Rent to Own or Lease Option
A lease option allows buyers time to repair their credit while living in the home they want to buy.
When the real estate market is hot, lease options are hard to come by because sellers do not need them. When the market slows, sellers find it more different to sell their homes, and so lease to buy options become more attractive.
A lease to buy option allows a buyer to rent a property, with an option to buy it at a predefined price after a predefined period. For example, a buyer agrees to rent a home for $1,300 per month, with an option to buy the property for $250,000 after one year.
The lease to buy transaction process is similar to that of a regular property purchase, but there are some differences explained below.
Option Money – This is similar to an earnest money deposit. The buyer provides Option Money to show that they are serious. The money is held in a real estate brokerage account and is refundable until the buyer due diligence period has expired. Note this is not the same as a security deposit, a separate renters security deposit will have to be agreed and collected when the buyer decides to proceed with the lease.
Due Diligence – It is down to the buyer to perform all necessary due diligence before the deadline expires. This should include performing a home inspection, and may include a home valuation, plus anything else that the buyer deems necessary to confirm their wish to proceed with the lease to buy.
Notice of Intent Deadline – This is the date by which the tenant needs to inform the seller of their intent to proceed with the purchase. The date is usually 1 or 2 months before the date on which the lease is due to expire. If the tenant does not notify the seller by this date then the tenant / buyer loses their right to purchase the property. One thing to note is that there is no loan denial deadline, which means the tenant / buyer must have their loan in place before they confirm their desire to exercise the option to purchase the property. Once the tenant notifies the seller of their intent to purchase, they are obligated to proceed with the purchase / settlement.
Most frequently asked questions
What sort of down payments do most people have?
We try to get between $2k and $3k as a lease option fee – more if we can. This is where we make our money so our goal is to get a much as possible. Also, the more we get as a down payment, the more stable the tenant is for you, so it benefits us both.
What is the number of people who walk away from the house when the lease is over (either because they are unable to get regular financing or decide they no longer want the home.)
Less than 30% of lease option buyers will exercise the option. So it is likely that they will not buy it at the end. But there are some real benefits –
- It doesn’t cost you a dime to fill the property. That is what we do and we are paid by the buyer.
- You no longer have to lose your mortgage or property tax payment every month since you will offset it with the monthly income.
- You don’t have to do maintenance on the property – the new buyer/tenant is responsible for repairs.
- You don’t pay for utilities.
- They cut their own grass and shovel their own snow.
- They don’t call you like regular tenants.
- You get a 3 years lease rather than 1 year for most renters.
- You get a more stable tenant than a regular renter because the folks that move in see themselves as owners rather than renters. Remember the old adage, “You don’t wash a rental car.” Same goes for buyers vs. tenants of houses.
If the person walks away from the lease what becomes of their down payment?
It is non-refundable to the buyer. When they end their lease, we would be happy to help you fill the property again – we have a very active and growing list of buyers.
Who is responsible for upkeep and maintenance of the home?
This is all the responsibility of the buyers.
Since the home has a mortgage are there any problems with leasing that would cause the “Due on sale” clause of the mortgage to be invoked by the lender?
No, a lender would see this as a lease, not a transfer of ownership.
Because it’s a lease, does the person leasing the home get the homestead exemption or would it be treated like a rental property, and if so, at that point the taxes would go up without that exemption.
It would be treated like a rental property so eventually the exemptions would be removed and the taxes would go up.
But – you also get the benefits of owning rental property. I know that some people think owning rental property is nuts, but I own a lot of rental property and I know how easy it is to handle if you set it up right.
You will get several financial benefits from keeping your property and selling it as a lease option:
- Depreciation on the property. This is a good thing. You can deduct 3.64% of the tax basis (27.5 years depreciation) of the improvement of the property against either active or passive income (depending on how you are set up). On a $100k property, this would equal about $1k in real cash savings on your taxes each year. (talk to your CPA for details about how this works).
- Appreciation of the property. Over time, the value of the property goes up. I know it’s been a rough patch in the market these last few years, but the likelihood is that the values will eventually go back up. This will make it possible for you to sell the property in the future and make a profit rather than have the potential (in many cases) of actually having to come to closing with cash to sell it.
- Buy down of the mortgage over time. Over time, the note will pay itself off. You may have years before this happens, but every month a little bit of your payment goes toward the principle and you will build equity.
- Rents go up over time as a hedge against inflation. The thing I love best about my investment property is that the rents go up. I know of no other investment that has an automatic hedge against inflation like this. Most houses have 30 year fixed payments, but as rents go up, if you apply the extra income to the mortgage each month, you will likely pay it off in 10-15 years because of the increased cash flow.
There are also some negatives to consider:
- Risk of vacancy. Over time, you will have vacancies. Each month the property is vacant, you lose money. The beauty of working with us is that we have buyers and can fill it very quickly. The risk of selling it on the open market is often much higher than selling it through us with a Lease Option. Keeping it on the open market, you must pay the mortgage, utilities, taxes, insurance, grass cutting, maintenance and wear and tear that comes from keeping a property vacant (did you know that the plumbing will often deteriorate in a vacant house because of lack of use?).
- Risk of damage from tenants. There is always going to be wear and tear on a house when someone lives in it. When they move out, you will need to have it cleaned up before you sell it again. It’s also possible that someone will deliberately ‘trash’ your house. This is very rare and is covered by insurance.
- Management headaches. I hate managing property and make a point NEVER to talk to any of my tenants. I have a competent property manager do this for me. The biggest reason people say they hate real estate investing is because they manage their own property. This, in my opinion just doesn’t make sense. Let someone else do it for you – they typically charge about 10% of the rent. I can recommend someone good if you like.
- Picking a bad buyer/tenant. This is another mistake most newbie investors make – they screw up on tenant selection. That is why we put them through a qualification process that vastly improves the tenant/buyer’s success rate.
The downside is that taking on tenant buyers, in my opinion, is much smaller than the upside – especially if the alternative is a vacant house. We know that in a good market, 33% of all properties listed for sale on the MLS do NOT sell. Right now, that percentage is much higher. We also know they will not sell for more than market value and that the cost to sell with a Realtor will run you about 10% after commissions, closing costs, repairs, and negotiation. For many people who are close to market value on their mortgage, this cost just isn’t possible.
How do buyers get financing when it’s time to exercise their option?
They go to any conventional lender and apply for a loan. The reason they are buying “Rent To Buy” right now is because they do not qualify for a conventional loan. Since 2007, conventional loans have become much harder to qualify for – ask any mortgage broker. That is why so many properties that are for sale by real estate brokers don’t sell. Buyers just can’t get loans without almost perfect credit. Appraisals have also been a problem recently, so even if the Buyer qualifies, if the appraisal doesn’t come in, they won’t be able to finance it.
Our goal is to help good, responsible people get into a home. People who will take care of it and treat it like their own. We’ve had good luck finding just that over the years.
If the Buyer exercises the option, that’s great and you make your money. If they don’t, the advantages of having someone pay your mortgage and buy a house for you are enormous.
I believe that selling the property as a lease option is a solution that is the least painful. In fact, it may end up being the best financial decision you ever make.
I hope these answers give you a better idea of how this all works and helps you decide if it is for you or not.
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