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Should You Rent-to-Own Your Investment Property?
Approximate Reading Time: 10 Minutes
Summary: In this article, you’ll learn whether you should rent-to-own homes as part of your real estate investment strategy. You will also discover the rent-to-own pros and cons for sellers, and what makes the right investment strategy for you and your family.
Rent-to-own investment properties look and feel like traditional homes. These type of home sales offer a viable alternative to the traditional home loan. In fact, rent-to-own homes offer benefits to both the buyer and the seller.
However, it’s important to note that clear contracts, financial status, professional legal advice, and an innate understanding of the local housing market are critical components for both the buyer and seller, before a rent-to-own home sale is completed.
What Does “Rent-to-Own” Mean?
“Rent-to-own” essentially means that the buyer is given time to purchase the home over time. Typically, the rent-to-own transaction starts with the buyer paying an option premium. As its name suggests, the option premium gives the buyer a chance or “option” to buy the home at a designated point in the future.
Generally speaking, the option premium is valued at approximately five percent of the home’s purchase price. As part of the rent-to-own contract, the buyer and seller will also agree on a lease term, monthly premium payments, and the sale price of the home. Sale price for the home must be agreed upon and listed within the contract, and must be honored regardless of the home’s actual value at the point of sale.
How Rent-To Own-Works
Rent-to-own transactions are especially beneficial to buyers who will be in a stronger financial position in the next few years. The typical rent-to-own transaction follows these key steps:
- The lease option starts with a contract.
- The buyer and seller enter negotiations and come to an agreement (as laid out within the contract).
- The buyer pays the option premium.
- The buyer makes the agreed-upon monthly payments throughout the lease term.
- At the end of the agreed upon lease term, the buyer has the right to decide if he or she wants to purchase the home for the agreed upon sales price.
Rent-To-Own Homes Pros and Cons
Is rent-to-own worth it? This is a common question that many real estate investors have when they begin to explore the rent-to-own pros and cons. While the following two sections will discuss rent-to-own pros and cons, it is important to note that only you can answer the questions, “is it worth it?” or “is this the right investment strategy for me?”
1 – Tenant may respect property more.
As with many things in life, when you own something, you are more likely to treat it with respect. This idea applies to rent-to-own homes. Instead of the “usual wear and tear” that a property might experience during a standard leasing period, tenants that are renting-to-own are more likely to treat the property with the utmost care.
With this in mind, respect can be a double-edged sword, as it may result in the tenants being extra picky about maintenance requests or repairs that have to be made to the home during the leasing period.
2 – Sales price can be premium.
The beauty of a rent-to-own home is that the seller can often set the sale price at a premium. The reason the sale price is higher is because the seller is taking a greater risk. In other words, they are counting on the tenant to complete the entire lease, treat the home with respect, and eventually purchase it at the end of the lease term.
Additionally, buyers wishing to own a home in a seller’s market are more likely to pay a premium on a rent-to-own property, so that they can afford to live in their dream house and / or dream neighborhood.
3 – Can get a premium monthly payment.
In addition to the premium sales price, rent-to-own homes often have a premium monthly payment throughout the entire lease term. This premium monthly payment covers the additional risk to the seller, while also benefiting the buyer, since he or she is able to pay off more on the house before they become the official owners. The premium monthly payment not only increases the passive income that the seller receives, but it can also be used as the funds needed to invest in another property.
4 – Longer term leases, typically 24 – 46 months.
The beauty of a rent-to-own home is that it often comes with a longer lease term. As any savvy real estate investor will tell you, longer lease terms tend to mean lower overturn, which in turn equates to lower maintenance and management costs. The longer lease term also gives the seller peace of mind, since they know that their investment property will be generating a guaranteed monthly premium for a set period of time.
5 – Some maintenance items can be tenant’s responsibility.
As noted in the first pro, tenants are more likely to respect the property in a rent-to-own scenario. With this in mind, sellers will often be able to transfer some of the maintenance items over to the tenant’s responsibility. For example, the tenant’s might be responsible for lawn care and HVAC care throughout the entire lease term.
There are a few downsides to rent-to-own investment properties. The first and foremost being that these types of transactions can be quite complicated, which is why it’s always imperative to seek professional advice before entering into a rent-to-own agreement as either a buyer or seller.
1 – Clouded title and thus harder to get an investor loan.
Often times, it’s hard to get equity out of the properties, especially if you want to fund another deal. The challenge is that many financial companies won’t offer a loan on a property that has a clouded title. In this case, a “clouded title,” refers to the fact that the seller has leased out the property with the option to own, which means that the tenant has the opportunity to have an equity stake in the property. In these instances, many financial lenders will not be able to offer a loan.
2 – Market rent may continue to go up during that time frame.
Typically, rent-to-own monthly premiums are based off of the current market rate. In some real estate markets, especially growing or seller’s markets, the monthly rent may continue to go up during the lease period. To combat this potential con, sellers need to conduct market research to ensure that they aren’t losing money due to increase rental trends.
