A Tutorial

Lease with option to buy (aka rent-to-own) is a viable solution for many sellers and buyers, yet it is largely under used. Browsing through the various real estate blogs there are many people asking questions that often go unanswered or receive the same type of safe/fluff answers every time. As we have navigated this process from start to finish and seen it work, We’d like to dissect this topic in hopes of shedding some light on a very viable method of transacting real estate.

A lease with option to buy is an agreement to lease a home with the option to buy it before a certain future date at an agreed upon price. This type of agreement is ideal for someone who is either not ready to buy because of a lack of assets or credit or a lack of desire to risk their assets or credit. Even though this is not a new concept it is largely under-developed and there are many things to consider for both sides of the transaction. We cannot stress enough that having an agent that is experienced in this type of transaction is something that should be strongly considered by both sides.

How much should the rent be?

The rent should reflect current market prices for comparable rental units plus additional amounts that may go towards purchase of the home or payment for the option. However, all three of these rent components are negotiable so this is a great reason to have an agent working with you who is experienced in this type of transaction. The key is for the seller to be appropriately compensated for taking the risk of future price depreciation while forfeiting all price appreciation to the buyer.

How much should the rent be increased to fund the future purchase?

As mentioned above, this is negotiable. Again, because this process is rarely used there is no standard or often used guideline to consult.  However, incorporating an extra amount into the rent to fund a future purchase amounts to nothing more than the seller operating a savings account for the benefit of the buyer. Does the seller really want to be in the banking business? And from the buyer’s perspective, how is this any different than the buyer starting a savings account and putting that extra money in there for an eventual purchase that doesn’t tie them to a particular unit? The only difference is that under this arrangement the buyer is “forced” to save money for their purchase. Interestingly, the Chicago Association of Realtors has a “Lease With Option To Purchase” rider that doesn’t even provide for such an accumulation fund.

How should the accumulation fund be managed until it’s time to buy?

There are a couple ways to go about this and it is largely affected by the profile of the seller. Is it huge profitable developer or a struggling couple that is trying to sell? First of all, if it was agreed that the monthly rent would be increased by a specific amount each month (above market price) and that amount would be put toward the eventual purchase, that money should be put into a separate escrow account by the landlord/seller until such a time as it will be used for the purchase or refunded to the buyer/renter. Another way this can be handled is for the landlord to keep a ledger to record the agreed upon amount so that when the time comes to purchase, the landlord will reduce the sale price on the home by the amount in the ledger. From experience this is the most common method, however a number of risks for the buyer present themselves. Namely when the time comes to sell will the landlord be able to sell the home at the reduced price? In addition, lack of funds for a down payment is a very common reason that buyers seek a lease with option and it is not necessarily the price of the home that is preventing them from buying. Often the amount of money accrued is a drop in the bucket when compared to the over all cost of the home and as such the highest impact of that money would be as down payment assistance for the buyer. If the landlord is not keeping the money in escrow, there is no guarantee that the landlord will be able to cough it up at the closing table.

At what point in the process should we agree on a purchase price?

In the Chicago Association of Realtors “Lease With Option Rider” there are two choices (this may differ for your local association’s forms, please consult your agent):

“Tenant shall have the one-time right to purchase the Property (“Purchase Option”) for a purchase price equal to (strike one) $_______________________________ / the fair market value (“FMV”) of the Property at the time such Purchase Option is exercised (“Purchase Price”). (Strike the following sentence if it does not apply) The FMV of the Property shall be determined by Landlord and Tenant, in good faith, taking into consideration the purchase price for properties similar to the Property, located in the same geographic area as the Property, which have been purchased in the preceding nine months. “

There is a lot to consider here. When does the renter plan on converting himself or herself into a buyer? Will it be six months or two years? What does the housing market look like at the time of purchase? Is it stable, falling or experiencing growth? Either way there is risk involved for both parties.  In a standard option there is an agreed upon purchase price, the “strike price”, established at the point at which the option contract is entered into. It is this set price that creates the value of the option for the buyer. If there is merely an agreement to negotiate a fair market value at some point in the future then the option has absolutely no value whatsoever.  If the buyer ends up purchasing the property at fair market value in the future then they have forfeited any right to appreciation of the property up to that point in time.  What if the buyer and seller can’t agree upon a fair market value in the future? This essentially provides an out for the seller. In other words, the seller is not really obligated to sell the property and the buyer doesn’t really own an option.  The existence of this second alternative in the contract is really rather pointless. It creates a situation where the seller can’t sell the property to anyone else, but the buyer is not guaranteed that they will be able to purchase it for a price they consider reasonable.

