefore, in the 1870s and 1880s, to sell their land property developers offered vendor finance terms which were typically ¼ of the price as a deposit, ¼ of the price after six months, ¼ of the price after 12 months and the final ¼ of the price after 18 months. Interest was payable at 6% p.a. on the outstanding amounts.
In the early 1890s, many banks collapsed as the weight of property speculation and the great drought took their toll. Variations appeared to the vendor finance model. For example, here is a plan of subdivision at Blacktown, near the railway station, dated 1895.
You will notice that the land is for sale, not at a price, but on vendor finance terms being a £1 deposit, followed by 24 monthly instalments of £1 each. The total terms price was £25 for the land, and it is safe to say that the cash price would have been less! But more importantly, the property developer was able to sell the land because they offered terms to suit the buyer’s pocket, in a climate where no bank loans were available.
1901
In Phillip Street Sydney, James
Edward Hogg authored a book on
Conveyancing Precedents and
forms for use in New South Wales
and other States and Colonies in
Australia. Included was a
precedent instalment payment
clause, which I reproduce –
Instalments. The purchase money, with interest thereon, or on the unpaid part thereof, at £-- p.c. p.a. from the – day of ---, shall be paid by – equal half-yearly instalments of principal amouting to £-- each, payable on the – day of -- & the – day of – in each year, the first to be paid on the said – day of --, with the addition to each instalment of the interest on the portion of the purchase money remainig unpaid, ….
Another precedent is for the conveyance of property following upon the exercise of an option to purchase contained in a lease – the title of the precedent is –
CONVEYANCE of a REVERSION
EXPECTANT on a LEASE to the
LESSEE, who purchases under an
OPTION OF PURCHASE given him by
the lease
1900 -1927
Between 1900 and 1927, the practice of selling land on vendor finance terms was widely used and accepted, with land in Sydney suburban locations such as North Sydney, Chatswood, Hornsby, Centennial Park, Randwick, Potts Point and Heathcote advertised for sale on terms.
The vendor finance terms were typically 1/5 th (i.e. 20%) of the price paid as a deposit, followed by 4 equal annual instalments of 1/5 th (i.e. 20%) each. Interest was payable at 5% pa on the outstanding amounts.
1927
With this high level of vendor finance activity, it is not surprising that the profits from vendor finance came to the attention of the Federal Commissioner of Taxation, and that a legal dispute arose.
In 1927, the High Court of Australia considered the tax consequences of two forms of Vendor Finance, in the legal case of:
The Federal Commissioner of Taxation -v- Thorogood
which is reported in: (1927) Volume 40 Commonwealth Law Reports at page 454.
The facts were:
James H Thorogood carried on the business of buying land, subdividing it into allotments and building houses on them, selling these as house and land packages.
Thorogood sold some house and land packages where he ‘funded’ the whole of the price with seller finance on terms consisting of - a deposit paid in cash which was paid to Thorogood, with the balance price payable by instalments over several years. These sales were documented by a Contract for Sale, which continued for several years, with Thorogood retaining the legal title to the property in his name until the Contract for Sale was completed by payment of the final instalment. Today these are known as Instalment Contracts.
Thorogood sold other house and land packages where he ‘funded’ a part of the price with seller finance on terms which consisted of - , the purchaser paying a deposit to Thorogood, an external financier funding a large part of the price secured by first mortgage, which was paid to Thorogood, with the balance of the price payable funded by Thorogood, who took as security a second mortgage over the property. These sales were also documented by a Contract for Sale which was completed in the normal time. Legal title to the property was transferred immediately to the buyer. 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 the external financier. Today these are known as Deposit Finance arrangements.
In both cases, interest was payable on the amount payable and owing to Thorogood.
The dispute:
The Federal Commissioner of Taxation assessed Thorogood to pay income tax on the whole price payable under the Contract for Sale in the year the Contract for Sale was entered into, even though in both cases, payment of part of the price was deferred until future years. Thorogood objected to the tax assessment and contended that he should only pay tax on the parts of the price for which payment was deferred until in future years in the future years in which payment was actually received.
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, and in particular, whether the taxpayer was in the business of providing vendor finance.
For our purposes, the important point is that the legality of both forms of vendor finance was accepted by the High Court of Australia.
For information on the current tax position, go to the Tax and Vendor Finance tab
1950s – early 1960s
- The use of vendor
finance continued to
fluctuate according to
social and economic
conditions and the
availability of bank and
non-bank finance.
- The supply of housing
real estate became scare
towards 1950, unable to meet
the demands or veterans from
World War II wanting to
settle down an raise a
family, as well as the large
numbers of migrants coming
to Australia wanting to do
the same. This drove up the
price of building materials
and housing, which
meant that saving the money
to purchase real estate
without borrowing was no
longer feasible. But who was
to provide the finance?
Answer - the vendor!
- In the 1950’s and early
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 usually provide loans
for the purchase of blocks
of land for housing.
- Therefore, in the 1950’s
and early 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
the terms finance form of
vendor finance. Once the land
was paid for, they would
borrow the money to build
their home from a bank.
- An example, here is a newspaper advertisement for the sale ‘off the plan’ of housing block land near Kiama south of Sydney, dated 1957, where terms were offered.
You will notice that terms
are offered over 3 years.
- In 1961, there was a
credit squeeze and many land
subdividers went broke,
leading to a tightening of
the law applicable to vendor
finance. Laws were passed in
many of the States to
restrict vendor finance. For
more information go to the
Laws tab – early laws
section.
