The Perils and Pitfalls of Rent-to-Own Deals

I’ve gotten several questions over the years about rent-to-own deals. It’s important to understand conceptually what’s going on in a lease-to-own situation.

Normally what happens is a buyer can’t buy a property outright. Either they don’t qualify, or they have other uses for their cash, or there is some other limitation preventing them from the buying the property in the first place. That’s when they think, “Aha! I’ll just rent-to-own. That way some of my rent will go towards a purchase.”

And sometimes sellers think that’s a great idea, too. Except almost always both of those sentiments are incorrect.

To peel this apart, let’s start by seeing what’s going on conceptually. The buyers are doing at least two and maybe three relevant things:

  • Renting a house.
  • Buying a house.
  • (Maybe) Buying an option to buy a house OR buying a right of first refusal on the purchase of the house.

For the rental, the buyers need to enter into a normal lease agreement. For the purchase, they need to enter into a (relatively) normal purchase agreement. If they want an option or a right of first refusal, the buyers typically need to pay money for that, too. The money paid for an option is often called a “premium.”

Options and Rights of First Refusal

You probably already know what a lease is, and you likely already know what it means to buy a house. You may not be familiar with an option, though. An option is the payment of a sum of money by the buyers in exchange for the right to buy the property at a certain price within a certain timeframe. For instance, I might pay you $10,000 for the right to buy your house for $1,000,000 any time in the next 6 months. As the name implies, I don’t HAVE to buy your house at all, but because I paid the premium it’s my option to do so if I want.

Think about that for a moment. If you buy an option, you not only need to know the terms of the option, but you also need to know all of the terms of the eventual purchase agreement for the house as well. That’s a decent amount of paperwork and negotiation.

If the sellers sell an option to the buyers, the sellers would be well-advised not to sell their house to anyone else while the option is still unexercised and unexpired. If the buyers “call” the option (otherwise known as “exercising” the option), the sellers have to sell to the buyers the house at the agreed-upon price. That’s tough to do if the sellers no longer own the house! The sellers will insist on being paid a premium because the sellers are keeping their house off the market for 6 months (or 12 months, or however long the option is open), during which time no one knows how much the house will appreciate.

A right of first refusal is similar to an option. A right of first refusal gives the buyers the right to match the price and terms on which another buyer makes an offer on a home, and it obligates the sellers to accept such an offer from the owner of the right. For example, I might pay you $5,000 for the right to buy your house in the event that someone else offers to buy your home at any time in the next 6 months. To exercise my right, I’d have to pay you the same amount and adhere to the same terms as the other buyer offered.

Both options and rights of first refusal are pretty rare in residential real estate, though they happen with commercial properties with some frequency.

Rent-to-Own Situations

Normally, residential buyers who stumble upon the idea of renting-to-own will say something like, “We’d like part of the rent to go toward the purchase.” Normally, the buyer cannot articulate exactly why this makes sense to them. But they tend to have some basic intuition that they can get a severe discount on either the rent or the purchase or both by somehow combining the payments.

What gets lost in the analysis, though, is why the buyers think they’ll get a discount. Sellers will only give such a discount for a few reasons:

  • The sellers are desperate for money.
  • The sellers have some emotional connection to the buyers.
  • The sellers are confused.
  • The market is illiquid, meaning it’s very difficult for the seller to rent out their place or it’s difficult to sell their place, or both.

Sellers may need some money very fast. If buyers are willing to pay a premium for an option, that’s $10,000 (or some such amount) in their pocket right away, plus they’ll get an income stream from the lease agreement. The possibility that they may sell the property to the buyers soon is also encouraging.

When sellers are emotionally involved or are financially confused, they may enter into lease-to-own agreement (or set of agreements, really). These folks can end up in a bad deal with poorly written terms. Poorly written agreements don’t do anyone any favors, except scammers.

If the market for home sales or rentals is illiquid, sellers may have the proper motivation to enter into rent-to-own agreements.

Paperwork

So economically, we know that buyers and sellers are entering into three different arrangements — a lease, a purchase agreement, and an option contract. That’s exactly what should happen practically and legally as well.

Despite that, some renters/buyers just feel much better if some of the rent they pay gets allocated to the down payment on the home. They don’t want to pay a separate amount for an option or for a down payment. Let me illustrate why this is problematic. In our following example, Sarah is the seller/landlord and Betty is the buyer/tenant.

