As an Owner/Investor, should I consider a Rent-to-Own (Lease-Option)?
A lease with an option to purchase (lease-option, rent-to-own, etc.) can be a mutually beneficial situation for a property owner and a tenant. Like in most leases, the advantages and protections are weighted more heavily on the side of the owner however, there are reasons why a tenant would want to explore the lease purchase. For an investor, they are a great way of increasing cash flow and the return on your investment. The below video goes into depth on the topic, or skip below for a bulleted summary.
Basic Overview: A lease-option is a strategy used by investors to increase their cash-flow, their return, and be able to reduce their responsibilities with maintenance. It’s also ultimately a way to sell a property for more than market value, although most tenants on a lease option do not end up buying the home (90+%). If an owner/investor ever has plans to move back into the rental home, we do not recommend they do a lease option. Some investors are hesitant to do a lease option because they are concerned about the tenant actually buying, and losing their cash flow and long-term investment. For these investors we recommend structuring the lease-option to convert to owner financing (learn more) to further increase the return and long-term cash flow.
1) Upfront Non-Refundable Option Payment Tenants often times have a lot of cash and are not buying for reasons other than not having money in the bank (or under the mattress). Lease-Options require an upfront option payment (down-payment) that is non refundable in the event the tenant does not go through with buying the property. The amount is generally determined by the price point of the property, but ranges between $3-7K. With this in place, the investors revenue is dramatically increased by having an initial influx of cash from the start of the lease. In the unlikely event the tenant buys the property, this amount is applied towards the purchase price, or if owner financed, toward the down-payment on the financed loan.
2) Longer Lease The lease term on a lease-option agreement is set at a minimum of 2 years and typically no longer than 3 years. This reduction in turnover will further increase the return to the owner/investor. Since the tenant has much more at stake with a lease-purchase, there is a lower chance of tenant defaulting on their payments.
3) Higher Rent (can be) When a property can rent for $1,200, a strategy to increase this is to offer rent credits. Rent credit payments are similar to the non-refundable option payment, and are applied to the purchase price in the unlikely event the tenant buys the property. A way to structure rent credits with a $1,200 rental would be to increase the rent to $1,300 per month, but offer a $200 rent credit per month. Although on paper the investor is giving up more than they are gaining, chances are the tenant will never buy and the credits will not be refunded. The tenant will appreciate the generous credit and will help solidify the option. To compensate for this, the purchase price is also set high enough to cover any decrease caused by rent credits.
4) Push Maintenance onto Tenant Since the tenant is in a position of preparing for home ownership, the option pushes all maintenance responsibilities onto the tenant. Although landlord/tenant law will require the owner to maintain core functions of the property (roof, foundation, HVAC, etc), often times the tenant will maintain these simply because they are assuming their “ownership” responsibilities. This alone can dramatically increase the cash-flow and return for the owner/investor.
5) Set Purchase Price The purchase price is set up front and at a point that it covers the projected appreciation for the time frame (typically 3% per year), upfront option payment, any applicable rent credits (discussed below), and at a point where the investor can realize a profit. When the property is appraised at the time of the unlikely purchase, and the appraisal comes in higher than the purchase price, the difference is split between the buyer and seller. If it appraises low, the buyer must make up the difference.
Example: • House has an estimated value (market price) of $200,000 • A two year lease is written for $1,300 per month (market rent is $1,200) • Tenant puts $5,000 down as the option payment • Tenant is given $200 per month rent credit ($4,800 for 2 year lease) • Appreciation of 3% per year for 2 years ($24,720) • Minimum Purchase Price = $234,520 (today’s market value + appreciation + down payment + rent credits)
6) About 90% of Lease Options Don’t Ever Buy Most tenants simply never end up buying the property. This is the sad truth, but it is a reality. Although during the lease we have done everything we can in working with lenders, credit restoration, etc. behaviors are simply difficult to change. Generally the behaviors that caused them to not buy in the first place, are still preventing them to buy at completion of the lease. These types of tenants can further be great candidates as buyers on owner financing (learn more). When the tenant moves out, the property can then be leased out again with an option.
7) High Demand There are many tenants that want a Rent-to-Own lease. They are tired of being uprooted from schools, neighborhoods, etc. simply because the owner decided to sell, move-back, or move their friend in. Tenants who currently can’t buy (credit, self-employed) want to feel like they own, have stability, and are willing to pay for it.
8) Better Tenants Rent-to-owns by default attract a higher quality tenant since they have intentions of being more permanent in the community. They also have so much skin in the game (down payment, rent credits, etc) that they are far less likely to miss payments, pay late, violate the lease, etc. out of fear and the risk of losing their option.
9) Convert to Owner Finance Lease-Options can start out as a long-term lease, but often times they are converted early on or after the term of the lease to an owner financed purchase. The method is through a Contract for Deed, or Installment Sale Agreement. This type of sale can be a long-term investment for the seller/investor where they can generate even higher returns and cash flow. Learn more about owner financing, here.
10) Lower Commission on Sale (if buyer ends up buying) If the tenant does end up buying (the 10%), our commission on the sale is half what you would pay through a traditional sale. This will further save you money and increase your final return on your investment property.
Other Noteworthy Item a) The owner’s rights as a landlord are still very prevalent. Inspections and other important functions can still be performed as with a standard lease. Also, the tenant must still pay on time and abide by the same rules and regulations as with a standard lease. The Owner can still evict a tenant for non-payment, nuisance, etc. which all null and void the agreement and forfeit any rent credits or prepaid option payment.