Rent to Own and Lease With Option to Buy

This has always been a portion of the market, but right now, more and more people are emphasizing it, or at least the ones who are able.

Actual Rent to Own is rare these days, a sign that the market is being driven by sellers, selling to poorly advised buyers. I can't remember the last time I heard of one happening, because there is an actual ownership interest right away, and the buyer is entitled to a share of the money put into rent, whether or not the deal is actually consummated. On the other hand, Lease Option seems to be a common Idea of the Moment, because the prospective buyer basically gets nothing if they don't want to buy, or if they cannot qualify for the loan.

Just like any other purchase contract, everything about these is negotiable, but the basics are thus: Buyer and seller reach a purchase agreement, with the date of actual purchase delayed by some amount of time. In the meantime, the agreement is for for the buyer to rent the property, usually for an above market rent. Part of each payment gets set aside for the buyer's down payment if and when the option is exercised. The difference between Rent to Own and Lease with Option to Buy is that in Rent to Own, a part of each payment is actually due back to the buyer if they decide not to buy, whereas in Lease with Option to buy, that money is just gone if the option to buy is not exercised.

Why do this?

For the prospective buyer, it's a way to engage in forced savings for a down payment. If rent is $2000 per month, with $1000 being credited to the buyer and $1000 in rent, over a period of two years, you've got a $24,000 down payment, and this is treated exactly like any other down payment, except that the seller already has it, so you only have to come up with the purchase price less this down payment money. This is useful for people with rotten credit and/or poor savings habits, especially if credit is expected to improve within the time frame of the agreement. It's horridly inefficient, and I've never seen a residential situation where it wasn't better to buy outright, but if you have a problem qualifying for a loan or saving for a down payment, this is one way to go about dealing with that problem. With 100% financing currently dead except for VA loans and a few Municipal first time buyer programs that run out of money at warp speed every time they get a fresh allocation, this is one way for people to get their foot in the door of property.

For the seller, it's a way to create a captive purchaser. These buyers have rotten credit and/or zero dollars for a down payment. Nobody else can do business with these buyers, because the buyers will not qualify for the necessary loan. They have Hobson's Choice: This one or none at all. This creates bargaining power for the seller even in the strongest of Buyer's Markets, because most sellers in such markets do not have the ability or willingness to offer a Lease with Option to Buy. They're not as powerful as offering a Seller Carryback, but they definitely give sellers pricing power they would not otherwise have. You can get an above market rent and an above market price, to boot, and the prospective buyers are more motivated than your average tenant to take good care of the property.

So why isn't everybody doing them?

First of all, the reason the seller has the property on the market is because they want or need to sell now, not two years from now. With either rent to own or Lease with Option to Buy ("Lease Option"), they aren't getting any equity out of the property now to enable them to buy their next property. Furthermore, they've still got all of the expenses of owning that property. Finally, the reason that buyer can't buy anything else is because the most generous assessment of their financial skills possible is "Needs improvement." Bad credit does not, generally speaking, happen like a lightning strike out of a clear blue sky. It happens because they don't pay their bills on time. There are some exceptions - mostly people who had major unexpected medical expenses, but there are limits to how badly one account can hurt your credit. Chances are high that they'll be late with the rent - which is money you're counting on to pay your mortgage, your property taxes, your insurance, etcetera. It takes a certain financial solvency to be able to offer these. Not to mention that until the tenants exercise the option to buy, you still own that property, which means you've got all of the headaches and obligations of being a landlord, or you're going to have to pay someone else to take care of them. Repairs, maintenance, etcetera.

For buyers, the prospective pitfalls are even worse. First, you're paying above market rent and agreeing to a price that is usually significantly above the current market. It might be below market when you actually exercise the option, but right now, it's almost certainly a goodly premium over the price that you can get similar properties for - because they're offering something extra that most sellers are not willing or able to offer, and if you didn't need it, you wouldn't be willing to pay for it, right? If you don't exercise the option to buy, the extra rent money you fork out is basically gone. There has to be equity in the agreed upon sales price, and there has to continue to be actual equity. No lender in the known universe is going to approve a short payoff for a Rent to Own or Lease Option, no matter how ironclad your contract. If the current owners lose the property to foreclosure, you're basically SOL. And it wouldn't be the first time sellers pocket the rent while not paying the mortgage, or even taking a cash out refinance. I'm not certain what the law is on this point, but I don't see a way to keep the current owners from doing any of this if that is their intention. It's a good idea to record the option, but that doesn't mean anything if the lender forecloses or is owed more money than the strike price. You can sue, but suing broke people is throwing more money down a black hole from which you're not going to recover it. Finally, and here's the rub that kills a very large proportion of the prospective buyers who enter into these agreements: You're still going to have to qualify for a loan for the rest of the agreed upon purchase price ("strike price") before the option period expires. Usually the market goes up, but sometimes it does go down, and the appraisal is less than the purchase price. If you can't make up the necessary difference between the biggest loan you can get and the strike price, you're not going to be able to buy. For that matter, if interest rates go up significantly, you could find yourself unable to afford the payments on that loan. In fact, these two phenomenon usually go together. Rates go up, therefore payments and cost of interest on the same number of dollars rises. People in the aggregate cannot afford to pay as much for real estate as they could formerly, and therefore, prices fall. Basic economics.

There usually is a significant deposit made, as well. Not as much as a regular purchase contract, but just because there's a time delay involved doesn't mean the seller isn't going to demand a deposit they can keep (maybe), or rent to a tenant without a deposit. The rules on whether they can keep a tenant's Rent To Own or Lease/Option deposit are also somewhat different and more advantageous to the current owner than California's renter-landlord law generally is (Don't ask me for details - I'm not a lawyer. I'm mostly parroting what I've been told on this point).

The prospective seller is entitled to do all the due diligence than any normal prospective seller or landlord is, and ditto the prospective buyers/tenants. Personally, I would want that inspection contingency period to run the full duration of the option period, and there really isn't an effective loan contingency period, as the owners already have the prospective buyer's money, and most Lease Option contracts are pretty solid upon the point of not getting it back. This point is negotiable, but usually that money has already gone to pay mortgage, property taxes, etcetera. What did I just say about suing broke people?

Rent to Own real estate and Lease with Option to Buy real estate are always a risk for both parties. The tricks are myriad, at the very least. This is not something to try without a very sharp agent representing your interests, and as for dual agency in this situation, I have it on excellent authority that slow roasting yourself while basting with acid is less painful for prospective buyers. With that said, if the situation is right and both parties act in good faith, it can be a way to make both sides of such an agreement very happy, when otherwise they would both have been very unhappy because neither could get what they want. The seller gets an above market price, albeit delayed, and a much improved cash flow in the meantime. The buyers can buy property, where otherwise they would not be able to.

Caveat Emptor

Original article here