- In the mid 1960s, the
Commonwealth Government
decided to make it easier
for banks to lend for
housing, and so bank finance
became more readily
available.
- These two events led to decline in the use of vendor finance.
1970s – 1980s
- In the late 1960’s,
1970’s & early 1980’s, home
builders became major users
of vendor finance to sell
house and land packages to
young couples.
- In those times, to
obtain bank finance to
purchase a home, a buyer
would need to demonstrate a
12 months savings record and
have a 25% deposit because
the banks would only lend up
to 75% of the value of the
home.
- Home builders therefore
sold house and land packages
on an Instalment Contract,
with payments mirroring a
bank loan. This enabled to
builder to obtain finance to
build from their finance
company. After twelve
months, the builder would
“cash out” the Instalment
Contract, by transferring
the Instalment Contract to
their finance company.
- Generally after twelve
months, the bank would be
satisfied that the payments
made by the buyer
constituted a satisfactory
payment/savings record, and
so might then provide
standard mortgage finance to
the Purchaser to pay out the
finance company.
- It is interesting to note that the NSW Department of Housing has had a policy to use the Instalment Contracts form of vendor finance to sell houses to its tenants since the early 1970’s, with 40 year terms on a 25% deposit being common. The same policy has applied in other States, such as South Australia.
Mid 1980s to date
- In the mid 1980’s the
Commonwealth Government
deregulated the banking
system, which resulted in an
influx of foreign banks
offering housing finance.
- From the mid 1990s until
the Global Financial Crisis
(the GFC) in 2008, non-bank
lenders, also known as
securitised lenders, sourced
loan money from the money
markets especially in the
USA and went from 0% of the
home loan market to 20% of
the home loan market.
- During this period of
between mid 1980’s to the
mid 2000s, increasing
availability of home loan
finance from the banks and
the non-bank lenders made
vendor finance shrink to a
rump of what it was. By the
mid 2000s, driven by
competition, loan finance of
up to 95% of valuation with
minimal savings record was
available to the employed
and the self-employed.
- In the 2006 Australian
Census, the Australian
Government Statistician
included Question 56 -
Q Is this dwelling: Being purchased under a rent/buy scheme?
A 1.2% of Australians ticked “yes”.
The answer to this question underestimates the houses financed with vendor finance because it is restricted to rent to buy and because rent to buy lasts a short time – often 3 years, and is used as a stepping stone to bank finance.
The question was repeated in teh 2011 Australian Census.
- The GFC has seen the
demise of the non-bank
lenders and Basel III has put
the shackles on bank
lending, leaving the 18% of
the lending market that the
non-bank lenders had
serviced, without finance.
- Some of this 18% of the
lending market will not
exist due to a decline in
demand for housing, but as
for the rest, represents an
obvious market for vendor
finance.
- In summary, there is an unsatisfied demand for vendor finance which has become apparent amongst buyers with low deposits, buyers who have their own business or trades and buyers whose credit rating is impaired, who do not qualify for loans from the banking system.
1 July 2010
- On 1 July 2010, the
National Consumer Credit
Protection Act came into
force. This Act is a
Commonwealth Act of
parliament, and consolidates
the laws governing consumer
credit in Australia. From 1
July 2010, ASIC (the
Australian Securities and
Investment Comission) is the
responsible governing body.
- This Act covers two
forms of vendor finance,
namely Instalment Contracts
and Deposit Finance. It does
so by making them explicitly
subject to the National
Consumer Credit Code.
- The act also provides
that
if a person is engaged in
the business of providing
these two forms of vendor
finance, they must hold a
National Credit Licence.
- For more information on the National Consumer Credit Code go to the National Consumer Credit Code tab
Illustrations of Vendor Finance
These three simple illustrations are of the three common forms of vendor finance. Assume a house is to be sold for $250,000, and is capable of being rented for $240 per week.
Illustration 1 – Instalment Sale
The house is sold on a deposit of $10,000, with the balance price of $240,000 vendor financed and payable by 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 buyer moves in immediately, also paying $35 per week to reimburse all rates and, insurances. The Buyer is also responsible for maintenance. This example is an instalment sales form of vendor finance because the price payable under the Instalment Contract is payable by instalments.
Illustration 2 – Rent to Own
A buyer rents the house at $260 per week for three years, at the same time paying a little extra ($125 per week) as ongoing option fees which is paid to the owner along with the rent. Over 3 years, the extra payments total $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% which is credited as paid towards the price of $250,000. This crediting is the vendor finance. Therefore, at the end of the three years the buyer is in a position to use external finance to pay the balance price of $225,000. If the purchaser requires further time, this can be given. This example is a rent to buy or rent to own form of vendor finance, documented as a lease with an option.
Illustration 3 – Deposit Finance
A buyer is given assistance to pay up to a 20% deposit of $50,000, by the seller giving deposit finance, with the balance funds (80% of the price) loaned by an external financier. The buyer 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 deposit finance form of vendor finance, which in this example is used to fund the payment of the deposit, documented by a loan offer and a mortgage.
Vendor Finance as an investment method
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 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:
- 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 Method for investing
Instalment Sale or Terms Finance, which is colloquially referred to as a “wrap” is a method 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” 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 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.
For further comments, see the Instalment Sales tab.
Using the Rent to Own Method 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.
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.
For more information upon Joint Venture Arrangements go to the Joint Ventures tab.
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. 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.
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 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 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.
