In 2005 I became a landlord. A good friend and I began investing in single family homes in the mid-west. We purchased two HUD foreclosures in 2005, and since then we’ve added 3 more HUD foreclosures to our portfolio. When we advertise one of our homes for rent, we always advertise the property as a rent to own home. Also called a lease option, we structure the agreement to allow the tenants to purchase the home within a specified period of time for a set price.
We’ve entered into several lease to own agreements with tenants, although we’ve yet to sell one of the homes to a tenant (more about that in a minute). This experience has taught me two things: (1) tenants make major mistakes when entering into a lease purchase agreement; and (2) some landlords take advantage of tenants who don’t understand how to approach a contract for a rent to own house.
Because rent to own real estate is becoming more and more common, this article will provide prospective tenants with tips on how to negotiate a fair lease option with a potential landlord. The article will also identify potential traps you should watch out for.
Here are the topics we will cover:
- Lease Options 101: A summary of a lease option and points to consider when deciding whether a rent to own home is right for you.
- Treat a Lease Option Like a Purchase: Although there is no obligation to purchase a home during the term of the option, tenants should enter the deal as if they are buying a home.
- Key Lease Option Terms: A review of the following key terms–
- Rental Agreement
- Lease Option Fee (the 1% rule)
- Rent Credit (the 15% rule)
- Maintenance Obligations
- Purchase Price
- Financing a Rent to Own Purchase
- $8,000 Tax Credit
Lease Options 101
A lease option, lease purchase, or rent to own home involves two agreements, a rental agreement and an option to purchase the property. The rental agreement in most respects is a standard landlord-tenant agreement to rent the property at an agreed price for an agreed term. The option gives the tenant the right to purchase the property within an agreed upon time (typically one to three years) at an agreed price.
There are several reasons why a lease option may be an attractive way to buy a home. First, lease options appeal to those who do not have enough for a down payment. Through rent credits (see below), a tenant can accumulate cash that goes toward the down payment. In addition, during the rental period, the tenant can save money above and beyond the rent credit to put toward the house. Second, for those who have a low credit score, they can work to improve their FICO score during the term of the rent. And finally, a rent to own home gives tenants an opportunity to live in the home and get to know neighbors before committing to the purchase.
Of course, you don’t have to rent a home with an option to buy to accomplish all of this. You can just rent a home in a neighborhood that interests you, save a down payment while you rent, and work to repair your credit score. But for those who do enter into a lease purchase, the above reasons are generally why.
Treat a Lease Purchase Like You’re Buying the Home
Before we look at the key terms, there is one very important consideration to keep in mind. You should treat a lease purchase property as if you are buying the home. It amazes me how some people will put down a lease option fee and enter into a 3 year contract having spent 10 minutes in the home. Almost without fail these people do not exercise the option to buy the home, instead moving on to another lease option deal somewhere else. The goal of a lease purchase should be that you eventually buy the home. While intervening events may cause you not to exercise the option, you should treat the transaction as if you will. So what does this mean?
First, you should inspect the home as you would with a purchase. Whether you hire a home inspector, have a friend or family member look at the home, or inspect the home yourself, you should look over the home as if you were going to sign a purchase agreement. Second, look for a home you actually want to own. Often tenants enter into a lease purchase agreement because the home happens to be available, not because it’s a home they truly want to own. And finally, negotiate all the terms of the deal as if it were a purchase. And with that, let’s look at the key terms of a lease option.
Key Lease Option Terms
A lease option is first and foremost a rental agreement. The key terms in any rental agreement are the rent and the term. In these deals, however, there are two key points to remember. First, the rent should be whatever reasonable market rent the home justifies. The rent should not be higher because of the lease option component of the deal. Remember, you’ll be paying an option fee which covers the value of your right to purchase the home. The rent is the rent. I’ve heard horror stories of tenants agreeing to outrageous rents because the landlord convinced them it was justified in light of the lease option.
Second, the term of the option should give you enough time to save up a down payment and repair your credit. If you know this will take two or three years, a one year option is a waste of time and money. If you are not sure how long it will take you to qualify for a loan, talk to a mortgage broker before entering the deal. They should be able to give you some idea of how long it will take to get your finances in order to qualify for a home mortgage. Generally, terms of two to three years are common for rent to own single family homes, at least they are where we invest.
Lease Option Fee (the 1% rule)
The lease option fee is the cost of the option to purchase the home. The option lasts for the length of the rental term, typically. In other words, if the rental term is three years, the option gives you the right, but not the obligation, to purchase the home anytime during those three years. When you negotiate the option fee, keep three key factors in mind:
- The amount of the option fee (about 1% of purchase price)
- Whether the fee is refundable (generally no)
- Whether the fee applies to the purchase of the home (generally yes)
First, of course, is the amount of the fee. As a rule of thumb, 1% of the purchase price of the home is reasonable. The homes we rent range in value from about $130,000 to $175,000. The option fees we charge generally range between $1,450 and $1,950, which is slightly higher than 1%. However, we do not require tenants to put down a security deposit on a lease purchase deal. I’ve seen landlords ask for and get option fees as high as 5%. I suppose if they can get it, why not ask. But as a tenant, 5% is just too high in most cases. If a property owner is asking for 5%, negotiate or keep looking.
