To wrap or not to wrap?
Recently there has been a significant increase in the number of people asking about the merits of "wrapping" properties.
Tuesday, October 16th 2001, 9:56AM
by Kieran Trass
This involves buying a property and then technically on-selling it to a tenant/purchaser on a long term settlement basis where the tenant/purchaser pays a "rent" equivalent to paying off the purchase price over a 25 year term at a rate of interest higher than you are paying to the bank.
The tenant actually signs a purchase and sale agreement with a settlement date able to be effected any time within the next 25 years (upon them paying the full balance owing to you).
Sometimes the tenant is also responsible for all outgoings like rates and insurance.
The purchase price is set at a predetermined amount and usually this price is above the current market value of the property.
Here is an example of a "wrap".
- Your purchase price $ 95,000 . Normal market rent achievable $180-/week.
- Your mortgage payment on a 25 year principal & interest term $161-/week (assume 100% funding @ 7.4% p.a. using equity in other properties)
- Your sale price to tenant/purchaser $120,000 (Nil deposit on a 25 year repayment term)
- Weekly repayment paid to you $222-/week (assume 100% funding @ 8.4% p.a.)
- Therefore you effectively have a surplus income of over $60 / week! And you will make a profit of $25,000 upon the eventual sale of the property to your tenant/purchaser!
- Your tenant/purchaser effectively builds up equity in the property by paying you weekly whilst you pay off your mortgage using the tenants payments to you. In the event of default by the tenant/purchaser they relinquish any rights to the money they have already paid you and it is treated as a rental income.
The theory is that you can effectively become your own bank and if you can build a portfolio of say 100 of these "wrap" properties then you have a surplus cashflow of $6,000 / week and you have created future wealth of $2,500,000 (i.e. $25,000 per property).
This makes "wrapping" sound like an easy way to become a millionaire but there are some potential issues…
How the banks feel.
Some banks I have spoken to are very concerned by the following issues:
1) You will draw up a legal document with your tenant which may affect the banks risk. Consider a worst case scenario where the tenant pays you say 20 months payments and then their lawyer finds a loophole in your legal contract (maybe a clause contravenes another law i.e. the credit contracts act) which entitles the tenant to recover any, or worse still all, payments made to you.
2) You are effectively financing (what the banks consider to be) high risk borrowers using an asset the bank has a financial interest in.
3) You could end up with a mortgage to your bank which is higher than what your tenant owes you to complete the purchase. This can happen in a few ways i.e. if you pay interest only on your mortgage but your tenant is paying you principal & interest. Or if the value of the property increases and you then increase your mortgage above what your tenant owes you.
4) If you default on your mortgage payment to the bank then the bank has to deal with the fact that the tenant may have the ability to "frustrate" a mortgagee sale as technically the tenant has a financial interest in the property too.
The banks are genuinely concerned about the legal complications (and potential implications on their lending risk) when you "wrap" a property.
I believe that borrowers have an obligation to inform the bank that they are entering into a contract for sale of the property (i.e. selling on a wrap basis) which may materially affect the banks security position.
How will you finance the "wrapping" of a large amount of properties?
Assuming you decide to "wrap" many properties you may then struggle to finance them.
Two main reasons come to light.
1) Serviceability of the mortgage - Banks are unlikely to recognise that you have a surplus income (i.e. of say $60/week per property) but instead will probably treat your income as rental income or worse still your main income and scale it back accordingly. This may not pose a problem if the bank base their serviceability calculation on the full rent amount you receive each week. But banks are likely to use the current market rental rather than the inflated rental you are receiving (which includes a portion of principal repayment to you). Sometimes banks will treat you as a full time investor and they will then require you to have a minimum surplus net income of $50,000 or more after all expenses.
2) Equity in your property purchases - You will need to input a minimum of 10% - preferably 20% (either cash or equity in other property/ies) into every purchase. So if you wish to quickly accumulate 100 properties worth say $100,000 each then you will need access to $1,000,000 of equity or cash. There is a theory that you simply revalue your properties , after 6 months of purchase, and then borrow more funds against any increased value of the property and use these funds as the deposit on the next purchase. If you are purchasing properties at values lower than the current registered valuation this theory can sometimes work but not if the values don't increase or if the values actually fall.
In addition to these two main reasons you may also find :
- Banks insist on charging you commercial interest rates i.e. @1% p.a. higher than normal housing rates.
- Banks may charge application fees up to 1% of the mortgage amount , again, citing the commercial nature of the transaction.
- Banks may lend a lower % i.e 70% or less of property values. This means you may need much greater equity to input as your portfolio grows.
The opportunity costs
- If you do become unable to fund further purchases then you will have effectively "capped" your long term profits and you may "paralyse" yourself financially in respect of growing your property portfolio.
If this happens after you have only "wrapped" a few properties the lost opportunities could be significant.
- Loss of focus on your property investment goals. In my years in the finance industry I have seen many "get rich quick" ideas and fortunately traditional property investment is not one of those ideas. In my experience the most successful property investors have a methodical and focussed approach to building their property portfolio using proven methods which create true wealth over a relatively long period of time. I am yet to see these investors adopting the "wrapping" method "en masse".
In summary the theory of "wrapping"
is quite simple but in practice the reality is very different.
Wrapping reminds me of "the hare" in the story of the
tortoise versus the hare … the hare starts quickly but then
has to rest whilst the tortoise slowly plods to the finish line
first.
Kieran Trass is a Director
of Mortgagenet (www.mortgagenet.co.nz)
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