Several years ago, I owned a couple of properties on a sought-after street in Georgetown, DC. When I put one of them on the market, I was presented with a lease to own proposal. It came from a nice, young couple who wanted the property but didn't have the down payment needed to qualify for a mortgage. They were professionals working at the IMF and World Bank and asked me to consider a lease option scenario, believing they'd have the needed funds in about two years. Their mortgage company required 20% down.
Frankly, I wasn't keen on the idea of such an encumbered offer for two reasons. First, because I didn't fully understand how rent to own agreements worked from the seller's side and secondly, because I wanted use the funds to buy a neighboring property I had been eyeing. I passed on their request and sold the home, after accepting a regular sales contract.
Now, years later, I find myself facing another lease to own consideration, but I still don't have a full grasp of pros and cons for an investor, so I set out to find out more. After searching around and reading several sites, I found straightforward explanations on Investopedia among others, and I want to share that information with you as we learn together.
How A Lease To Own Works:
A lease to own is a viable path to homeownership, for potential buyers who don't have the credit or funds to lock-in a mortgage right now but feel confident their financial picture will improve in the next two to three years.
For The Investor:
- You draft an agreement laying out all of the terms of the lease to own contract. The selling price for the home can be established when the contract is signed and is often higher than the list price. However, the selling price can also be
negotiated later, based on the current market value allowing you to increase the price each additional year they rent.
Example: The regular asking price is $295,000.
However, if your potential buyer purchases after the first year the property will cost them $300,000.
After the second year, $305,000 and after the third year the selling price may jump to $310,000. Again, increasing the price per year is optional.
For The Potential Buyer:
- Your potential buyer gets to occupy a property they could not otherwise afford right away. They rent it for a set period, solving their immediate housing need and may get to lock-in the final selling price up front.
What Is An Option to Buy?
- Before the end of their lease, the tenant has the option to purchase the property at the previously established price.
- You protect your interests, with a one-time, generally non-refundable fee called an option consideration, giving your tenant the right over any other potential buyer, to purchase the your property.
Can the Tenant Just Walk Away?
- It is important to note that generally your tenant is not obligated to purchase your property and can walk away from the deal at the end of their lease, usually forfeiting the option fee.
However, there are some agreements in some regions, which could obligate the tenant to purchase. You should be clear about your state regulations and agreement options, before entering into this type of potential purchase.
In fact, Investopedia goes on to make a great suggestion about having the contract vetted by a real estate attorney, before either party signs such an agreement.
How Does An Investor Set The Fee?
- One of the big questions that remain for the investor is how do I determine the option fee? While there is no set amount, it can typically go as high as 6 or 7%. That's 6% of the agreed-upon purchase price. Investopedia also notes that in some cases, a portion of that fee may be applied to the purchase price at closing. Keep in mind, that the terms are all negotiable with your potential buyer. But you have to be realistic and not greedy.
Let's look at the numbers from my Georgetown property. In that case, remember, the potential buyers didn't have enough money for the down payment allowing them to buy the property outright, so asking them to come up with 6%, could still be cost prohibited.
Back then, the asking price on the 27th street property was around $800,000, so 6% would require them to come up with $48,000 -up front. Now, even though it is significantly less than the 20% required by the mortgage company, it's still a huge chunk of change for a young couple trying to get their finances together. Some option fees are less than 3%, but again the terms are all negotiable and remember, that is a non-refundable fee.
Rent, How Does It Work?
- In many contracts, a percentage of the monthly rental goes towards to purchase price. Investopedia uses the following example:
*The rent is $1,200 with 25% credited ($300.00) back to the purchase price each month.
So, if the lease term is three years, the buyer will earn a $10,800 credit towards the purchase. You, the seller will be deducted that amount at closing.
To make up for that loss, the rent you charge per month may be slighter higher than the going rate.
Maintenance, taxes, insurance and any HOA fees or special assessments would also need to be negotiated up front. It is not uncommon for the rent to increase f 3-6% each year, to help cover costs.
Make Your Decision Wisely:
If your agreement does not obligate your tenant to purchase at the end of the contract, and they are unable to obtain financing, the option will simply expire.
Lease options can tie up your property and funds for a few years, so consult your team of advisors and a real estate attorney or experienced broker, before accepting this type of offer.
I don't regret declining the rent to own offer years ago, and I'm not sure if I'll consider one now, but many of my fellow investors offer them.