Becoming an energetic and persistent problem solver is crucial to real estate investing success. There’s the previously hidden plumbing issue that needs fixing now because the drywall guys are on site. Or the listed property with fewer-than-expected showings because some of the pre-rehab photos are still popping up online. Problem solving is a constant challenge.
I’ve found there are often several solutions to any real estate investing problem. Most of the time, the best solution is not the most obvious. With a little research, I can usually find a creative solution I’d not considered. And sometimes a multitude of problems can be fixed with one solution.
That’s how I stumbled on a real estate strategy called “Rent to Own.” I was facing several major problems with one of my properties. It was my first fix and flip. The rehab had gone fairly smoothly, but the sales process was not going well.
Buyers are much more critical against a rehab than a similar home that’s not listed as “rehabbed.” I found this out the hard way after rehabbing and trying to sell.
This particular rehab was substantial, but I didn’t build a new home! I redid the plumbing, rewired most of the electric and gutted and rebuilt a bathroom. It seemed, though, that buyers were expecting a new home. One buyer was scared away by an inspector who made an inconsequential and simple fix appear to be a potential catastrophe.
On top of that I was using a new agent who, as I soon found out, was not very detail-oriented, responsive or skilled in negotiation. And there was a limited pool of qualified first-time homebuyers where the property is located. (I knew this going in and had planned on a longer sales timeline. But with these issues, the timeline stretched even longer than I had planned.)
After seven months on the market and three contracts falling through, I’d had enough. I took down the listing and advertised it for rent.
As I was showing the house, a number of prospective tenants asked about renting to own. They had a sincere desire to buy a home but didn’t qualify for a mortgage for a variety of reasons. The top two reasons were:
They hadn’t saved enough for a down payment.
They were in the process of building their credit score. It wasn’t yet high enough for a traditional bank to give them an attractive interest rate.
At first, I responded with an emphatic “no.” I had no idea how to structure such a deal or what the benefits were to either party. But I was asked about this over and over again. So I took the hint that there seemed to be a real demand for this type of deal.
I decided to look into Rent to Own to see if there might just be something attractive in such an arrangement for me as a seller.
“Lease to Own,” “Rent to Own,” “Lease to Purchase” and “Lease with Option to Buy” all refer to the same thing. It is a home purchase arrangement in which the buyer agrees to lease for a set amount of time before exercising an option to purchase the property for a specified price.
Here’s How Rent to Own Typically Works
While it has more moving parts than a traditional mortgage, it’s not difficult to understand. It works like this:
Rather than rent the property outright, you advertise the property as Rent to Own once you determine:
The monthly rental fee and rent credit amount,
Lease terms and purchase date, and
A purchase price.
The buyer pays you an upfront option fee. This is a deposit on the property and gives them the option to buy the home. The fee, while negotiable, is typically 3% to 5% of the agreed purchase price. When they end up buying the house, the option fee is credited toward the purchase of the home. On a $150,000 home, for example, the option fee might be $6,000.
The buyer commits to a purchase deadline, which is typically two to five years. During this time, they’ll lease the property from you. The monthly rental payments consist of the fair market rental value plus an agreed additional amount. This additional amount is commonly called a rent credit. It also is credited toward the purchase price of the home.
Let’s say, for example, that similar homes in the area rent for $1,500 a month. You might agree to a rent of $1,750 a month, with $250 set aside as the buyer’s rent credit amount. This monthly rent credit accrues for the term of the lease. On a three-year lease, the buyer will have accrued $9,000 in rent credit. This accrued rent credit is added to the option fee ($6,000 in this example), and voila, the buyer has $15,000 saved for their down payment and can now qualify for a first-time homebuyer mortgage.
Advantages for Rent to Own Sellers
I can tell you from personal experience that a good tenant is a blessing. And a problem tenant will cost you time and money (and cause unnecessary frustration). A Rent to Own tenant wants to take good care of the property because they are planning on buying it. That makes for a better tenant and lessens the likelihood of tenant/landlord issues. Both you and the tenant are working toward the same goal: to transfer ownership of the property at the end of the lease.
Full Asking Price and a Higher Monthly Rent
If you don’t need to cash out immediately, the best way to get your full asking price for the home is with a Rent to Own contract. You’re offering a huge value: locking in today’s asking price for a future purchase and providing attractive financing to assist the buyer. So the buyer is willing to pay full asking price. And because you’re offering a generous rent credit, they are eager to pay a higher than average monthly rent as well.
Nonrefundable Option-to-buy Deposit
As the seller, you negotiate and receive an option deposit under a Rent to Own agreement. While this amount will be credited at closing to the buyer, it’s cash in your pocket at the beginning of the lease. If the deal falls through and the tenant/buyer never exercises their option to buy, you keep the deposit.
Larger Market of Buyers
I read somewhere that only 15% of those who are serious about home ownership can qualify for a mortgage. If true, that means that selling outright really limits your pool of buyers. While I’m not in favor of loose lending terms, there are good reasons some people just can’t qualify. Rent to Own agreements can greatly increase the number of prospects looking at your property. You are marketing your home not only to traditional buyers, but also to renters and investors.
