Brittany Foster | June 19, 2014
For individuals who are having a difficult time selling their home, finding a tenant who is interested in a rent-to-own property could be a valuable solution that may benefit both parties involved. In this post we’ll cover the benefits and disadvantages to both landlords and tenants of rent-to-own agreements.
What is a rent-to-own property?
You’ll notice that our residential lease has a rent-to-own option included, but have you ever wondered what that means?
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.
The tenant pays a fair price for monthly rent, but must also pay a premium called a “rent credit”. The rent credits are put towards the down payment at the end of the term as well.
Example: Greg, a homeowner, enters into a rent-to-own agreement with Betty, who will be his tenant. Betty puts down an option fee of $5000.00 to secure the option to buy the home when the agreement expires.
Based on other properties, and the home’s value, a fair monthly rental amount would be $1000.00 before rent credits. Because Betty wants to own the home at the end of the lease, she also has to pay in monthly rent credits to go towards her down payment. Betty and Greg agree that $200.00 is a fair monthly rental credit, so each month Betty pays $1200.00 to Greg—$1000.00 for renting the property, and $200.00 per month to go towards her eventual down payment for the home.
The option fee and rent credits are almost always non-refundable.
What can you negotiate in your agreement?
The biggest decisions that need to be discussed between the landlord and tenant are:
- Option fee
- Rent credit
- Length of lease (usually 1-3 years)
- Price of the home
Some other important things to remember to discuss are:
- Maintenance and repair responsibilities
- What happens if the value of the home changes significantly
- What will happen if you need to extend the terms
- Opt-out clauses
Who benefits from a rent-to-own property?
In the right circumstances, both parties can benefit greatly from a rent-to-own agreement.
Landlords that benefit from these arrangements are generally individuals who:
- are having trouble selling their homes
- already purchased a new home and are stuck carrying two mortgages
- need to own their home for a certain length of time
Because the option fee and rent credits are non-refundable, if the tenant decides not to purchase the property after the lease ends, you still benefit financially from the agreement.
Tenants who take on rent-to-own contracts tend to take better care of the home since it will be theirs in the near future.
Tenants that benefit from these arrangements include individuals who:
- have mediocre credit and cannot qualify for a mortgage
- don’t have enough employment history
- cannot save up a down payment large enough for a mortgage
The tenant has the opportunity to improve their credit or to gain further employment history. By the time the lease is up, the tenant should be in a good position to buy the home.
Not only will they have the necessary deposit covered (at the very least in part), but they will have already built equity in the home that they wish to buy without being penalized for poor credit history or lack of a down payment.
What are the disadvantages?
One of the most crucial aspects of a rent-to-own agreement between a landlord and a tenant is open and clear communication. Many conflicts can arise simply because of misunderstandings, assumptions, and unclear terms. Both the tenant and landlord should have a pristine perception of what the agreement covers, what it does not, and everything in between.
Some of the disadvantages to landlords include:
- tenants who don’t follow through by purchasing the property at the end of the agreement
- being stuck with a fixed sale price for your home, regardless if the market value increases
- having a tenant who breaks the agreement early on leaving you in your original position
Some disadvantages to tenants include:
- paying a higher than normal rent
- losing your option fee and rents credits if you decide not to purchase
- being stuck with a fixed sale price in a fluctuating market
In order to avoid some of these circumstances, it’s necessary for both parties to share their questions and concerns prior to signing the agreement.
What you should know
Before entering into a rent-to-own agreement, there are a number of things that you, as either a tenant or a landlord, should be aware of. In order to decide if a rent-to-own property is right for you, make sure to weigh all of the components to find a fit for your needs.
Higher offers. If, at any time during the rent-to-own agreement, another buyer comes along with a higher offer, the landlord cannot back out of the agreement with their existing tenant. A landlord is locked into the contract with the property’s occupant until the contract has expired.
Tenant obligations. Tenants have no obligations to remain in the home for any reason. Although they will lose their rent credits and option fee, they can end the contract at any point in time.
Late payments. Some contracts state that if the rent payment is made even one day late, the rent credit for the month has been forfeited. It may even be the case that the landlord reserves the right to evict the tenant if the rent payment is made late by one day.
Investors. Individual landlords aren’t the only ones who invest in rent-to-own properties. There are mortgage brokerages, real estate agents, and seasoned real estate investors that participate in rent-to-own opportunities.
- It is not guaranteed that the tenant will be able to qualify for a mortgage once the terms are over. It’s recommended that the tenant speak with a mortgage broker or their bank prior to negotiating the length of the contract so that they can get an idea of what they need to do and how long it will take to improve their situation.
- Sometimes, scam artists take advantage of rent-to-own homes and leave both the landlord and the tenant in a bad position. Make sure that if you are hiring someone to assist you, you research their credentials, talk to other clients, and have a solid contract in place.
The importance of a contract
Aside from discussing the terms between the tenant and landlord, it is equally crucial to have everything in writing. Although verbal contracts occasionally hold up in court, they are difficult to prove and hard to enforce.
Anything and everything regarding your agreement should be written up in a legal contract, revised by a real estate lawyer, and signed by both parties.
Without a signed agreement you risk more than just losing money. If you, as the homeowner, cannot pay your mortgage because your tenant left before the lease expired, you may be forced into foreclosure or even bankruptcy as you will likely be responsible for two mortgages.
As a tenant, you risk losing any equity that you have built and the home that you intended to purchase.
As with any real estate agreement, you should do your best to gather all of the information that you can before making a decision. Talk to other people who have participated in rent-to-own contracts, ask questions, and ensure that you are fully aware of the risks.
Have you ever participated in a rent-to-own agreement? Was your experience positive or negative? Share your thoughts in the comments!