First-time homebuyers or people with poor credit and limited cash can ease into home ownership with a rent-to-own (or lease) option.
While the idea of rent-to-own sounds simple and straightforward, legally the agreements are incredibly complex and require significant expertise to navigate.
Unlike a conventional transaction, in which a sale price is agreed upon, and within 30-90 days the entire transaction is complete; in a lease option, the title transfer generally doesn’t take place for years. During that time, the property will likely require maintenance and repairs, suffer depreciation, may get some improvements, and will almost certainly have a change in value.
The advantages to the buyer are fairly obvious: the buyer takes occupancy of a property today as a renter with the right to become the owner at some point in the future.
The benefits for the seller can also be significant. The seller obtains a tenant for a vacant property—hopefully one that has more inclination to treat the property well compared to someone who never plans to own it. In addition, the seller will likely receive additional compensation, either cash up front or higher rent.
When it comes to the agreement, the amount of rent paid should be negotiated to include a clear determination of how much (if any) of the rent will be applied to the purchase price. If fair market rent is $1,000 per month and no up-front option money is paid, the seller would be foolish to grant an option, especially if the option is based on today’s values. Why would the seller obligate himself to sell the property five years from now at the same price he could get today unless he is getting compensated for the potential change in value? While the option is in effect, the seller cannot sell to someone else during that time.
Most rent-to-buy (options) are written at a specific sales price, but some change over time, either at a predetermined rate or cost-of-living-adjustment—or on occasion, based on an appraisal of fair market value at the time the option is exercised (when the sale takes place).
These provisions will dramatically affect the amount a buyer is willing to pay for the option and the amount a seller is willing to accept. The critical issue is that all parties understand and agree to the contracts.
This type of agreement actually requires three contracts: a rental agreement, a purchase agreement, and an option agreement. The rental agreement outlines the rights and responsibilities of the landlord and tenant. The purchase agreement outlines the price, financing terms, what personal property is included in the sale, what inspections the buyer is entitled to, and what repairs the seller is obligated to perform. The option agreement ties the other agreements together and specifies the time frame for the option.
The stickiest issues arise around inspections. Clearly, before escrow closes the buyer should have all standard inspections. The question is: when should the inspections take place: when the option agreement is written, or closer to the transfer of title? Few people want to take on unnecessary expenses any sooner than they have to, but I strongly recommend getting the inspections up front, prior to taking possession of the home and committing non-refundable option money to the transaction.
When it comes time to execute the option and purchase the home, the amount of money paid for the option is not relevant. The decision to purchase the home should be made solely on the basis of whether the property is worth the purchase price to you. The option money paid is irrelevant. Do not throw good money after bad. If they house isn’t worth the purchase price, walk away. You are under no legal obligation to exercise the purchase option.
If you have questions about real estate or property management, please contact me at firstname.lastname@example.org or visit www.realtyworldselzer.com. If I use your suggestion in a column, I’ll send you’re a $5.00 gift card to Schat’s Bakery. If you’d like to read previous articles, visit my blog at www.richardselzer.com. Dick Selzer is a real estate broker who has been in the business for more than 35 years.