Questions Regarding “Rent to Own”

Right out the gate I will say that I have zero experience in the rent to own market and do not have any first hand experience to draw from, for this article. However, I have recently been asked several times about a “rent to own” situation, which has required me to put on my thinking cap and playing a little ‘devils advocate’, while researching the topic.

Common Knowledge

I’ll start with what I believe to be the ‘basic’ way that a ‘rent to own’, or ‘lease to own’ program works. For this purpose, I’ll work with a set of assumptions throughout my discussion:

Today’s fair market value of home: $250,000
Today’s fair market rent value for this home: $1200/month
2 Months security Deposit (Move In Cost): $2400

So, a renter would be expected to pay $1200 a month for the property and at the end of the year the renter would have no equity in the property. If the renter were to leave, they would have their 2 months security deposit returned minus any damage beyond normal wear and tear.

A ‘Rent to Own’ or ‘Lease to Own’ may be an ideal situation for a family that has just lost their home due to foreclosure or has recently gone through a bankruptcy. Typically there is not a lender that will touch these people for at least 2 years of established credit. It is also an alternative to the first time buyer, who does not have a down payment, now that the 100% financing options have all but disappeared.

Purchase Price

In a ‘rent to own’ or ‘lease to own’ situation, it gets a little more complicated. First, you have to determine the market value of the home. Is it today’s value or is it an anticipated value for when the lease is up – in either a year or two. Let’s say it’s a 2 year lease for this discussion. So, does the homeowner sell their home in 2 years for today’s value or do they allow for depreciation and maybe add an additional 10%. After all, just 2 years ago we were seeing up to 25% annual appreciation in certain segments of our Hemet market. Either way, we have to lock in a price now…

But you ask, what if the values continue to go down as dramatically as they have in the last 3 or 4 months – we could see a 25% drop in value – so will the renter/buyer lose money on the deal? Maybe…

Monthly Payments

If the fair market rent is $1200 a month, then the first $1200 of a monthly payment should be just that, rent. In order to ‘purchase’ the property, the renter will have to make larger contributions, so they can build up equity in the property – typically about 25% of the monthly rent. In this case, the monthly obligation would increase from $1200 to $1500 a month for the same property and the same period.

The extra $300 a month would be credited towards the purchase price. This money is suppose to be used towards a down payment, to help qualify for a loan, when the time is right. At the end of the 2 year lease, the cash collected for the down payment would be $7200

Can You Spell Late Fee’s?

Now I have heard of lease clauses that specify if the ‘renter’ is ever late with a monthly payment, then all of the excess funds are forfeited, up to that point. This can be scary. Again, we have a 2-year lease at $1500 a month with $300 being applied towards the purchase price. Now lets say in month 9 life throws our renter a wild card and they have to pay their rent 2 weeks late. The renter just kissed $2700 good-by. <!--[if !supportEmptyParas]-->Ouch! <!--[endif]-->

Down Payment / Security Deposit

The security deposit in this case is $2400. This does not change. However, in consideration of taking the home off of the market and gambling on locking in a sale price today for a purchase that will not take effect for 730 days the seller is going to want some form of financial consideration.

I am not aware of any ‘rent to own’ or ‘lease to own’ offers that would even consider the risk for anything less than $5,000 in addition to the security deposit. The first $2500 is just that, a security deposit that will be returned at the end of the lease, minus any damages in excess of fair, wear and tear. The $5,000 (or more) will only be applied towards the purchase price of the home, added to the $7200 collected as part of the 2-year lease and also applied to the down payment.

Based on this scenario, at the end of 2 years, the homebuyer would have contributed $12,200 towards the purchase price - $300 shy of 5% of the purchase price.

Who Pays the Plummer for the Stopped Up Toilet?

In most ‘rent to own’ or ‘lease to own’ agreements, the renter assumes the responsibility of the homeowner when it comes to maintenance and repairs. The dishwasher goes out, it belongs to the new owner! Toilet clogged, fix it, don’t call the seller.

