Typically, when people sell a home, an offer price is agreed upon by both parties and accepted, then the transaction is completed at the closing table. This is the case for almost all standard Real Estate transactions. Only the first part of a typical Real Estate agreement will occur in a Rent-to-Own sale.
How Rent-to-Own Works
In a rent-to-own agreement, the buyer won’t pay the purchase price in full. This means that closing will not be conducted immediately after the agreement is signed between buyer and seller, but rather at an agreed upon date in the future. The buyer will first rent the property for a certain number of years (usually one to three years) and then he or she will buy the house afterwards. The seller rents the property out to the buyer, but with an option for the buyer to purchase it at the end of the agreement period.
Instead of selling the property to you right away, I'll lease it to you, then sell it to you for a higher price at a later date.
Here are the four most important elements of a rent-to-own agreement home owners should know about when using this option to sell their house:
Option Money
Option money in a rent-to-own agreement is similar to the earnest money deposit in a regular property deal. The buyer pays the seller a one-time, usually non-refundable fee at the time of signing the agreement. Agreements are highly customizable, so a homeowner can include a clause that gives the potential buyer the right but not the obligation to purchase the property when the lease expires. If the buyer chooses not to sell the house at the end of the agreement period, the seller doesn’t refund the option money.
The percentage of the purchase price that should be paid to the seller as option money depends on how the negotiation goes between the buyer and the seller. It can typically be anywhere between 2.5% and 7% of the purchase price. So if the current market value of a home is $250,000 with a 5% option consideration, the buyer will need to pay $12,500 up front.
Purchase price
The purchase price can be determined at the time of signing the agreement or when the lease expires. The agreement should clearly specify when the purchase price will be determined. It depends on the condition of the real estate market in your area. If home prices are expected to rise in the future, the buyer and seller will typically agree on a purchase price that is higher than the property’s current market value. Many buyers prefer to “lock in” the purchase price right now as the property will likely be worth more in a few years.
Rent Credit
The rent-to-own agreement will specify how much rent the buyer will pay during the ‘option period’. A certain portion of the rent is then applied to the purchase price. This portion of the rent is called rent credit. For example, if the buyer is paying a monthly rent of $1500 and 20% of that goes towards the purchase price, the rent credit in three years will be for $10,800.
Property Maintenance
The buyer usually pays for the maintenance of the property during the option period, but the terms should be specified in the contract. Homeowner’s Association fees, major repairs, property taxes and insurance are among the few other costs that should be included in the agreement. Since the buyer is a tenant during the option period, he or she will need to take out a renter's insurance policy to cover the costs for protecting against personal property damages and liability if someone is injured while in the home or if the buyer accidentally injures someone else.
What Happens if the Buyer Backs Out?
The buyer will forfeit all rent credit accumulated during the option period in addition to any option money deposited at the closing table upon signing the initial agreement.
Who is the Ideal Buyer for Rent-to-Own?
There is a myth in the real estate industry that rent-to-own properties mostly attract those who cannot qualify for regular financing. That typically means there is something amiss in their credit histories, a missed payment here or there, perhaps, or even worse, maybe a bankruptcy or foreclosure. But this view is definitely limited and doesn’t reveal the entire story. Many real estate investors with a history of closing deals quickly may be interested in your property.
You will find it extremely hard to sell your home to a regular buyer through a rent-to-own option if your home is in poor condition. However, a real estate investor will buy your home ‘as-is’, so you don’t need to spend thousands of dollars on costly repairs. This means that you are free to spend your time collecting monthly rent for a few years without having to worry about your property maintenance and repairs, some of the biggest causes of stress among landlords.
The deal will be shrouded in uncertainty if you decide to sell to a regular buyer using this option. What if the buyer’s mortgage application falls through? This problem can be mitigated by selling to a Real Estate investor because you can be more certain that the deal will go through eventually. In fact, most investors will pay the purchase price in cash at the end of the agreement period.
Conclusion
Rent-to-own is a great option for distressed home owners struggling to pay mortgage installments or cover the cost of maintenance and repairs. If you are selling in a buyer’s market and you still find that you are having difficulty getting people to agree to our asking price, rent-to-own is definitely an option that should be considered.
Written by Brandon Lor