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October 19, 2013

Inside a property option deal

By EYNAS BRODIE

Property options; many of us have heard of them, few of us understand them. That’s partly because there’s a perception that they’re complex arrangements reserved for sophisticated investors and property developers, but that’s not always the case.

Put simply, property options are one way investors can secure an opportunity and achieve a profit without stumping up a large sum of money upfront.

A buyer strikes a deal with a seller, usually for the buyer to have the opportunity – but not the obligation – to acquire the seller’s property at some point down the track for a set price and under agreed terms and conditions.

And so it is for investor Peter Koulizos, the first Australian to take advantage of Property Options for Seniors, Pensioners and Investors (POPI). But here’s where this option deal starts to get interesting.

Through POPI, this South Australian TAFE property lecturer has secured the right to buy a house in Unley Park, arguably Adelaide’s most prestigious suburb, for a fixed price of $700,000 – today’s market value.

Normally, property options have a life of one to two years, but Peter doesn’t expect to exercise his right for another 15 to 25 years. And regardless of how much the market rises in that time, he won’t have to pay a cent more than the agreed $700,000.

On the other side of the transaction is a couple in their early seventies who own the house. Under the option agreement, they’re now receiving $250 in cash each week from Peter in a much-needed boost to their pension income, plus the peace of mind that they can stay in their home until their health dictates otherwise.

Not only that, but Peter has also wiped their credit card debt of $12,000 and given them an additional $2000 to clear other expenses, which actually entitles him to a $22,000 discount on the $700,000 price.

More on this later.

Before we take a closer look at the risks and rewards of this deal for both sides, let’s rewind a little…

HOW THE DEAL CAME ABOUT

Like many investors, Peter is signed up to receive regular email alerts from property portals with property listings that match his search criteria.

It was in one of these emails that he stumbled upon this property – a three bedroom sandstone bungalow on 600 square metres of land.

The Unley Park property front yard

The Unley Park property front yard

“I wasn’t interested in getting a $300,000 property because I can go to the bank and borrow the money and do that myself and the negative cash flow isn’t so bad,” he tells API. “But to be able to have an interest in a property in the best suburb in Adelaide and to be able to capitalise on all of that growth in the future for only $250 a week and I don’t have to go to the bank and borrow money and I don’t have any tenant hassles and I don’t have any interest rate worries, from an investor’s point of view that just seems fantastic to me.”

The property had been independently valued at $700,000. Peter undertook his own research of comparable sales to see how much room there was for negotiating and realised the asking price was fair.

“I actually think it’s worth a little bit more because I’ve seen what other properties have sold for, not just in Unley Park but even in that same street, so when they said to me $700,000, I said ‘yeah, that sounds good to me’.

“This is a blue-chip suburb so you may not have exponential growth in (some) years, but you’re also not going to go backwards.

“This is going to sound crazy for some people, but on average – not every year – but on average property has increased by 8.5 per cent per annum since World War II.

On average I would expect Unley Park to do similar. Now it won’t do that this year and it won’t do that next year, but there’ll be some years when it does 20 per cent or 25 per cent, just like any other suburb.

“I figure I’ve got an interest in a property in the best suburb, I’ve got a character property which is what Adelaide people love, a sandstone-fronted bungalow, it’s on a block of land which you can actually subdivide if you want. You can split it up into two 300-square-metre blocks, so there’s a number of opportunities for the property to grow in value, whether it’s a development site or whether it’s a character property for somebody to live in.”

HOW DOES IT WORK?

Property solicitor Sean Ryan is one of the masterminds behind this option arrangement, together with financial planner Brenton Harris. Here he explains the mechanics of how POPI works.

“On one side of the equation are senior homeowners who are asset rich and income poor. The second side of the equation is investors. The advantage of the scheme from the investor point of view is that those that might have hit serviceability levels or those that don’t have sufficient equity or can’t get into the market because they don’t have a deposit can access the market via the scheme.

We match them.

“We put them together and in simple terms the property investor pays a cash flow on a monthly basis to the senior homeowner and in exchange the senior homeowner gives the property investor the right to buy their property in the future but at a price agreed today.”