No Sales Commissions to Pay
As the seller, you pay the commission due to both the buyer’s agent and the seller’s agent. Typically that’s a total of 5% to 6% of the agreed purchase price. So, if you’re selling a home for $200,000, you will shell out $10,000 to $12,000 in commissions at closing. If you use a realtor in a Rent to Own deal, you will pay a flat fee, typically $2,500 to $3,000.
Rent to Own Deals Take Less Time
With real estate transactions, you’re dealing with a lot of money, so time wasted is expensive. A typical real estate sale will take between 45 and 90 days to get from a written offer to the closing table. Until closing, all you have is an earnest money deposit while your property sits vacant.
With Rent to Own, you can get your buyer/tenant into the property in a week or less and start collecting rental income. It also means that someone is living on site who will watch and guard your home against fire, theft, vandalism and other potential threats.
Tax Shelter Stays Intact
Owing rental properties provides tax advantages including deducting property taxes, insurance and other costs from your rental income, as well as an annual depreciation write-off. Because you remain on the deed until the purchase option is exercised, you retain all of the tax benefits of ownership while your buyer/tenant is paying your mortgage.
No Maintenance and Repair Costs
Most Rent to Own contracts put the responsibility for repair and maintenance costs on the tenant/buyer rather than the seller. That means you won’t get those middle of the night calls about a clogged toilet.
No Costly Vacancies
No matter how careful you are when you’re renting a property, you will always have some vacancies from tenant turnover. In my area, tenants stay an average of two years. And there’s a minimum of one month in which the property sits vacant awaiting the new tenant. I’m still paying utilities, taxes and insurance all that time. With Rent to Own, there is no turnover.
Skip the “Double-Inspection” Nonsense
When one applies for a mortgage loan, the lender will send a representative to inspect the property. The inspection is certainly thorough. The lender wants to make sure there are no issues that will threaten the value of the property or the safety of anyone entering or living in the home. They want to protect their investment.
When a buyer submits an offer to buy, it is often contingent on a separate inspection by someone they hire. The intent is good. Check out the major systems before buying. Make sure the roof and basement don’t leak. Make sure the plumbing and electric are safely functioning. But the process can and does so easily go awry.
This inspection costs between $375 and $500 and includes a 40 to 60 page report. This report catalogs every little thing that isn’t perfect or might be a “future area of concern” on the property. Many things in the report are inconsequential things. These may include a small tear in a window screen or a slight crack in a ceramic tile that’s located behind the washing machine. These might turn into a “must fix or I’m not buying” proposition by the would-be homeowner who trusts the inspector as the expert and authority.
I have nothing against the good people who have chosen to inspect houses for would-be buyers, but my personal experience (and that of the other investors with whom I network) has been that these inspectors are often deal-killers.
In a typical Rent to Own agreement, the buyer is moving in before they buy. They get to try the house on for size. And when time comes for a pre-purchase inspection, they are more likely to rely on their lender’s inspection than hire and pay for an additional and separate inspector.
Cautions for Rent to Own Sellers
Frozen Rental Rates
Costs of most things increase each year. In typical circumstances, landlords can raise monthly rents to keep pace with cost of living increases and rising costs of doing business. In a Rent to Own lease, the monthly rental amount is typically frozen in time and cannot be increased during the term. So if the rental prices in your property’s location increase substantially, you could be leaving money on the table.
Of course the terms of any Rent to Own contract are whatever you and the buyer agree to. An annual rent hike can be part of the contract.
Frozen Purchase Price
Likewise, in most markets across the United States, real property values rise over time. In a Rent to Own situation, you, the seller, are agreeing to sell your home at today’s market value. If the market price appreciates during the lease and before the renter exercises their option to buy, that increase is equity that gets transferred to the buyer, not something you benefit from.
Unless you’re familiar and comfortable with the process, it’s advisable to get a real estate agent or attorney to draft and/or review all the legal documents before you enter into any agreements. Homes are bought and sold every day, but Rent to Own deals are less common so there’s more of a chance of something going amiss. Make sure you understand what’s in it for you as the seller, what’s in it for the buyer, have contractually included all the moving parts inherent in a comprehensive deal and are comfortable with all the terms of all the agreements.
Rent to Own is a real estate investing strategy that can be beneficial for both buyers and sellers in certain types of situations.
As the seller of a problem property that languished on the market for seven months, I was tired of paying holding costs — taxes, insurance and utilities — month after month. And I was leery of leaving the home vacant any longer. Vacant homes are targets for break-ins.
I was starting to look like what’s called a “motivated seller” — a target for opportunistic investors looking to close with low-ball offers. However, I didn’t want to sell for less than market value. I worked too hard to find and rehab this property to let it go for a song.
Rent to Own turned out to be an excellent opportunity for a young couple with three small children. And it was great solution for me. The family needed to move quickly, and I was anxious to fill the vacant house and start collecting rental payments to cover my costs.
We are finalizing the transaction now and it’s going really smoothly. In fact, the process has been amazingly better than any other real estate buying or selling experience in which I’ve been involved.
Rather than the adversarial relationship that usually exists between buyers and sellers, the negotiation has been a transparent and open discussion between the buyer and myself. There are no agents involved, so there’s no middleman to clog up the communication flow.
And because I don’t have to pay any sales commissions, I was able to give the buyer a better deal on the purchase price. Granted it’s my first deal with this sort of arrangement, but it really does seem like a win-win method of transferring real estate ownership.