A popular type of real estate investment strategy is what is known as “rent-to-own” investing, or “lease option” investing. I will use the term “rent-to-own” since it is probably the most common term used.
Rent-to-own investing takes place when an investor acquires a property and rents it to a tenant with the intent that the tenant will eventually buy the property. A typical rent-to-own agreement could last between three to five years, depending on the situation of the tenant buyer. As part of the agreement, the actual purchase price for the ultimate sale is agreed on upfront.
The main reason prospective homebuyers would enter into a rent-to-own agreement is that they want to live in a house today, but can’t currently qualify for the mortgage and are tired of renting.
Rent-to-own is not necessarily a “cheap” alternative to renting, however. The monthly payment could actually be higher than the rent of a similar home. This is because the rent has to cover all of the investor’s housing expenses (mortgage payments, taxes, insurance, etc.), his or her profit, and any monthly credit that is part of a monthly savings program established for the tenant buyer. The monthly credit is an amount that will be applied to the down payment at the time of the purchase.
The approval and terms of a rent-to-own arrangement depend on the risk tolerance of and any restrictions associated with the investor, along with the tenant buyer’s income and debt burden. An extensive evaluation and calculation is usually carried out to determine the price of home the tenant buyer will be allowed to shop for. Normally, the investor finds a tenant buyer for their program first and then they both work with the same realtor.
Once a price range is agreed on, the tenant buyer will work with the realtor to start looking for properties in that price range. Once a home is found, the investor then works with the realtor to purchase the property. After the property is purchased, the tenant buyer moves in. This search and purchase process could take anywhere from one week to three months depending on the tenant buyer situation, the investor situation, and the market.
Rent-to-own is one of the easiest and best investments you can get into as a real estate investor. Here are some advantages:
No property management. Since the tenant intends to purchase the property at the end of the contract, it is reasonable to expect that he or she will treat the property as his or her own. The investor can structure the contract such that the tenant buyer is responsible for all maintenance and repairs, while the investor is responsible only for major repairs such as a new roof.
Improvements. Any property improvements the tenant buyer may make, such as painting, new carpets, a new deck, or an additional bathroom, will increase the property value. This will make it easier for the tenant buyer to get financing at the end of the deal. Or if the tenant does not buy, the investor has a property worth a lot more.
Guaranteed seller. At the end of the term of the rent-to-own agreement, the investor already has a buyer lined up. The other advantage is that the investor doesn’t have to pay realtor fees at the end of the deal, since it is a private sale between the investor and tenant buyer.
Rent-to-own does have some disadvantages, however:
Tenant buyer doesn’t buy. This is always a concern and happens about 10 to 20 percent of the time in my experience. The investor will then have to rethink the exit strategy. The tenant buyer would usually lose any deposit made and any earned monthly credits.
There are at least four exit strategies that can be used at the end of the term:
- The tenant buyer buys, as originally agreed.
- The tenant buyer doesn’t buy, and the investor sells the property to another buyer.
- The tenant buyer doesn’t buy, and the investor finds another rent-to-own tenant buyer.
- The tenant doesn’t buy, and the investor keeps the property as a rental.
Tenant problems. Just like owning a rental property, the investor could get bad tenants. Tenant problems will still exist, but they are typically fewer and less costly in practice, since the tenant buyer is expected to eventually own the property and has an incentive to take better care of it.
Appreciation scenarios. What if the property doesn’t appreciate to the level needed to complete the sale (i.e. to the agreed-upon purchase price)? There are basically two options that could be considered:
- The investor does not agree to sell the property at the lower price, and the transaction cannot go forward as originally agreed. The tenant buyer would have to move out, and the investor keeps the property. The tenant buyer loses all deposits and credits.
- The investor and tenant buyer agree on a lower price for the sale.
On the other hand, if the property appreciates to a level higher than the agreed-upon sale price, the tenant buyer gets the benefit of buying a more valuable property at a lower price.
I have had a lot of success with the rent-to-own strategy. It is now my preferred strategy. I am in the process of getting rid of all my multi-family rental units in favour of lower-maintenance rent-to-own investments.