Real estate investors have many opportunities to invest in real estate and potentially earn a profit. Sometimes, though, you want that guarantee that you’ll be able to sell the home and have an exit strategy. While there are very few guarantees in real estate, a rent-to-own contract may be just what you need.
So what is rent-to-own, and how does it work?
What Are Rent-to-Own Homes?
A rent-to-own home is a home renters lease with the option to purchase it after a specified period. The own part of the contract usually has a two- to-four-year timeline, and the lease part typically requires higher rent than the market rental rate.
The extra portion of the rent goes to the buyer’s down payment if they purchase the home.
Types of Rent-to-Own Contracts
There are two types of rent-to-own contracts to consider: lease option contracts and lease purchase contracts. The main difference is in the wording and requirements each contains.
Lease option contracts
A lease option contract gives the renter the option to purchase the property at the end of the lease, but they aren’t contractually obligated to do so.
In exchange for the guarantee to buy the property, renters usually pay an option fee of 2% to 7% of the agreed-upon sales price. They also pay a higher monthly rental fee, or rental premium, which goes toward the down payment if they purchase the property.
If the renter chooses not to exercise the option to purchase the home, they forfeit the option fee and rent premium they already paid.
Lease purchase contracts
A lease purchase contract is similar to a lease option contract, but with more legal footing. Renters are obligated to purchase the property when the lease expires.
The contract gives the renter exclusive rights to purchase the property at the end of the term. And, as in a lease option contract, renters pay a rent premium that goes toward the down payment when they purchase the home.
If the renter doesn’t follow through on the contract, you keep the rent premium and have the right to sue the renter for breach of contract.
How Does Rent-to-Own Work?
Rent-to-own homes give renters more time to save for a down payment and get financing without risking losing the home they want to purchase.
Whether you choose a lease option or lease purchase contract, you typically agree on a sales price with the renter before signing the agreement. Most homeowners use a sales price higher than the current market value.
Instead, they base the sales price on the future value using past appreciation for the area. This ensures they get at least the current market value when the lease expires, and the renter purchases the property.
Throughout the lease term, renters pay a higher-than-market rent, called rent premium. The market rent is for the landlord to cover the property’s cost. The rent premium goes toward the down payment for the renter to use when purchasing the property.
If you enter a lease option contract, the option fee and rent premium go into an escrow account until the contract has been settled and the house sold.
At the end of the contract, the renter/buyer is responsible for having mortgage financing and purchasing the home. If they can’t follow through on the agreement, the landlord typically keeps the rent premium and option fee, if applicable.
Pros & Cons of Rent-to-Own Homes
As you can imagine, rent-to-own homes have pros and cons for buyers and sellers. Here’s what to consider.
Advantages for buyers
Buyers benefit greatly from rent-to-own contracts. Here are some of the top advantages:
- More time to save a down payment: Lease purchase contracts allow renters more time to come up with a down payment by paying a rent premium monthly. This allows them to “reserve” the home they want but take two to four years to come up with the down payment and purchase it.
- Time to improve credit: Renters who use the rent-to-own option reserve the home they want before they have the credit to qualify for mortgage financing. During the rental period, they can work on their credit to increase their chances of approval and better terms.
- Predictable payments: Rent-to-own agreements are typically longer than an annual lease. This gives renters more predictability and allows them to consistently save for the down payment.
Disadvantages for buyers
Like any real estate transaction, there are downsides to rent-to-own contracts for buyers to consider, such as:
- Higher rent: Buyers pay higher rent than the market average to save for the down payment. While this is a great way to save to buy a house, it requires a higher monthly payment, which can be hard for some buyers.
- The option fee is like a down payment: Buyers who want a lease option contract must pay an option fee that can be as high as 7% of the sales price. This is almost the equivalent of a down payment, and it’s nonrefundable if they can’t meet the contract requirements.
- Prices can decrease: There’s no guarantee home prices will remain the same or increase. Since you’ll typically agree on the sales price before signing the contract, buyers could be in a contract for a price higher than the current market value when it’s time to purchase the home.
Advantages for sellers
Sellers can benefit from rent-to-own contracts in many ways, including:
- Depreciation protection: Since real estate investors set the sales price for the home at the onset of the contract, they protect themselves from future depreciation. For example, if the contract is for $250,000 but the market price drops to $240,000, the renter is still under contract to purchase for $250,000.
- Guaranteed income: Real estate investors have a guarantee to earn income even if the renter doesn’t purchase the property. Sellers keep the rent premiums and option fee (if applicable) even if the renter doesn’t follow through with the contract.
- Less tenant turnover: Since rent-to-own contracts are longer term, real estate investors don’t have to deal with finding new tenants annually. This decreases the risk of losing money through vacancy.
- Renters have a vested interest: There’s a lower risk of damage to the property or excessive maintenance requirements, since renters have a high likelihood of owning the home. This may keep your costs of ownership down.
Disadvantages for sellers
To understand if it’s worth it, it’s important to consider the downsides of rent-to-own contracts for sellers, such as:
- Locked-in rent prices: Real estate investors risk losing money if the market rent increases significantly. Since you set the rent at the onset of the contract, you can’t increase the rent, even if the market rent goes up.
- Lack of use of equity: You may be unable to use the property’s equity for other real estate investments if there is a rent-to-own contract on it. Most banks don’t lend money on the home’s equity when there is a high chance the owner won’t own it in the next year or two.
- Legal complications: A rent-to-own contract is much more legally complicated than a traditional purchase contract. You’ll need the support of a reputable real estate attorney to handle the transaction.
Final Thoughts
Understanding what rent-to-own homes are and how they work is essential for real estate investors. You may consider it your exit strategy or want to use it to help potential homebuyers in the area.As with any real estate investing strategy, weigh the pros and cons, and consider how it will affect your overall investment to increase your chances of earning a profit.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.