The option payment the investor pays to the property owner will depend on the property’s value.

“Every property is calculated separately,” Ryan says.

“To calculate the payment we model that property as though it was fully financed by the investor and rented. We plug in rates, taxes, rental yields, management fees, an assumed interest rate, and that spits out a figure. We apply a discount to that figure to calculate the POPI payments. We’ve got the ability to say to an investor ‘here’s what it would cost you per annum if you bought it outright fully financed and here’s what it would cost you under a POPI’.

“The big difference between the two is that under a POPI you put no capital in the deal, you’ve got no stamp duty cost going into the deal and if the market falls in five years’ time and you’ve bought direct and your circumstances change, you either hold on for the hard slog and wait for the market to move, or you liquidate.”

All going well for the investor, property prices will rise, leaving them in a profitable position when a ‘trigger event’ prompts the option to be exercised.

The Unley Park property backyard

The Unley Park property backyard

A trigger event occurs when the property owner either dies or chooses to relocate.

In Peter’s case, he doesn’t intend to hold the property after a trigger event occurs.

“I don’t want to buy it. It will go to auction, as most properties in Unley Park do, and they (the owners, or their estate in the event of their death) will take the first $700,000 because that’s what we’ve agreed the value is. And then I’m going to take the rest,” he explains.

WHAT’S IN IT FOR PETER?

For Peter, the benefit of this arrangement is that he has secured the right to buy a property in a blue-chip suburb where capital growth seems assured. So for the amount of $250 a week – or $13,000 a year – he’s effectively staking his claim on the capital growth the property achieves in coming years above $700,000.

Based on Unley Park’s 10-year growth rate of four per cent, according to Australian Property Monitors data, a $700,000 house could reasonably be expected to achieve a value increase of $28,000 a year. That represents a $15,000 profit in the first year Peter holds the option over the property, which will compound over time.

“I see a lot of capital growth in that particular area, so the longer the time period before I have the opportunity of buying it, the happier I’m going to be,” Peter says.

Of course, markets don’t always behave as we’d like them to. So in the event the market stays flat or deteriorates, what happens then?

Because Peter made a large lump sum payment upfront, he receives a five-year grace period (it’s normally three years) in which if a trigger event occurs in the first five years and Peter doesn’t wish to exercise his option to buy, he can walk away and recover the money he’s invested to date.

Ryan says it’s mandatory pensioners obtain independent legal advice beforehand to ensure they understand all the possible scenarios so they can proceed confidently.

“Like anything in the property market, the risk is that the market doesn’t move and you’re in the deal and you’re making your payments and a trigger event occurs.

So (for example) the pensioner passes away or relocates three years on and in that time the property market has been flat, so the choices for the investor at that point are firstly, to walk away and not buy; secondly, you buy which means you need to get funding; or thirdly, you execute the contract and sell the property on the open market which you can do because the investor gets full marketing control after a trigger event occurs; or fourthly, you onsell your option,” Ryan says.

He adds even if the investor gets the money they’ve invested to date back or part of it back, that’s better than walking away with nothing.

“You can also onsell the option before a trigger event occurs, so you could just ride the capital growth curve. Assume a trigger event hasn’t occurred and seven years down the track, the Unley Park property has moved from $700,000 to $850,000, and you think ‘you know what, I reckon that’s the best growth I’m going to get for a couple of years, I might get out now’. You can sell your option to somebody else and take your money out of the deal, having never bought the property.”

The senior knows from the outset that the option can change hands, Ryan says.

“From the senior’s point of view, the reason they don’t care is they have nothing to lose. The title doesn’t transfer.

If the investor refused to pay the option payments, there’s a really strict time period: 30-days notice and then another 30 days to remedy the default, so if you’re in arrears 60 days your option can be terminated by the senior, which means they keep all the money. They don’t really care if an investor transfers the option to someone else, as long as money’s coming through. They have to sell their property at some point in the future either when they die or relocate and for a fixed amount. But as long as they’re receiving cash, they’re living their retirement years in some comfort.”

