Land Contract Snag

by Rocket Finance

Most of you know that my family and I recently moved several states to the west. Our move took place rather quickly and now we find ourselves as the proud owners of an empty house in Wisconsin and as the recent signees of a twelve month lease in Colorado. Our finances are stretched as tight as possible, but with the help of a small raise and a similarly sized budget surplus from 2007, the situation will be tenable for six months to a year. Housing expenses are currently consuming seventy-five percent of our monthly income. Obviously we are doing all we can to sell our home. A month ago, I mentioned that I was considering a land contract.

After researching the concept, I met with the potential buyer and we began to discuss various scenarios of a rent-to-own arrangement. Rent-to-own or also known as a land contract can be a complicated venture. The basic principle around which they are based is that the buyer assumes all of the risk in exchange for the opportunity to purchase a home without a down payment. Typically the buyer is allowed to move into the property and pay rent with the commitment to purchase the home at a certain point in the future. Many times the owner agrees to apply a portion of the monthly rent check toward the purchase price. The risk comes from the fact that there is not a lot of protection for the buyer. The owner can re-take possession of the property at any time and if the buyer cannot purchase the home outright on the agreed upon date, he loses all of the previous payments and equity.

My discussions with the potential buyer broke down in one critical area: purchase price. The buyer wanted to purchase the house outright after leasing for three years, the problem was that he wanted to purchase the home in 2011 – for the 2008 price. Here is the set-up: he would give me a monthly rent check and take possession of the house. I would apply a portion of the check toward the total price of of the house (or the principal). In April of 2011, I would agree to sell him the house for the agreed upon price minus his payments toward the principle. The problem was that he would not allow for any appreciation of the house.

Let me demonstrate using fictitious numbers – the house is worth $150,000 in 2008. He makes monthly payments of which $100 is applied to principle each month. The contract then allows him to purchase the house for $146,400 in 2011. The problem is that houses almost always appreciate, even in a down market. In fact, in our area, the average appreciation per year is 5% to 8% – even over the last two years. So I proposed that we set a price that reflected an annual appreciation of 3%. Which would make the property’s value approximately $164,000 in 2011. The monthly principle payment would be subtracted from this amount meaning that I would commit to selling the house for $160,400 in 2011.

He walked.

Was my proposal unfair? Or did this post include too many numbers for you?

Photo by artsy_t

  1. 5 Responses to “Land Contract Snag”

  2. By fathersez on Apr 21, 2008 | Reply

    Ultimately the market price will be what someone else is willing to pay for it.

    So if this buyer walked, and if you think the price is fair, there should be other buyers.

    It may also be useful to input opportunity costs of the property lying idle.

  3. By rocketc on Apr 21, 2008 | Reply

    Good points. I have since decided to simply pursue selling the property outright and I have listed it with a realtor.

  4. By Four Pillars on Apr 21, 2008 | Reply

    Your offer certainly wasn’t unfair but obviously the buyer didn’t like it.

    I think selling it outright is the best thing to do.

    Mike

  5. By SBerc on Apr 22, 2008 | Reply

    The answer is not necessarily to sell it outright. This rent-to-own plan of yours can carry some weight, but just be sure to protect yourself and to cover all your bases with a contingency plan if this renter decides to walk in the middle of the agreement or if the market continues to get clobbered. A situation could arise where the buyer decides to take his loses from walking out of the contract but it would be better than his alternative.

    I find this predicament especially intriguing because it applies to the most basic economic principals: Supply and Demand, Equilibrium, and Opportunity Cost. To make the right decision, you must do a risk/reward analysis and have some foresight into the future of the housing market.

    First, take a look at the current housing market environment. People have realized that real estate has been appreciating at unprecedented levels. Ultimately, this is what caused the credit crunch. People started taking loans that were worth more than the actual value of their home. This has caused buyers to become very weary of the housing market and owners to panic and try to obtain liquidity by putting their houses on the market, thus creating a glut of supply. When the supply exceeds the demand, there is more competition which drives prices down. Eventually, once a fair and reasonable price is offered, houses will begin to sell again. Unfortunately, I do not foresee supply = demand happening in the near future because there is a steady supply of homes popping up on the market due to foreclosures and people who need to move (like yourself) are also adding to the supply.

    So what can you do about this? My advice is to sell ASAP (Remember: A dollar today is worth more than a dollar tomorrow) or consider a land contract, like you mentioned. In the next three years, I would not count on 5-8% appreciation due to the mere fact of the supply of houses currently on the market. The only chance would be if you are in an inelastic location (near a college, on the coast, etc) where the demand will not be affected by the health of the economy. Your opportunity cost is to continue to pay 75% of your income on housing vs. getting a lump sum of money today from a sell or payments in the form of rent that will help pay your current rent in Colorado.

    This is a buyers market so, unfortunately, it is hard for you to dictate terms of a land contract. Therefore, if you enter a land contract, you might consider having the potential buyer pay interest on the delayed principal of the home rather than charging 5-8% appreciation. The best option to protect yourself is to peg this interest to the 10-yr US Treasury Note on a monthly or quarterly basis. Doing so will protect you and the potential buyer in a good and bad housing market.

    The 10yr Note is often used by investors as a benchmark of the health of the economy and people usually flock to it in terms of uncertainty, often referred to as “a flight to quality.” If the stock market were to continue to fall, the yield of the note will go down, but the chances of the housing market continuing to be flooded with homes is high and it keeps the price of the home reasonable for the potential buyer. If the economy starts to recover, people will take their money out of Notes and put it back into the stock market and the yield of the note will increase, most likely to a yield between 3.5% – 4.5%. The buyer shouldn’t mind this proposal because he is also protected in a bad market and the yield of the 10yr not is not likely to exceed 4.5% anytime soon. This is not your 8% appreciation, but its better than nothing and I bet days of real estate appreciation like you have seen in recent years are gone for a while after the mess it has created in the credit markets.

    Doing this will take a lot of pressure off of your family’s income and it potentially creates a win/win situation for yourself and your potential buyer.

    Hope that is not too much information and that it will help you in your decision to sell/rent your home.

  6. By Deamiter on Apr 27, 2008 | Reply

    No, your offer wasn’t unfair, but I wouldn’t have taken it in these market conditions. There’s way too many people desperate to sell their houses right now, and as there are still many people who wish they COULD sell, but are waiting for prices to go up, buyers can still afford to walk away from deals that are merely ‘fair.’

    Unfortunately for you, it’s just how supply and demand works. I’m far from deeply knowledgeable (unlike the comment before me) but I suspect you’ll end up settling for just under your ‘fair’ valuation if you end up simply selling the house. Frankly, it’s not worth what you WISH it were worth, only what somebody’s willing to pay for it.

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