There are typically two situations in which a homeowner decides to offer a rent-to-own deal to a tenant. The first occurs when the homeowner is unable to sell the property in a timely manner, and can’t afford to keep paying the mortgage without some level of assistance.
The second occurs when the landlord wants to get rid of an investment property but has a tenant and is in no rush to sell. If you find yourself in either of these situations, you too may want to consider offering your tenant a rent-to-own option.
While the term “rent-to-own” is pretty clear, do you fully understand how the process works? Most people don’t … so that’s fine.
If you’re looking for a precise definition, consider the following one offered by Brittany Foster of LawDepot.com. She does a good job of touching concisely on each important factor involved in the process.
“A rent-to-own property is a home that the owner leases to the tenant and that the tenant has the option to purchase at the end of the agreed-upon terms. The tenant is required to put down an ‘option fee,’ which is a percentage of the home’s value (generally between 2.5-7%) that will go towards the down payment at the end of the term.”
This should make it clear that renting to own provides the tenant with an opportunity to purchase the home at the end of the tenancy. The idea here is that, in addition to the fair monthly rent, the tenant pays a premium.
Sometimes called a “rent credit,” this premium ultimately goes towards the home’s down payment. In order to make the concept extra clear, consider a specific example.
Let’s say that John, the homeowner, decides to extend a rent-to-own option to his tenant Mary. At the beginning of the tenancy, the home is believed to be worth $200,000.
Both parties mutually agree that Mary should put down an option fee that’s equivalent to two and a half percent of the estimated purchase price. That means Mary hands over $2,500 to secure the option of being able to purchase the home when the tenancy expires.
In addition to her option fee, John also asks that Mary add $200 per month to the standard rent. So if Mary were currently paying $800 per month, she would now pay $1,000 per month. Each month, that $200 premium is set aside in an escrow account designed eventually to go toward the down payment.
If the agreement is designed to last for 24 months, Mary would have $4,800 — plus the initial $2,500 — accrued for her down payment at the end of the tenancy.
The important thing to remember is that each individual facet of a rent-to-own agreement may be negotiated. This includes the option fee, rent credit, price of the home, length of the lease, maintenance and repair responsibilities during the lease, opt-out clauses, options for extending the lease, and almost anything else.
It’s also in the interest of both parties to take into account the potential for changes to the home’s value. In a situation where the rent-to-own agreement is in place for three years, a lot can happen.
The home that was previously worth $200,000 could be worth $210,000 or $230,000 within 36 months. Although it’s less likely, there’s also the possibility that the value could fall to $190,000 or $175,000. You never know how the market will turn.
The Pros and Cons of Rent-to-Own Agreements
As with any real estate deal, there are potential pros and cons for each party. Start by looking at the agreement from the perspective of the tenant.
In most cases, a tenant chooses a rent-to-own option because he or she wants to be a homeowner, but isn’t currently able to buy, perhaps because of bad credit or a lack of capital.
By renting to own, the tenant is able to work gradually toward home ownership while building credit and setting capital aside in a safe place.
Tenants also find the rent-to-own option favorable because they can always walk away. There will likely be financial penalties for doing so, but the option exists.
The tenant is not legally obligated to purchase the property under a rent-to-own agreement. Most tenants do go through with the purchase at the end of the tenancy, but it can be comforting to know you aren’t contractually locked into the deal.
Finally, renting to own is advantageous for tenants who are new to an area. By renting for a period of time, they can learn about the neighborhood, schools, and other amenities before committing to a purchase.
There are also a range of pros and cons from the landlord’s perspective. Let’s start with the positive aspects. In tough real estate markets, landlords may find it easier to find a buyer through a rent-to-own agreement than they would using a traditional sales strategy.
It also allows the owner to keep a tenant (which means steady cash flow) since he or she doesn’t have to clear the house to put it on the market. Finally, many landlords like rent-to-own because it secures long-term tenants and encourages them to take better care of the property.
There are some potential disadvantages, however. Rent-to-own agreements are unilateral contracts. This means, as a landlord you are contractually obligated to sell the property to the tenant at the end of the agreement regardless of whether or not you change your mind.
As mentioned before, the tenant can decide to back out at any time. It’s also quite possible that the home’s value increases over time. This can be disconcerting to some landlords.
Green Residential: Professional Property Management
At Green Residential, we’re proud to offer honest and trustworthy property management services to real estate investors and landlords in the Houston area. Our locally owned, family-operated company has been in business for more than 30 years, and we take pride in helping our clients navigate the nuances of property management.
Whether you need help screening tenants, scheduling repairs, collecting rent, or crafting contracts, we can help. For additional information regarding these services and others, please don’t hesitate to contact us today!