Buyer's guide to rent-to-own homes
Key steps to take and traps to avoid if you pursue this homebuying method.
In 2005 I became a landlord. A good friend and I began investing in single-family homes in the Midwest. We purchased two HUD foreclosures in 2005, and since then we've added three more HUD foreclosures to our portfolio.
When we advertise one of our homes for rent, we always advertise the property as a rent-to-own home, also called a lease option. We structure the agreement to allow the tenants to purchase the home within a specified period of time for a set price.
We've entered into several lease-to-own agreements with tenants, although we've yet to sell one of the homes to a tenant (more about that in a minute). This experience has taught me two things: Tenants make major mistakes when entering into a lease-purchase agreement, and some landlords take advantage of tenants who don't understand how to approach a contract for a rent-to-own house.
Because rent-to-own real estate is becoming more and more common, this article will identify tips on how to negotiate a fair lease option with a potential landlord and potential traps you should watch out for.
Lease Options 101
A lease-option, lease-purchase or rent-to-own home involves two agreements -- a rental agreement and an option to purchase the property. The rental agreement in most respects is a standard landlord-tenant agreement to rent the property at an agreed price for an agreed term. The option gives the tenant the right to purchase the property within an agreed upon time at an agreed price.
There are several reasons why a lease option may be an attractive way to buy a home.
- Lease options appeal to those who do not have enough for a down payment. Through rent credits (see below), a tenant can accumulate cash that goes toward the down payment. In addition, during the rental period, the tenant can save money above and beyond the rent credit to put toward the house.
- Those who have a low credit score can work to improve their FICO score during the term of the rent.
- A rent-to-own home gives tenants an opportunity to live in the home and get to know neighbors before committing to the purchase.
Of course, you don't have to rent a home with an option to buy to accomplish all of this. You can just rent a home in a neighborhood that interests you, save a down payment while you rent, and work to repair your credit score. But for those who do enter into a lease purchase, the above reasons are generally why.
You're buying it
Before we look at the key terms, there is one very important consideration to keep in mind. You should treat a lease-purchase property as if you are buying the home. It amazes me how some people will put down a lease-option fee and enter into a three-year contract having spent 10 minutes in the home. Almost without fail these people do not exercise the option to buy the home, instead moving on to another lease-option deal somewhere else.
The goal of a lease purchase should be that you eventually buy the home. While intervening events may cause you not to exercise the option, you should treat the transaction as if you will. So, what does this mean?
- You should inspect the home as you would with a purchase. Whether you hire a home inspector, have a friend or family member look at the home, or inspect the home yourself, you should look over the home as if you were going to sign a purchase agreement.
- Look for a home you actually want to own. Often tenants enter into a lease-purchase agreement because the home happens to be available, not because it's a home they truly want to own.
- Negotiate all the terms of the deal as if it were a purchase. And with that, let's look at the key terms of a lease option.
Rental agreement. A lease option is first and foremost a rental agreement. The key terms in any rental agreement are the rent and the term. In these deals, however, there are two key points to remember.
First, the rent should not be higher because of the lease-option component of the deal. You'll be paying an option fee that covers the value of your right to purchase the home. The rent is the rent. I've heard horror stories of tenants agreeing to outrageous rents because the landlord convinced them it was justified in light of the lease option.
Second, the term of the option should give you enough time to save up a down payment and repair your credit. If you know this will take two or three years, a one-year option is a waste of time and money.
If you are not sure how long it will take you to qualify for a loan, talk to a mortgage broker before entering the deal. A broker should be able to give you some idea of how long it will take to get your finances in order to qualify for a home mortgage. Generally, terms of two to three years are common for rent-to-own single-family homes in areas where we've purchased homes.
Lease-option fee (the 1% rule). The lease-option fee is the cost of the option to purchase the home. The option typically lasts for the length of the rental term. In other words, if the rental term is three years, the option gives you the right, but not the obligation, to purchase the home anytime during those three years. When you negotiate the option fee, keep three key factors in mind:
- The amount of the option fee (about 1% of purchase price).
- Whether the fee is refundable (generally no).
- Whether the fee applies to the purchase of the home (generally yes).
First, of course, is the amount of the fee. As a rule of thumb, 1% of the purchase price of the home is reasonable. The homes we rent range in value from about $130,000 to $175,000. The option fees we charge generally range between $1,450 and $1,950, which is slightly higher than 1%. However, we do not require tenants to put down a security deposit on a lease- purchase deal.
I've seen landlords ask for and get option fees as high as 5%. I suppose if they can get it, why not ask. But for a tenant, 5% is just too high in most cases. If a property owner is asking for 5%, negotiate or keep looking.