As a seller, when should I ask for a pre-approval?

This is a tricky one because in many cases the reason people are looking for a lease with option is because they cannot yet qualify for a loan for one reason or the other. Our advice is this: With the assistance of a lender you or your agent are comfortable with, get the renter/buyer pre-qualified for the purchase amount you’ve negotiated and find out what it would take for them to be able to qualify. It could be increased assets or it could be credit clean up. Whatever the case may be, this will give them a clear picture of what their goals need to be in order to eventually purchase the home. This is also very important because this will give them a glimpse of what their monthly cost to own would be. A lot of first time home buyers have no idea what their mortgage, insurance, taxes, and assessments (for condos) will add up to. It may be that once they see what their monthly cost to own will be that they realize there is no way they would be able to ever buy this in the near future. The last thing a seller wants is to waste time renting their place when their goal is to attract a buyer. Getting the pre-approval done up front is also a good way for the seller to assess the risk of a given buyer. At the beginning this will serve as a credit check, which most landlords require anyway. If you see that the potential buyer has a 300 credit score and has never paid a bill on time, it may not be a good idea to tie your home up with that candidate. If you see that they are 800+ credit, never missed a payment, and the only thing preventing them from buying is a lack of down payment or lack of income, you may consider this to be less of a risk than the former example. Obviously the buyer will need to get re-approved once the purchase is close at hand.

Will the security deposit be handled separately from the earnest money?

We recommend that these two be handled separately. Through the Landlord Tenant Ordinance (LTO) the City of Chicago requires a lot from the landlord with respected to the security deposit and noncompliance comes with some very heavy penalties. That said, we feel that the seller acting the part of the landlord should adhere to the LTO and ask for earnest money if and when a purchase comes to fruition. This will reduce the liability to the landlord who is at significantly more risk than the potential buyer.

Should I keep my home for sale during the agreement?

Only if someone will buy it with the option attached. You gave the buyer/renter the right to buy the place and you can’t just ignore that fact. Again, consider the comfort level of the buyer. Do you think a buyer would go through all of this trouble with the possibility that the rug can be pulled out from underneath them at a moment’s notice? Plus a renter who is planning on buying this home may be very put out by having “potential buyers” traipsing through the home.

What happens if the home is foreclosed during our agreement?

This situation is largely effected by the type of agreement you had. If you are paying above market rent and having that money put into an escrow account, obviously you should have claim to that excess money. We recommend that you have some verbiage in your agreement that covers this possibility no matter how remote you think it may be.

Can section 8 vouchers be used in a rent-to-own home purchase?

The answer according to the HUD website is yes, depending on your personal situation and the program that you are involved with. We advise you to consult the hud.gov website for details.

Do I have to sell my home at the end of the agreement?

Absolutely. That’s the whole idea behind an option and that’s what you are being paid for.

In Conclusion

With all of the different variables to consider it is clear why a lot of agents steer clear of this type of transaction. It is unfortunate that often the professionals that people turn to for advice are the ones that push them away from viable options due to lack of familiarity or out of sheer laziness (short sales are another example of this). In the end, rent-to-own has the potential to be a win-win situation for all parties involved. The buyer gets a chance to test out a home before buying it, continue to build credit, and an opportunity to put their money toward a home purchase prior to qualifying to do so. For sellers, they can have a renter in the short term to help alleviate some of the financial burden of their cost to own while cultivating this renter into a buyer. The situation can also be a very easy out for both parties. In a market where serious buyers are hard to come by, this has the potential to be an excellent compromise.