Are Rent To Own Deals Risky?

Rent to own is a great concept where a family wishing to buy a home is declined at the bank due to a number of reasons such as credit issues, employment, type of house or location. With no other options to buy besides coming up with a 25-35% down, they can enter into a rent to own agreement with as little as 2-5% down. They pay market rent plus an additional option credits to be applied to the initial down, and exit in a couple of years and be approved for a mortgage. The concept is simple, the investor holds onto the deposit as collateral, and they keep it when the tenant defaults. Simple right? Allow me to enlighten you on the other side of the fence.

Financial lending in Canada has changed greatly over the last five years with the departure of major sub-prime lenders such as GMAC, Accredited, HSBC Financial, Citi Financial, Wells Fargo just to name a few. Banks has also tighten up guidelines due to low interest rates making mortgage agents jump through more hoops for an approval. CMHC has pretty well hit their maximum lending cap and now the government has cut the budget even more making CMHC more discrete on whom to insure. As our Finance Minister capped all re-finance in Canada at a maximum of 80%, has opened the market to alternative lenders such a Home Trust, Equitable Bank and Optimum to scoop up new business, but that is changing. As defaults rise, so does the tightening of underwriting guidelines to protect the money. Another news that hit the mortgage industry lately is CMHC requesting the bank pay a deductible whenever a claim is placed. If the bank misrepresented the file, the claim is 100% denied and the bank bears the brunt of the default. The Canadian Bankers Association is fighting back because they know the banks bend the rules frequently when they compete with Mortgage Brokers, Credit Unions and Trust Companies. They rather keep that advantage with the banks to build bigger portfolio’s for shareholders. We are expecting banks to increase the decline rate for initial 5% down deal going forth. Speaking to Principal Brokers of major Mortgage franchises, they are seeing the steep rise of declines with 5% down that they never seen before.

So let’s go back to rent to own, does each deal pass scrutiny at the Banks? I was speaking to the Head of Escalation at Genworth and he told me 99% of all rent to own deals in Alberta was declined. HOS Financial was the first company to be approved, and after we spoke about why? He simply said it all in the contract but he thought we provided a valuable service in a time of place where banks are willing to take less risk and we are doing it through the private sector.  So let’s examine deeper into the reasons that kill rent to own deals.

1) Contracts – That state the Option Fee and credits are non-refundable. This is the instant deal killer because every insurance underwriter has a handbook on rent to own. Once they see non-refundable, it is an instant decline, I am seeing this now on our mortgage side with agents sending in rent to own deals that has gone to 6 different lenders with no success. The underwriter is so busy with new files, this is the excuse they were looking for so they can save time by not reviewing the file, banks are now requesting contract upfront to present to the insurance before committing on an approval. This is the number one rent to own killer.

2) Down Payment – If a client with a clean credit history of 680 beacon score gets declined by CMHC with 5% down, why would a exit rent to own client with equal 5% be approved? Answer is they never will. Speaking to a CMHC underwriter, I asked if any rent to own client ever got approved by an insurance with a low 5%, the answer was not recently. That is way too light for a client with previous credit derogatory. The underwriter commented if the client had 10-15% down, the file would be considered as long as the contracts conform to the rules. This is the number two killer.

3) Credit Issues – This is also a major deal killer because default rates on most rent to own deals reach upwards to 75% because the reason they are in this program was never resolved. Outstanding writs, collections and judgments is a deal killer. Anyone with a bankruptcy or consumer proposal must be discharged a minimum of 2 years and one year of re-established credit and reporting a minimum of two trade lines with balance of $1,500 or greater with no late payments. Even that is not true now, lenders are looking for at least 2 years of reporting or they consider that credit light.

4) Income Disclosure – This is very important factor, yet it doesn’t rank higher. Why? Underwriters can kill deals faster reviewing the above details that calculating gross (GDS) and total (TDS) debt service ratio’s. Most lender follow the GDS guidelines of 32% of the mortgage payment divided by gross income should not surpass 32%. The TDS is the mortgage payment plus credit payments divided by the gross income does not surpass 40%. The final ratio can be played according to the lender appetite but they generally follow this rule. This is a major reason why investors find themselves chasing for rent money due to NSF cheques and eventually experience a default with rent owning while the client does a midnight move.

5) Know Your Client (KYC) -. We see too many investors focus on returns and not the people that live in your home. Does the personality match? What type of people are they, would you allow them to live in your home if they were hoarders? The type of work they do? We saw a stay at home auto mechanic that left derelict cars all over the property. We saw one home with five Saint Bernard dogs that love eating baseboards and tore up all the lawn. Marriage breakdowns is a constant threat. From our history we found truckers seem to default at a higher rate than anyone else. An investor has to engage in profiling to make sure they are not punished on this particular deal.

It doesn’t matter if it is a sandwich lease, house first or a rescue re-finance, risk is always there. As an investor, it is up to you to do your due diligence in knowing where the risk are. It is not just simply buying a house and filling it with the first applicant off Kijiji, it is a lot more sophisticated because you will require a background in finance and mortgage lending and asking a friendly mortgage agent for advice sometimes invite huge disaster. There is many more reason how rent to own deals can derail that will cause investor grief and frustration, financial loss, and running for safety towards Buy and Holds, Multi’s and Mix-use Properties. That shouldn’t be so, no where else can an investor buy a home with a occupant intact. They pay you anywhere from 5-15% of the value as collateral, pay 30% or more above market rent and treat the house like their own. The utilities are paid by them and any upgrades to the home is on their own cost and not towards the investor. The investor has an exit strategy in three to five years, bound by contract, and enjoy a nice return of anywhere from 25% per annum and up. If the rent to own program is formulated correctly, the risk factor is very slim compared to buying a home and having a tenant pay rent with last month as deposit.

This is a great concept that is badly needed in this time of place and all investors should know if there is a solution, you can profit from it. Just do it right.

Guy Lew