When you are pricing your properties, it is important to balance your desire to make the most money possible and your need to keep a low workload.
What I 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, you lose out on part of your profit.
Here is the simplest way I know to explain exactly how you determine 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:
A few questions lowered the price $25,000
The house you are selling is valued at $245,00 to $250,000. The market rent for a four-bedroom house like this one is $1,500 per month. The area has been appreciating at between 4% to 5% for the past two years.
You agreed with the seller on a four-year lease option that you will pay a monthly rent of $1,400 and an option price of $225,000. In case you forgot how to get the seller to lower the price, here is how the conversation probably went:
Investor: What are you asking for the property?
Seller: $250,000
Investor: And what do you realistically expect to get?
Seller: Around $240,000
Investor: Oh, $230,000 to $240,000, okay.
Seller: Not $230,000; I expect to get at least $240,000.
Investor: Oh, okay. A question for you: If a real estate agent came to you and said she could guarantee you a sale at the full $240,000, would you let her sell it for you at that full $240,000 or you’d what, probably turn her down?
Seller: No, I guess I’d let her sell it just to be done with this.
Investor: Oh, that makes sense. Then her 6% commission would be…
Seller: Roughly $15,000.
Investor: Okay, 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!)
Determine your tenant buyer’s sale price
Let’s take this information and price 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 buying price, so that you make a healthy profit. In our example we are going to sell the house on a two-year lease option.
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 the current value of the property at the highest justifiable comparable property. In our example that means the current value is $250,000.
Projected value after two years of appreciation
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% and 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 lease option, 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.
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. I recommend $259,980 for this house.
I could have been really aggressive and gone after a price like $269,980, but this is your first deal, so I thought I would make it easier for you to sell. You can be more aggressive on the pricing of your next property!
Bump up the monthly rent with “rent credits”
Next, you need to decide how much 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 “rent credits” to bump up the amount of rent you collect. You will 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.
Collect a non-refundable option payment
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 from 3% to 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 price 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.
Talk the tenant buyer through the numbers
Now lets go back and learn how to talk through the numbers with your potential tenant buyers, John and Sarah.
Investor: Do you know how the lease option program works?
John: A little bit, could you explain it to us though.
Investor: Sure, you simply put down an up-front payment that will all go towards your purchase of the house if you buy. Then you rent 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?
Sarah: Sure.
Investor: Okay, 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. How much up-front money did you have to work with again?
John: $9,000.
Investor: Oh, $9,000 to $10,000–Okay. [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 okay?
John: Yes.
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: Okay, Sarah. How about you John?
John: I’ll go along with Sarah and choose option two.
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.
I 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!)