However, there will be a clause or two in the agreement that will prohibit you form encumbering the property with any additional liens – so you can’t borrow against any equity and you can’t hire a contractor who places a mechanics lien on the property – so you are limited. You may even be prohibited from making certain improvements to the property that would alter the property until you are able to close escrow – so forget about the new walkway or the custom colors you want to paint…

The Accidental Landlord

Many of today’s landlords are landlords by default. They put their home up on the market, went and bought another home and then after several painful months decided that in today’s market, they would rent out the ‘old’ family home.

Almost sounds like the “American Dream” buying houses and making money in real estate. But, chances are the reason they got into the trouble they are in is because of a bad financial decision…or worse, bad financial judgment.

So, who knows what will happen to the landlord over the course of the next two years? Will their financial worries continue to drag them down? Will they not be able to keep up with the payments for either home? Are they “robbing Peter to pay Paul?”

Do you think the bank will care if the home you have been paying ‘rent’ on for the past year ends up in foreclosure and is lost to the bank with 6 months of non-payment? Absolutely not! Heck, as an REO agent, I can tell you the bank won’t even continue to rent the property to you – for their own liability reasons, they must have the home vacated.

The Protected Tenant…is it Possible?

Now it is important for me to disclose that this next section, (like the whole article) is just part of my thought process and I have absolutely no idea on the legalities of what I am going to suggest…this is just common sense thinking, ala John Occhi (my head can be a scary place sometimes).

As a ‘buyer’ in a ‘rent to own’ or ‘lease to own’ real estate transaction, there are several precautions that I would take to protect myself. See if this makes sense to you and if you can pull these off.

First, I would want my ‘purchase money’ (the initial $5,000 in this case and the $300 a month deposited into a savings account where I could receive a monthly statement to verify the existence of the funds. I would also want this to be an interest bearing account. Ideally, you and the seller would be able to sit down with a bank officer and set up some very specific guidelines for access to the funds, not allowing them to be withdrawn for any reason, short of the termination of the lease. If you are a real good negotiator, see if the funds can be released in the event of a major repair issue. This will guarantee that the property is maintained and not neglected

Second, I would record the lease with the County Recorder. This puts the world on notice that you have a vested interest in this property, albeit a weak one. The seller probably won’t be thrilled, but this is for your protection, as the buyer of this real estate. Third, I would also submit the form to the County Recorder that has the Recorders office notify you directly as an interested party, whenever any additional documents are recorded against this property.

Fourth, for further protection, I would have the landlord put the property into a ‘Trust’ so that any of the landlord’s personal financial woes cannot spill over to the property you are buying. This may scare some landlords, but it shouldn’t. This is just sound financial planning.

The Lucky Landlord

From where I sit, this appears to be the ultimate sale of a home. Good work, if you can get it.

You get the full asking price of your home…

You get all of the tax advantages of owning the home for two years…

You don’t have to worry about maintenance issues…

If the seller defaults (as most do)…you get to keep a lot of money that you did not otherwise earn…

You still have a security deposit and rent that covers your risk and your costs every month…

Like you, I am curious to learn more. So if you have experience in this field (good or bad), please chime in and educate myself and my readers.

Now Have a Blessed Day,

John Occhi, REALTOR®
Century 21 Crest - CrestREO
CrestREO.Com
Hemet - San Jacinto Valley
951-927-9473

Author of "What You Need to Know...About Foreclosure and How You Can Stop It!" - If you are a Hemet or San Jacinto Homeowner.

This blog and the contents written here is the intellectual property of John Occhi, Hemet California REALTOR®. The views and opinions expressed are just that - views and opinions of John Occhi and those who comment. Please note that I am not an attorney or a tax professional and any time I discuss either topic, I suggest you consult with the proper professional for relevant assistance.

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