A: These “rent-to-own” arrangements are also called lease-option agreements. They can take many forms, but basically, your tenants sign a lease containing clauses that give them the option to buy the home at a fixed price and at a fixed time, called the “exercise date.” The purchase agreement should contain all other mutually agreeable terms and conditions that you would find in a traditional purchase and sale agreement.
Typically, to induce tenants to enter into a rent-to-own agreement, you agree to apply a portion of their monthly rent as their earnest money deposit, which gets applied toward their purchase price at settlement if they exercise their option to buy. If they do not exercise their option to buy by the set date, they forfeit their accrued earnest money deposit. There are many permutations on this basic theme, depending on your and your tenant’s needs.
Usually, the rent is above fair market value, since some percentage will be applied to a tenant’s earnest money deposit. Depending on the market conditions, it could also be at or even below fair market rental value. You may wish to adjust your agreed-upon purchase price to reflect whether you believe prices will go up or down by the exercise date and to account for the fact that you are applying a portion of the rent each month toward your tenant’s eventual purchase price.
For example, you could lease your home for $2,000 per month and agree to apply $500 per month toward the earnest money deposit. After the first year, your tenants will have $6,000 saved toward the purchase price. If they exercise their option, you apply the $6,000 as their earnest money deposit toward their purchase price. Your tenant and their lender will have to come up with the remainder of the purchase price at settlement. If they decide not to buy on the exercise date, you keep the $6,000. Then they either remain as rent-paying tenants or move out and you sell to another buyer.
Rent-to-own contracts are often used in a buyer’s market when buyers, especially first-time home buyers, have a stable income, but not the cash saved for the down payment. Similarly, rent-to-own agreements can be useful when tenants’ current credit may be insufficient to qualify for a mortgage, but they anticipate their credit will improve by the exercise date and they can then qualify for a mortgage.
A variation is an “agreement for deed,” where a seller agrees to sell the home to tenants, but the deed does not get conveyed to the tenants until they pay an agreed-upon monthly amount for an agreed-upon period. The seller only conveys the deed to the property after the tenants have made the required payments. If tenants fail to make the required payments or otherwise default, they forfeit the right to the deed and all payments made up to the time the default occurred.
There are many risks associated with these transactions. For example, your tenant may damage or fail to maintain your home in a satisfactory manner. Your tenant may not leave voluntarily at the lease expiration, requiring you to resort to an expensive and time-consuming judicial eviction. There is always the risk that your tenant may not be able to qualify for a loan by the settlement time. Perhaps the biggest risk for a seller is to agree to a sales price that is below the fair market value at the exercise date. If the property appreciates more than the seller anticipates, the seller may be leaving money on the table.
The tenant also bears risks. For example, a seller may further encumber the home by taking out additional mortgages or drawing on existing home equity credit lines. If the seller does that, the purchase price may no longer be enough to allow the seller to convey the home free and clear. Other risks arise if a seller dies or becomes incapacitated. If that occurs, the home could be tied up in probate or other legal proceedings for years. An unscrupulous seller could sell the home to someone else[KA1] [HJ2] . Such a sale would be illegal, but the tenant would then have to successfully sue the seller for damages and might not be able to void the illegal sale. One way to reduce the tenant’s risk is to record the lease in the land records of your state. By recording the lease, the public is on notice that the tenant has an equitable right to acquire the home.
Based on the current market uncertainties, you are wise to explore various strategies for maximizing your profit from your recent home flip. I suspect we will be seeing more rent-to-own transactions in the foreseeable future.
Harvey S. Jacobs is a real estate lawyer with Jacobs & Associates Attorneys at Law in Rockville. He is an active real estate attorney, investor, landlord, lender and settlement attorney. This column is not legal advice and should not be acted upon without obtaining your own legal counsel. Contact him at email@example.com, jacobs-associates.com or firstname.lastname@example.org, or call 301-417-4144.