What Do Rent-to-Own Homes Entail?

Real estate investors have many opportunities available to them for investing in real estate and potentially turning a profit. Sometimes however, investors need a guarantee that they’ll be able to sell the home at some point and have an exit strategy; although few guarantees exist in real estate investment transactions; rent-to-own agreements may provide just such assurances.

What exactly is rent-to-own, and how does it operate?

What Is Rent-to-Own Housing? A rent-to-own home is defined as any home rented with an option for purchase at some future time. Contracts generally span two to four years and the lease portion often requires higher monthly rent than the market rental rate.

Rents collected go towards their future purchase downpayment if they end up purchasing the home.

Rent-to-Own Contracts
There are two basic rent-to-own contracts to consider when looking at rent-to-own contracts: lease option contracts and lease purchase contracts. Their primary differences lie in terms of wording and requirements they contain.

Lease Option Contracts
Under a lease option contract, renters have the opportunity to purchase the property at the end of their lease agreement; however they aren’t contractually required to do so.

Renters wishing to secure the property by renting it often pay an option fee of 2%-7% of its agreed upon sales price as part of a guarantee to do so and an increased rental premium, which counts towards their down payment should they decide to buy.

If the renter decides not to exercise their option to purchase, they forfeit both the option fee and rent premium they already paid.

Lease Purchase Contracts A lease purchase contract works similar to a lease option contract; however, renters are legally obliged to buy the property when their lease comes to an end.

Contracts such as these grant the renter exclusive rights to purchase the property at the end of their term, similar to lease option contracts; renters pay a rent premium that goes toward making down payment when purchasing their home.

If the renter fails to honor his/her end of the agreement, you retain their rent premium and can sue them for breach of contract.

How Does Rent-to-Own Work? Rent-to-own houses give renters more time to save up for a down payment and secure financing without taking risks by losing the home they want to buy.

Before signing a lease option or lease purchase contract with a renter, typically an agreed-upon sales price must be established. Most homeowners use an estimated market value as their base sales price.

Instead, they base the sales price on future value using past appreciation in the area, to guarantee at least current market value when the lease ends and the renter purchases it.

Renters pay a higher-than-market rent, known as rent premium, during their lease term to cover costs associated with maintaining and operating the property while contributing toward their down payment when buying it in future years.

If you enter into a lease option contract, any option fees and rent premiums paid will be held in an escrow account until both the contract has been fulfilled and your house sold.

At the conclusion of their contract, renter/buyers are expected to obtain mortgage financing and purchase their home. If this fails to happen, their landlord typically retains both rent premium and option fees (if applicable).

Pros & Cons of Rent-to-Own Homes
Like anything, rent-to-own homes present both advantages and disadvantages to buyers and sellers. Here is what to keep in mind when looking at rent-to-own properties as an option.

Advantages for Buyers
Rent-to-own contracts provide buyers with many advantages. Here are just a few:

Increased time to save a down payment: Lease purchase contracts give renters extra time to save for a down payment by paying a rent premium monthly – giving them enough time to “reserve” the home they want and save up for it over two to four years before purchasing it outright.
Rent-to-own offers renters an opportunity to increase their chances of approval and secure better terms by giving them time to build credit during the rental period.
Rent-to-own agreements tend to last longer than traditional lease agreements, giving renters greater predictability in payments while giving them time to save for a down payment. But there may also be downsides for buyers:
As with any real estate transaction, rent-to-own contracts come with their own unique set of issues for buyers to take into account, such as:

Buyers pay higher rent than market average in order to save for a down payment, which requires higher monthly payments – something some may find hard.
The option fee serves as a down payment: Buyers who wish to enter into lease option contracts must pay an option fee that can reach as much as 7% of the sales price as part of the lease option contract requirements; it is nonrefundable should they fail to fulfill them.
Prices Can Decline: Home prices cannot always remain the same or increase, since contracts typically include sales prices agreed to before signing them, which might lead to buyers entering contracts at prices higher than current market value when it’s time to purchase their home. Advantages for Sellers
Sellers can take advantage of rent-to-own contracts in several ways, including:

Depreciation Protection: Real estate investors who set the sales price of the home at the outset of the contract protect themselves from future depreciation by setting it for an amount that’s comparable to its market price, such as $250,000 but then it drops down to $240,000; their renter will still have an agreement for purchasing it for that sum.
Guaranteed Income: Real estate investors have the security of guaranteed income even if the renter decides not to purchase the property they leased from them. Sellers keep any rent premiums or option fee (if applicable) that accrue even if they decide not to fulfill their contract obligations.
Rent-to-own contracts tend to offer longer lease agreements, reducing tenant turnover risks. By having less frequent vacancies on their books, this reduces vacancy risk significantly and saves real estate investors time and effort in finding suitable tenants each year.
Renters Have an Informed Vested Interest: Renters tend to reduce damage or maintenance needs because they have an increased chance of becoming homeowners themselves – helping keep costs of ownership lower for both parties involved.
Yet selling may also have disadvantages.
To assess whether rent-to-own contracts for sellers are worth their while, it’s essential to evaluate all of their risks, such as:

Locked-in Rent Prices: Real estate investors risk significant financial loss if the market rent significantly increases, since you set the rent at the outset and cannot increase it even if the market rent does.
Lack of Equity Use: You may not be able to utilize the property’s equity for other real estate investments if there is a rent-to-own contract on it, since many banks will not lend money against a home’s equity if there is a high probability that its current owner won’t own it in one or two years.
Legal Complications: Rent-to-own contracts are more legal intricacies than traditional purchase contracts and require professional help to complete successfully. Therefore, for this transaction to go smoothly you should seek guidance from an experienced real estate attorney.
Final Thoughts Understanding rent-to-own homes is essential to real estate investors. You might consider this an exit strategy or use it to assist potential homebuyers in your local area. As with any investment strategy, carefully evaluate all its possible impacts to increase your odds of making a profit.