In a traditional real estate purchase, the process works as follows: the seller accepts the buyer’s offer, they exchange funds and final costs, and the transaction is closed. However, not everyone is financially capable of buying a real estate property the moment he/she finds one. Usually, buyers take a mortgage to finance most of the purchase. There is an alternative option to buying a real estate property, though: rent to own agreement. But what is rent to own? How does it work? Are there any disadvantages related to it? Let’s jump right in!
What Is Rent to Own: The Definition
In the real estate investing business, rent to own – also known as a lease option or lease to own agreement – is an option that gives potential buyers the opportunity to purchase the real estate property later, based on a signed contract between them and the sellers.
Basically, the answer to what is rent to own is: it is a binding agreement between the real estate property owner (seller) and the tenant (buyer) in which the buyer is allowed to keep renting the real estate investment property for a set time period (usually 1-3 years) before actually purchasing the property and claiming ownership.
Upon signing the contract, the seller can’t place the real estate property back on the market for sale during the set time period and agrees to sell the investment property to the tenant when the duration of the contract expires.
Note: Some rent to own contracts give potential buyers the right – not the obligation – to purchase the real estate investment property at the end of the lease. However, if the wording is “lease-purchase” without the word “option”, then the tenant could be legally obligated to buy the investment property when the lease expires.
What Is Rent to Own: How Rent to Own Works
The process is not as simple as tenants paying rent for a set time period and then buying the investment property. Certain terms and conditions must be met, in accordance with the signed contract. The following are the key aspects of what is rent to own:
What Is Rent to Own: Option Money
In a rent to own agreement, the potential tenant pays the real estate property owner a one-time (usually non-refundable) lease option fee called option money. This fee gives the tenant the opportunity to purchase the property in the future. There is no standard rate for the size of the option money, and it can be negotiable. Typically, it ranges between 2.5% and 7% of the real estate property’s purchase price.
In some (but not all) rent to own contracts, all or some of the option money is considered a portion of the purchase price when closing the real estate investing transaction. In this case, if a home has a purchase price of $200,000, for example, and a 7% option consideration, the buyer would only need to pay $14,000 up front, which is a lot less than the $40,000 (the size of the standard 20% down payment) he/she’d have to pay in a traditional purchase.
What Is Rent to Own: Purchase Price
The contract specifies when and how the purchase price of the real estate property will be determined. In some cases, the buyer and the property owner agree on the purchase price when signing the contract. In other situations, the buyer and the property owner agree to determine the purchase price after the lease ends, based on the fair market value at that point in time. Many potential buyers prefer to “lock in” the purchase price if possible, particularly in real estate markets where investment properties prices are increasing.
What Is Rent to Own: Rent
During the terms and conditions of the rent to own agreement, the potential buyer/tenant pays the real estate property owner a specified amount of monthly rent. In some cases, a portion of each monthly rent payment (called a rent credit) is applied to the purchase price. For instance, assume the contract states that the tenant will pay $1,200 monthly rent, and 25% of that will be credited to the purchase price. If the time period of the lease option is three years, then the tenant will earn $10,800 rent credit to apply toward the purchase price ($1,200 x 0.25 = $300 per month; $300 x 36 months = $10,800).
Related: How to Set the Right Rent Price for Your Investment Property
Oftentimes, this makes the monthly rent payments slightly higher than with regular rental properties. For the buyer, rent payments act as down payments on the real estate property. As for the property owner, they act as compensation for taking the real estate investment property off the market.
What Is Rent to Own: Maintenance
Depending on the contract’s conditions, the tenant may be responsible for maintaining the property and paying for any repairs, property taxes, and insurance. However, the seller may choose to cover taxes and insurance costs as he/she is still the owner of the real estate property and is thus ultimately responsible for these costs.
Real estate investors need to ensure that maintenance and repair requirements are detailed in the agreement. Maintaining the property such as mowing the lawn, raking the leaves, and cleaning out the gutters is very different from replacing a damaged roof, for example.
What Is Rent to Own: Purchasing the Property
If the tenant or potential buyer decides not to purchase the investment property (or is still unable to secure financing) at the end of the lease, the option expires. The tenant loses the option money and any rent credit earned at that point. Moreover, if the tenant/buyer is obliged to but can’t purchase the real estate investment property, the property owner may initiate legal actions.
On the other hand, if the buyer wants to purchase the property, typically he/she applies for financing (a mortgage) and pays the seller in full. As mentioned earlier, a portion of the option money and rent payments may be deducted from the purchase price. Thus, the transaction is completed at the closing, and the buyer becomes the owner of the real estate property.
Related: Is Mortgage the Best Way to Finance Rental Property?
Rent to own is increasing in popularity and becoming a much-favored option to buy investment properties in today’s real estate investing business, mainly due to the strict requirements from many banks, which make it difficult for some real estate investors to afford a mortgage loan. Now that we’ve covered what is rent to own and how it works, let’s explore its advantages and disadvantages to both sellers and potential buyers.
What Is Rent to Own: Advantages to Tenants/Potential Buyers
Equity Growth: The rent to own strategy allows tenants to save up enough money and pay towards the down payment for the purchase price of the property through part of the monthly rent payment.
No Competition: As the seller can’t place the property on the market for sale during the set time period of the lease, tenants ensure that no one can compete with them for the ownership of the property, which further means that the price won’t go up.
Control of the Home: Tenants or potential buyers have total control over the real estate investment property while paying monthly rent. This gives them the opportunity to check the property, what needs to be changed, what improvements are needed, and so on before buying and owning the property.
What Is Rent to Own: Advantages to Owners/Sellers
Option Money Fee: This fee is, as mentioned earlier, non-refundable in case the agreement is broken, or potential buyers change their minds. Additionally, this fee allows the property owner to make a profit when the tenant first moves in, then enjoy the monthly rental income (which is higher than in traditional rental properties – another benefit!).
A Guaranteed Sale: As sellers benefit from rental income for the duration of the lease option, they also guarantee that the investment property won’t go vacant during that time. Moreover, they are ensured that the property will be sold, which gives them a sense of security for their real estate investment.
Less Risky: Since tenants are going to purchase the real estate property that they’re renting, naturally, they will start treating it as their own home (because it will be). This means tenants will contribute towards the repair and maintenance costs on the investment property, and they’ll be far less likely to cause damages.
Real Estate Agent Aren’t Needed: A typical rent to own strategy does not require hiring a real estate agent to find a buyer for the real estate investment property, which eliminates the extra fee that would have been otherwise paid to the agent.
What Is Rent to Own: Disadvantages for Buyers and Sellers
- Buyers: If the tenant is just a day late on paying rent for a particular month, some rent to own contracts reduce the rent credit for that particular month void.
- Seller: If the potential buyer decides not to purchase the investment property, then the property owner will have to start over the process of finding someone to sell the property to. This also affects the buyer as he/she will lose all money invested until that point.
Related: Is the current housing market in the US a seller’s market or a buyer’s market?
What Is Rent to Own: Conclusion
Real estate investors consider a rent to own option a “win-win” if both parties stick to the terms and conditions of the agreement throughout the set time period and the lease option is not broken. We hope you got a sense of what is rent to own, how it works, and its advantages and disadvantages after reading this blog.
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