Second, recognize that option fees are non-refundable. If you don’t buy the home, the landlord still keeps the fee. In this way, a lease option for a home is similar to an option contract on a stock. The cost of the option is not refundable even if you chose not to exercise the option. As a result, you should think carefully through the transaction and whether you really want to purchase the home and whether you’ll have the financial means to do so during the term of the option.
Finally, make sure that the fee will go toward your down payment if you exercise the option to buy. While this is typical in my experience, you may find some landlords who seek to treat some or all of the option fee differently.
In most lease purchase arrangements, the tenant receives a credit that will go toward the purchase price if they buy the property. While there is no universally agreed upon amount, for residential real estate, 10% to 15% of the monthly rent seems to be a good rule of thumb. For a home costing $1,295 a month, for example, we offer a monthly rent credit of about $150. The rent credit is an important part of the deal for tenants for at least two reasons.
First, it of course reduces the cost of the home when you exercise the option. And second, it can help you build up a down payment on the home. The key is to make sure that the deal includes a fair rent credit. Finally, we make the rent credit contingent on timely rent payments. If rent is late one month, the tenant loses the rent credit for that month.
Recently, we’ve started shifting the maintenance obligations over to the tenant. This practice is not uncommon, particular with land contracts or rent to own arrangements. From a tenant’s perspective, taking on the responsibility of maintaining the property may seem like an unwanted financial risk, and to some extent it is. There are, however, some potential tax benefits of taking on this obligation (see below).
If you do find a landlord that wants you to assume the maintenance obligations and you’re willing to accept this responsibility, here’s a tip. Instead of taking on this responsibility on day one, consider delaying the transfer for six months. This gives you a chance to identify any latent issues with the home and to get them repaired on the landlord’s dime. In effect, this gives you a six month warranty on the home.
There are two big mistakes that many tenants make on the purchase price. First, they don’t negotiate for a lower price. And second, the enter into option to buy deals where the price is not fixed.
Since we began offering our homes on a lease purchase, not a single tenant has even tried to negotiate the purchase price. This is a big mistake. The purchase price is always negotiable on a lease purchase deal, just as if you were buying the home outright. It’s easy to research home values on the Internet. Begin with online home value websites to get a rough guide. And then look at comparable homes that have sold in the last six months. Armed with this information, negotiate a fair price.
And whatever price you agree upon, it should be fixed during the term of the option. Avoid deals where the purchase price will be “agreed upon” later or based on some future appraisal. The option fee is paid in exchange for the right to purchase the home for a set price within an agreed upon period of time. If a landlord won’t agree to a fixed price that is fair, look for another property.
Financing a Rent to Own Purchase
It may seem odd to talk about financing since you won’t need a mortgage unless and until you decide to buy. But my recommendation is that you talk to a mortgage broker BEFORE entering into a lease option. A good mortgage broker will give you an honest assessment of your chances of being approved for a loan during the term of the option. While a broker can’t offer you any guarantees, they can arm you with important information that will help you make the best decisions for you and your family.
$8,000 Tax Credit
As you may know, first time home buyers may qualify for a $8,000 tax credit if they purchase a home in 2009. In addition, a bill has been introduced to extend this tax credit beyond 2009. In the context of a rent to own house, the question arises whether you can qualify for the $8,000 credit in 2009, even if you haven’t yet exercised the option to buy. The short answer is yes, under certain circumstances a lease option transaction may qualify you for this tax credit. Of course, you want to check with a tax specialist before making any decisions.
Here’s a Q & A from the IRS on this topic:
Q. Can a taxpayer claim the first-time homebuyer credit if the purchase is pursuant to a seller financing arrangement (for example, a contract for deed, installment land sale contract, or long-term land contract), and the seller retains legal title to secure the taxpayer’s payment obligations?
A. If the taxpayer obtains the “benefits and burdens” of ownership of a residence in a seller financing arrangement, then the taxpayer can claim the credit even though the seller retains legal title. Factors that indicate that a taxpayer has the benefits and burdens of ownership include: 1. the right of possession, 2. the right to obtain legal title upon full payment of the purchase price, 3. the right to construct improvements, 4. the obligation to pay property taxes, 5. the risk of loss, 6. the responsibility to insure the property and 7. the duty to maintain the property. (New 7/2/09)
You’ll notice that #7 is the duty to maintain the property, which brings us back to the transfer of maintenance obligations. Of course, that’s just one element the IRS considers, and as I noted earlier, you should consult with a tax specialist if you are considering a lease purchase and the $8,000 tax credit. And keep in mind that qualifying you for the tax credit may require entering into a land contract rather than a lease purchase.
A lease purchase can be a reasonable way to purchase a home. Particularly if you’ve recently been through a bankruptcy, have bad credit, or lack enough cash for a down payment, a rent to own home may be a good option. If you’ve ever purchased a home this way, please share your experience in the comments below. And if you have additional tips, please share those, too.