PETER'S COSTS
Upfront POPI fee*$8,000
Pay out the homeowners' credit card debt$12,000
Additional assistance to the homeowners$2,000
Total$22,000
Fixed property purchase price$700,000
Less $22,000 discount$22,000
New fixed property purchase price$678,000
$250 weekly payments until a 'trigger event' occurs.$13,000/year
Based on the $700,000 amount the Unley Park property needs to appreciate by 1.85% in the first year for Peter to break even. His risk reduces as growth compounds over a longer timeframe, presuming the market doesn’t suffer a setback.
*The upfront cost to the investor is $8,000 or 1.1% of the price of the property, whichever is the greater.

Another advantage for Peter is the discount he has received on the $700,000 property price, in lieu of the $12,000 credit card debt and $2000 for other expenses he contributed upfront.

“The benefit is that he gets a greater discount on the purchase price than he would otherwise,” Ryan explains.

“The reason for that is that he’s in the deal for the long-term capital growth. He’s just dumped $12,000 into their pocket to get rid of their credit card debt and if they died next month, Peter hasn’t been in the deal long enough for the market to move so to reward his contribution, he gets some bonus on the purchase price (a $22,000 discount).”

SO, WHAT’S IN IT FOR THE SENIORS?

The advantage for the seniors is that they can convert future capital growth into monthly income while still owning the equity they’ve already achieved in the property. What’s more, that extra income they receive from Peter isn’t means tested by Centrelink, so if they’re on the pension, it isn’t affected.

Ryan says this is because it’s based on their principal place of residence, which is exempt from Centrelink’s income test.

A letter of ruling from Centrelink elaborates: “Under the income test, the ongoing option fee payments will not be considered to be income on receipt.

This is because the payments are in the nature of capital payments for the future purchase of the home by the option holder. However, while payments are exempt on receipt, where the person retains the payment, the continuing income and assets assessment will be determined by how a person makes use of the funds. For example, if the amounts are used to obtain assessable assets, the value of the assets would be assessed for assets test purposes in the same way as other assets are assessed.”

Ryan says this option arrangement helps seniors who have insufficient superannuation and insufficient savings to enjoy a better quality of life than what the pension alone can give them.

“We have an increasingly ageing population, many of whom are asset rich and income poor and frankly their number one asset is their home and predominantly it’s freehold, so they’re sitting on this whopping amount of equity yet they have to struggle on the pension and the pension is set across Australia.

It has no fluctuation based upon whether you’re in Sydney or in Tassie. If you’re on a single pension, you get $22,000 a year.

If you’re a couple on the pension you get about $33,000. Well that figure is the same whether you’re in Sydney or in Tassie and frankly our elderly are completely and utterly struggling.

“Their choices at the moment are that they continue to live and struggle and they’ve got no discretionary spend once they pay their cost of living, or they downsize in order to free up some capital, which our research shows they don’t want to do for a whole host of reasons.

They’ve lived there for years, their friends are there, they’ve got family close by, their doctor’s around the corner, they know the shopping centre, it’s familiar – a whole lot of reasons why people don’t want to relocate.

“Plus, if you’re downsizing, you obviously need to sell your house, pay your agent their commission, then you need to buy or rent somewhere else, so if you’re trying to free up some equity and you’re downsizing, inevitably you end up moving out of that suburb. The cost of downsizing is frankly prohibitive.”

WHAT STRUCTURE DO INVESTORS HAVE TO USE?

Peter uses his self-managed superannuation fund to administer the property option, but Ryan says it’s up to the buyer and they can use any structure that is normally available for a property transaction.

CAN ANYONE DO THIS?

While anyone can copy the intent of this kind of option arrangement, Ryan offers a word of caution. It took him and Harris four and a half years to sort through the red tape, consult with the Australian Securities and Investments Commission and receive rulings from Centrelink and the Australian Taxation Office (refer Product Ruling 2013/13).

About Eynas Brodie

Eynas Brodie is a journalist and former Editor of Australian Property Investor magazine.