Dec. 13, 2011
Each year, I end up having a number of conversations about renting to own. Renting to own is a situation where a buyer desires to rent a particular property, and then, at some point in the future, to buy that property from the landlord. Oftentimes, these queries are asked by people calling on listings asking if the seller would be willing to do rent to own. We'll discuss the competing factors that make these deals difficult to put together, and from there you can judge whether they make sense for you. Occasionally, I get calls from Landlords asking if they should offer rent-to-own, but that is less common.
I'm a Potential Buyer, and I Want to Rent To Own
Most people who are looking to rent to own are in situations where they can't buy today, but would like to in the future. Often, this is because they don't have the cash or the credit to buy, so the credit markets have locked them out. Let's look at the basics of a rent-to-own transaction, and what would be desirable from the Tenant/Buyer point of view.
Key Elements of a Rent-to-Own Transaction
Any rent to own purchase has four main components.
A) What the tenant will pay in rent during his stay
B) How long the tenancy is expected to last
C) What the purchase price of the home will be in the future
D) What happens to any escrow money
Let's look at each.
What the tenant will pay in rent during his stay
Most tenants know what this is. Rent payments! What they don't understand is that most Rent-to-Own agreements have rent that is ABOVE market rates. So if a landlord would normally rent for $1000/month, he might ask for $1200, $1400, or more in a rent-to-own situation. The portion of the rent that is "above market" goes into an escrow account - which we'll talk about in just a bit.
How Long the tenancy is expected to last
Typical rental agreements are month-to-month, or year long leases. But usually, people looking to rent-to-own are thinking about doing so in more than one year. This presents a problem for the landlord, and a similar one for the purchaser, as we'll see when we get to the next item.
What the purchase price of the home will be in the future
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Not Executing the Purchase in a Rent-to-Own Agreement
Could Wreck your Savings. Be cautious.
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Ok, here's where most of these deals falter. In order for these agreements to make sense for the purchaser, it is ESSENTIAL that they understand what their future obligations are. That means they need a contract that states when they'll be able purchase, at what price the home will be. That means both buyer and seller need to agree not just on the value of the home today - but how much the market will rise or fall in the future. If the landlord is optimistic, he might say that real estate will grow at 4% a year. The tenant might not be so optimistic, and say that the market might just grow at 2% a year. There are, of course, many other factors in the properties future valuation, but even a 2% difference on a $200K home over four years of an agreement results in a gap of $16,500 between the two parties. That's a lot of money for the tenant to come up with - and a lot of money for a landlord to walk away from. As a tenant, you're only other choice other than choosing the price in the beginning is to agree that you'll pay "market" at some point in the future, but how are you going to determine that? An appraisal? Real estate agents? Such estimates could differ by more than the $16K if you get more than one, and getting just one is risky for both parties. Not so simple!
What happens to any escrow money
Lastly, any escrow money that is accrued usually goes to the home purchase when the buyer purchases it. And that's great. But what happens when the buyer can't or won't purchase the property? In many agreements, the landlord keeps the entire escrow amount. Obviously, a tenant should keep his wits about him and get this part of the contract down cold, to protect his savings if his purchase wish doesn't materialize.
What Landlords Look for in a Rent-to-Own Transaction
Let's take a look at these items from a landlords perspective. If he's going to agree to sell the property to a tenant for price in the future, why won't he rent the unit at market price? Well, to rent at market he doesn't have to agree to selling the house, and the tenant is asking for an additional "compensation" in creating the option to buy, so the way most landlords are convinced is by charging a rent premium which they get to keep if the tenant doesn't purchase the property. If he's not doing such a thing, it makes no sense for him to "commit" himself to the buyer, and certainly not to commit to a price that could be too low in the future. Very likely, a landlord will insist on a hefty rent premium.
Let's take an example. Let's say our tenant has good credit, but no down payment. Today's value of the property is $200,000. Even FHA will require 3.5% down payment in today's market. That's $7000. So the buyer needs to save $2000/ year to have $8000 in four years. Now, the home will likely appreciate, 3% a year or so, so it'll be worth $225,000 four years from now. Luckily for the tenant/buyer, 3.5% of 225,000 is just under $8000. So here's how a deal would look.
A) Rent: Rent will be $800, + $167 in rent premium to be put in escrow for a total of $967 for four years, with rent (but not the premium), going up 3% a year for the four years.
B) The term will be four years,
C) at which time the buyer can purchase the property at $225,000.
D) The "rent premium" will be held in escrow, and will be given to the buyer at closing for his down payment on the property.
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Make sure you Understand
A Rent-To-Own Agreement-no matter
what side of it you're on.
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That's a fair deal for both parties, but there's still a lot of risk for both. What if the property is damaged and is worth less (it doesn't matter who does the damage, it's still an issue for the purchaser). What if the market goes higher for the landlord (he's leaving money on the table). What if the market goes down? (The tenant won't be able to get the property to appraise at the agreed purchase price, and may forfeit his savings).
The real question here is why doesn't the tenant just save the money on his own and then go to purchase this or any other property for $225,000 when he's saved it up his down payment? That's usually what ends up happening, and if you're a buyer, that's my recommendation. It insulates you from lots of risk, and protects your savings. If you can negotiate with a landlord who doesn't protect himself than I guess you could go ahead, but over four years he'll probably figure out he's got a raw deal on his hands - expect him to try to get out of it.
Where can I find Rent-to-Own Housing?
It's really a market you need to make yourself. I would look for rental property that you would like to rent, and possible own, and make the landlord an offer. You're likely to get a lot of "No, Thank You", but that's probably your best source. Sellers of residential property are a lot less likely to be interested in renting.
If I Still Want to Rent-to-Own my Next Home, What Should I do?
Make sure you have a property that you can protect and be excited about. Get your agreement in writing, and make sure that it favors you as much as permissible. Understand that any type of agreement that looks to the future has risk baked into it, and make sure you're comfortable with that risk.
Do Good Things Today!
Matt Heisler
*All information is posted in good faith and is assumed to be reliable, but may rely on third party information sources.