Betty asks Sarah to enter into a lease-to-own arrangement, and Sarah thinks that sounds like a good idea. Sarah’s house has a fair market value of $500,000 and its fair market rental value is $2500 per month. The house is in decent shape and the market for sales and rentals is just fine; not particularly fast, but Sarah expects her house would either rent or sell within 1-3 months. Home sale prices are appreciating at about 4% or so per year.

At first blush, Betty is thinking, “Wow, it’d be awesome to rent the place for 12 months at $2500 per month and have $300 of that go every month toward a down payment. I’ll end up saving money.” Meantime, Sarah is thinking, “I’ll get a little income for while, and then at the end I’ll have sold my home. I’ll end up with more money.”

Having agreed on the basic idea, Betty and Sarah get down to negotiating their agreement. Betty’s representative, Aaron, is going to write the documentation.

Aaron:  Ok, I’ll start with the lease. You want to pay $2500 per month, but $300 is going to be allocated to your down payment on the purchase a year from now.

Betty:  Right.

Aaron:  Gotcha. What happens if in a year you cannot buy the house because you don’t qualify for a loan at that time?

Betty:  Well, I guess I’d get my down payment money back.

Aaron:  Good enough. Does that mean you want Sarah to set aside the down payment money in a separate account? If we don’t make her do that, then she might spend the money in the meantime.

Betty:  Yeah, that sounds good.

Aaron:  Ok, based on that, then, I’ll write the rest of the lease just like any other lease agreement. Now let’s talk about the purchase agreement. You want to put 5% down on the purchase, right?

Betty:  That’s right, a total of $25,000.

Aaron:  After a year of $300 per month being allocated to your down payment, that’ll be $3600 that Sarah is holding in her separate account for you and you’ll still need an extra $21,400 for the rest of your 5% down payment. Will you be able to save that amount?

Betty:  I think so, yes.

Aaron:  Ok, I’ll write up a normal purchase contract, but I’ll have the closing date — the date on which money and title to the property change hands — set for about 12 months from now.

Having written up their agreements, they present them to Sarah.

Sarah:  If I’m reading these right, I don’t get to spend all of the monthly payment I’d get from Betty.

Aaron:  That’s right.

Sarah:  Also, I’d be getting less rent than I would get from someone else, right

Aaron:  Yes.

Sarah:  And then I have to hope that a year from now Betty will be able to buy the house. But I have no guarantees.

Aaron:  Correct.

Sarah:  Also, Betty will have a locked-in price of $500,000 for the house, even if the market goes up.

Aaron:  Yep.

Sarah:  Hmm…I’m not sure this is such a great idea.

Sarah is slowly realizing that if she wants to rent out the house, she could do so to some other tenant for more money. Then she could sell in a year for fair market value. She is also realizing that she’d have the accounting hassle of holding Betty’s money for her, which she cannot really spend.

It’s starting to not look like a great deal for Sarah. She is slowly realizing that she is in fact doing Betty a favor by renting to her below market value, holding her money for her, and locking in Betty’s purchase price. That is, it’s slowly dawning on Sarah that she is delivering value to Betty and that maybe she should be compensated by Betty for it.

Since Sarah isn’t a super-sophisticated real estate investor, she doesn’t know the technical term “option,” so it doesn’t occur to her to ask for one. Instead, she decides to do the next best thing:

Sarah:  Look, if I’m going to take below market value for the rent, and I’m going to Betty’s money, and I’m going to sell her the house a year from now, then I think Betty needs to kick in a little extra for the house.

Aaron:  What are you thinking?

Sarah:  Since homes have been appreciating at about 4% per year, I think I want to sell Betty the house for $520,000. Also, I don’t want Betty to be able to cancel the contract. And I want Betty to pay $2800 per month, with $400 of it being applied to down payment. Finally, if she does cancel the contract, I get to keep all the down payment money, plus I’m keeping all of the earnest money in the purchase contract.

Betty:  Hmm…no deal.

Notice that, while the items Sarah is asking for aren’t precisely the same rights that would come with a lease, a purchase agreement, and an option contract, they’re very similar. The key point is that she’s recognizing that she is delivering a different bundle of rights to Betty than she thought she’d be delivering, so she felt she needed to adjust her pricing accordingly.

Conclusion

As parties dig into the weeds in negotiating rent-to-own deals, they tend to find that, in almost all cases, there isn’t a good reason to do them. Also, there is an endless number of ways to structure them, many of which could get quite complex. Such complexity is usually beyond the capacity of most residential buyers and sellers. Lease-to-own deals are rarely a good fit and should only be used in very special circumstances.