Second, recognize that option fees are nonrefundable. If you don't buy the home, the landlord still keeps the fee. In this way, a lease option for a home is similar to an option contract on a stock. The cost of the option is not refundable even if you chose not to exercise the option. As a result, you should think carefully about whether you really want to purchase the home and whether you'll have the financial means to do so during the term of the option.
Finally, make sure that the fee will go toward your down payment if you exercise the option to buy. While this is typical in my experience, you may find some landlords who seek to treat some or all of the option fee differently.
Rent credit. In most lease-purchase arrangements, the tenants receive a credit that will go toward the purchase price if they buy the property. While there is no universally agreed upon amount, 10% to 15% of the monthly rent seems to be a good rule of thumb for residential real estate. For a home costing $1,295 a month, for example, we offer a monthly rent credit of about $150.
The key is to make sure the deal includes a fair rent credit. The rent credit is an important part of the deal for tenants for at least two reasons.
- It reduces the cost of the home when you exercise the option.
- It can help you build up a down payment on the home.
Finally, we make the rent credit contingent on timely rent payments. If rent is late one month, the tenant loses the rent credit for that month.
Maintenance obligations. Recently, we've started shifting the maintenance obligations over to the tenant. This practice is not uncommon, particularly with land contracts or rent-to-own arrangements. From a tenant's perspective, taking on the responsibility of maintaining the property may seem like an unwanted financial risk, and to some extent it is. There are, however, some potential tax benefits of taking on this obligation (see below).
If you do find a landlord who wants you to assume the maintenance obligations and you're willing to accept this responsibility, here's a tip: Instead of taking on this responsibility on day one, consider delaying the transfer for six months. This gives you a chance to identify any latent issues with the home and to get them repaired on the landlord's dime. In effect, this gives you a six-month warranty on the home.
Purchase price. There are two big mistakes that many tenants make on the purchase price. First, they don't negotiate for a lower price. And second, they enter into option-to-buy deals where the price is not fixed.
Since we began offering our homes on a lease purchase, not a single tenant has tried to negotiate the purchase price. This is a big mistake. The purchase price is always negotiable on a lease-purchase deal, just as if you were buying the home outright. It's easy to research home values on the Internet. Begin with online home-value Web sites to get a rough guide. And then look at comparable homes that have sold in the last six months. Armed with this information, negotiate a fair price.
Whatever price you agree upon should be fixed during the term of the option. Avoid deals where the purchase price will be "agreed upon" later or based on some future appraisal. The option fee is paid in exchange for the right to purchase the home for a set price within an agreed upon period of time. If a landlord won't agree to a fixed price that is fair, look for another property.
Financing. It may seem odd to talk about financing since you won't need a mortgage unless and until you decide to buy. But my recommendation is that you talk to a mortgage broker BEFORE entering into a lease option. A good mortgage broker will give you an honest assessment of your chances of being approved for a loan during the term of the option.
$8,000 tax credit. As you may know, first-time homebuyers may qualify for a $8,000 tax credit if they purchase a home in 2009. In addition, a bill has been introduced to extend this tax credit beyond 2009. In the context of a rent-to-own house, the question arises whether you can qualify for the $8,000 credit in 2009, even if you haven't yet exercised the option to buy. The short answer is yes: Under certain circumstances a lease-option transaction may qualify you for this tax credit. Of course, you want to check with a tax specialist before making any decisions.
Here's a Q & A from the IRS on this topic:
Q. Can a taxpayer claim the first-time homebuyer credit if the purchase is pursuant to a seller financing arrangement (for example, a contract for deed, installment land sale contract, or long-term land contract), and the seller retains legal title to secure the taxpayer's payment obligations?
A. If the taxpayer obtains the "benefits and burdens" of ownership of a residence in a seller financing arrangement, then the taxpayer can claim the credit even though the seller retains legal title. Factors that indicate that a taxpayer has the benefits and burdens of ownership include: 1. the right of possession, 2. the right to obtain legal title upon full payment of the purchase price, 3. the right to construct improvements, 4. the obligation to pay property taxes, 5. the risk of loss, 6. the responsibility to insure the property and 7. the duty to maintain the property. (New 7/2/09)
You'll notice that No. 7 is the duty to maintain the property, which brings us back to the transfer-of-maintenance obligations. Of course, that's just one element the IRS considers, and as I noted earlier, you should consult with a tax specialist. And keep in mind that qualifying for the tax credit may require entering into a land contract rather than a lease purchase.
A lease purchase can be a reasonable way to purchase a home, particularly if you've recently been through a bankruptcy, have bad credit, or lack enough cash for a down payment. If you've ever purchased a home this way, please share your experience in the comments below.
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