3 – In some states eviction is only possible through a forfeiture or foreclosure.
Many states in the Midwest don’t allow simple evictions on rent-to-own properties. Instead, the seller will be forced to go through the forfeiture or foreclosure process, if they need to legally evict the tenant. These processes can be costly and time consuming. Whenever possible, sellers want to choose landlord-friendly states, so that they can avoid the negative impacts and pitfalls associated with this particular con.
4 – Some counties require you to record the option contract.
If you have to record the option contract, additional legal fees will apply. Other fees will also need to be paid if the buyer does decide to purchase the home, or if they choose to walk away after the lease term has ended.
If sellers want to enjoy the numerous benefits of a rent-to-own transaction, it’s essential to complete an extensive list of “dos’s.”
1 – Create a separate lease and option purchase agreement.
The lease agreement should be separate from the option purchase agreement. This is especially important if the seller needs to evict the tenant in a landlord friendly state. If the tenant violates the lease agreements, then the landlord will typically have the grounds to complete a simple eviction. However, if the two documents are not separate, then the eviction process can become complicated and quite costly.
2 – Consult an attorney in the state where properties are located.
Rent-to-own transactions can be quite complicated, as such it is vital that an attorney is consulted. As part of the process, all documents and contracts should be carefully reviewed before any agreement is signed.
3 – Get a periodic inspection of the property while it’s occupied.
While tenants are more likely to respect a rent-to-own property, it’s the seller’s responsibility to ensure that the property is maintained throughout the entire lease period. Remember, the tenant has the option to purchase the property at the end of the lease, but this doesn’t mean that they are obligated to complete the purchase.
By conducting periodic inspections, sellers can ensure that their property is being properly maintained and that all agreed upon lease terms (especially those pertaining to maintenance and upkeep) are being met.
4 – Get periodic updates from water and sewer companies.
It’s important to make sure that the tenants are treating your home with the utmost care. Water and sewer companies can provide valuable insights into how your home is being treated.
5 – Verify that rent is at appraised value.
An appraiser should determine the market value of the rent for the entire lease term. The monthly rent premium should be agreed upon by both the buyer and seller.
6 – Purchase Title Policy Insurance.
A title insurance policy will protect the amount of money that a lender has given you. It’s especially important for sellers who still have a mortgage payment on the rent-to-own property, to obtain a title insurance policy. This provides an extra layer of financial protection for their investment.
If sellers want to enjoy the potential benefits of a rent-to-own property, there are three things to avoid.
1 – Don’t mix verbiage about the purchase option terms in the lease agreement.
The option terms should not be a part of the lease agreement. For legal purposes, and financial protection, the option terms should be in one contract, while the lease agreement should be in a separate contract.
2 – Don’t wait for tenants to resolve code violations.
Do not wait for the tenant to resolve any code violations. You are still financially and legally responsible for the property, which means that if there are code violations, they must be resolved in a timely fashion. Failure to resolve code violations can, not only result in hefty fines, but also lead to the tenant walking away from the home or even a potentially costly lawsuit.
3 – Don’t expect the tenant to exercise the rent-to-own option.
Remember that the option term is just that … an option. Your tenant has the right to buy or not buy the property at the end of the agreed upon lease term. Don’t leave yourself in a bind by counting on the tenant to purchase the option. Instead, you should plan ahead and be financially ready, should the tenant decide to decline the option.
Completing a rent-to-own contract is a complicated process that should not be attempted without the help of a legal professional. There are a few items you’ll want to pay close attention to when reviewing the contract verbiage. These include:
- No mixing of verbiage between the two contracts (i.e. the lease terms and the option contract)
- Make sure the option contract clearly states that the option fee will not reduce the price of the home, but rather be credited towards the down payment. Keep in mind that the majority of option fees are only worth five percent of the home’s agreed upon sale price.
- An appraiser should be the one to determine the market rent value.
- Credit towards the down payment can be determined by calculating the difference between the market rent and the actual rent paid for the last 12 months.
State Laws To Be Aware of
There are several state laws that should be carefully considered before considering a rent-to-own transaction. In many states, tenants gain equity in the property, which impacts the landlord’s ability to bundle properties and receive certain financial loans.
Additionally, when the tenant gains equity in the property, it is much harder for a landlord to complete a simple eviction (if needed). In these instances, you will have to go through a costly and timely foreclosure or forfeiture process if the tenant gains too much equity in the property. To avoid these situations, sellers should avoid tenant-friendly states, and instead choose rent-to-own homes in landlord friendly states.
Finally, many judicial states have very lengthy foreclosure processes, which means you could potentially lose more money and time during the eviction process.
Understanding the rent-to-own pros and cons for sellers is the first step in determining if this is the right investment strategy for you. With this in mind, rent-to-own transactions can be beneficial to sellers in landlord friendly states and in the right market conditions. By working with a team of trusted industry professionals, you can best determine if the pros of rent-to-own homes outweigh the potential cons and risks.
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