Real estate investor Justin Pierce writes an occasional column about his experiences buying and selling houses in the Washington area.
I’ve been watching the market closely and I’ve noticed there are a lot of buyers who don’t quite qualify for conventional lending right now. It also seems like these buyers are not getting the best advice.
I am having deals fall apart and realizing that the buyer had a lender who was unresponsive and a real estate agent whose priority, well, didn’t seem to be the clients’ best interest. It’s hard to really know for sure what is happening on that side of the transaction when you can’t talk to the buyer directly.
So I decided to do something different with a home I just finished in District Heights. It’s a nice little four-bedroom, two-bathroom Cape Cod. I purchased it for $83,000 and I put about $55,000 of renovations into the home. Instead of selling it outright, I decided to try to offer a rent-to-own deal on the home.
My thinking is that I can tap an even larger pool of buyers who are just below the threshold for qualifying for a loan. I can also deal directly with the buyer whose interests are more aligned with mine without someone in between us. I could then recommend good reputable lenders in the beginning of the deal who would help identify the buyer’s major credit issues and help them best allocate their resources to become creditworthy in a year’s time.
The drawbacks for me are that I put a lot of money into the home’s renovation, much more than most rentals and I have to wait an entire year to get my money out of the deal. A bad tenant could mean thousands in repairs and the year wait creates an opportunity cost because the resources in this home will not be available for other deals.
To mitigate those risks I am asking for a bigger deposit upfront that will be contributed to the sales price when the buyer closes on the deal. I also got a friend to finance $120,000 of the holding costs at 8 percent per year to offset my opportunity costs. I will receive a nice cash flow from the renter, which will offset the time value of money losses. Oh, and I also save about $10,000 in real estate commissions.
To sweeten the deal for the buyer, I am offering to contribute $400 of the monthly rent of $1,600 toward the final purchase price.
The response has been amazing. In less than two weeks, I’ve taken six applications. People are very eager to find a path to home ownership. I have not accepted a buyer yet but at least two of the applicants look very good. I have rejected three applicants, however.
The rejected applicants just had too many negative entries on their credit reports. There was very little chance they would be able to repair that amount of damage in one year’s time. In each case, they have been very disappointed with my decision. I had to explain to them that it’s a good thing I turned them down and warned them about rushing into rent-to-own deals.
Be careful before getting into a rent-to-own deal — they can be tricky.
A rent-to-own or a lease option consists of two separate agreements. First, you agree on the terms of the sale. In this case, the sales price is $185,000 and the buyer has one year to close. You also do what is essentially a preoccupancy agreement — a lease stating that the buyer is going to rent the home for up to one year, in this case. Normally, the buyer can close at any time prior to the agreed upon closing date.
Now if a year down the road the buyer goes to close and the parties find that the home has gone up in value by $20,000, the seller is still obligated to sell the home for the agreed upon price. So the seller has some risks, particularly in a market like we’re seeing now. To mitigate that risk, the seller usually gets more significant upfront deposits. If you do an Internet search on rent-to-own, you’ll probably see real estate investors bragging about getting $10,000 deposits.
Normally that deposit is completely non-refundable if the buyer doesn’t close for any reason. And that is where buyers need to be careful. Some sellers get very large deposits and essentially don’t care if the buyer closes. If the buyer doesn’t close, then the deposit is forfeited and the owner moves on to the next buyer.
I had two real estate investors call me recently. One guy told me that he had a list of people ready to go. He would collect a $10,000 deposit and he would give me half. He would keep half as a finder’s fee. He told me if the buyers were unable to close, he and I could keep the deposit and move on to the next person on the list. It seemed to me that it would be very much in his best interest if the buyer did not close the deal.
I am asking for a total of $4,000 in deposits, which is slightly less than the 3.5 percent down payment the buyer will need at the time of sale. But I broke it up into a purchase deposit of $2,500, which is nonrefundable, and a $1,500 rental deposit, which is refundable if the home is returned in good shape should the deal fall through.
That gives the buyer an incentive to take care of the property if they are unable to purchase the home and have to move. As long as the home is in good condition, they will get there rental deposit back. The purchase deposit will be on the line to provide an incentive to make sure the buyer is really committed to following through with the contract.
If all goes well at the end of the year, the buyer will have $4,000 in upfront deposits and $4,800 in rental credits to apply to the purchase of the home.
Rent-to-own deals can be really good for both parties. Buyers need to be aware that the seller is taking on additional risk and deserve additional deposits.
However, it is also highly abused and can be used to take advantage of desperate home buyers who do not do their homework.
On the other side, many renter/buyers get into homes and make no real effort to fulfill their contractual obligations.
Whether a buyer or a seller, you need to do your homework. The buyer should not expect the seller to be their personal financial adviser.
If you’re thinking of selling this way, make sure you do a good screening before accepting any applicants. A bad tenant can cost you and that large deposit may not be enough to cover all your expenses.
Justin Pierce is a real estate investor in Northern Virginia.