Rent-to-own homes: Do the risks outweigh the benefits?

During the 1980s and 1990s, “rent-to-own” homes were relatively popular. The notion that renters could take a home for a test drive before purchasing it lured in many prospective homeowners. It was a great option for people who lacked the credit score or down payment to buy a home; and it allowed renters to dip their toes into the concept of homeownership before taking final plunge.

The practice started to fall by the wayside in the first half of the 2000s as mortgages became easier to come by. However, as banks have tightened their lending requirements again, rent-to-own homes have grown in popularity.

What Are Rent-to-Own Homes?

Rent-to-own homes, also known as lease options, are properties that an owner agrees to lease to someone for a specific period of time (usually 2 to 5 years). After that period of time, the renter has the option to purchase the home for a predetermined amount.

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Units are typically leased out at market rates with an additional rent-to-own fee tacked on each month. That fee varies, but it’s usually anywhere from 10 to 15% of the monthly rent. For instance, a unit that would rent for $1200 on the open market may cost a rent-to-own lessee $1350 per month, with the $150 difference put aside in an escrow account. Any funds collected in the escrow account can usually then be used toward the purchase of the home if the tenant decides to exercise their option to buy. Otherwise, the funds are forfeited to the owner at the end of the lease term. Using the same example as above, this would result in $5400 collected over a 3-year lease period, which the tenant could put toward closing costs or a down payment on the home.

Why Are Rent-to-Own Homes Becoming Popular Again?

As a result of the mortgage foreclosure crisis, banks have increased borrower scrutiny. On one hand, interest rates are still near record lows. On the other hand, mortgages have been difficult for some people to secure. Banks are requiring people to have better credit and longer employment histories than in past years, decreasing the possibility of homeownership for people who experienced job loss, foreclosure, bankruptcy, and other credit ailments as a result of the Great Recession.

Meanwhile, banks have all but stopped underwriting home loans for less than $100,000. New banking regulations require significantly more time and paperwork, so these smaller loans tend to not be profitable for most banks nowadays. Rent-to-own homes tend to be most common in weak market areas where borrowers would need these smaller loans. Basically, rent-to-own provides an alternative for people who can’t make their way through today’s new banking system for one reason or another.

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We’re also seeing an uptick in rent-to-own homes now that property values have recovered from the recession. As prices have increased, it has become harder for some homebuyers to save enough for the requisite down payment. Rent-to-own homes provide a built-in mechanism to help people save for the down payment on a home they love but simply cannot afford at the moment. Rent-to-own homes can also help a person rebuild their credit by making timely rental payments during the contract period, thus increasing the likelihood that they’ll be approved for a mortgage to buy the home a few years down the road.

Why Do Rent-to-Own Homes Get a Bad Rap?

There are a number of reasons why rent-to-own homes appeal to prospective buyers. However, some industry insiders are wary of the practice—and rightly so.

The rent-to-own market segment of the real estate industry is not particularly regulated, nor are these transactions carefully tracked. However, a number of horror stories have made their way into the headlines. Most pertain to landlords who took advantage of low-income or unsuspecting renters by structuring the agreements to make tenants responsible for maintenance and repairs, but not disclosing to the renters that the homes were riddled with code violations.

The Houston Chronicle profiles one such story:

Samuel Rankin thought he was starting fresh when he and his two daughters moved out of a 1970s trailer home into a three-bedroom Vision rental home in Alexander, Ark. But he soon discovered that the house, located just outside Little Rock, had no heat, no water and major problems with its sewage system that led to nearly $10,000 in repairs.

Vision, the company with which Rankin signed a rent-to-own agreement, is a property management company that oversees a portfolio of over 5500 properties, many of which are marketed as rent-to-own opportunities. The Columbia, SC company is now under legislative scrutiny for its business practices.

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Sadly, there are countless other stories about landlords wrangling their way out of the eventual sale to renters that don’t have the means to hire an attorney to enforce the contract. When this happens, the landlord walks away with all of the escrow funds that the tenant has dutifully paid.

One of the challenges of rent-to-own contracts is that there is no uniform agreement for parties to use—unlike what you’d expect with traditional, state-sanctioned lease or purchase and sale agreements. In fact, rent-to-own agreements are rarely regulated by the government. As a result, rent-to-own agreements can look markedly different from transaction to transaction, with the property owner nearly always retaining the upper hand.

Why Some Owners Opt for Rent-to-Own

Entering the unregulated rent-to-own market isn’t for every property owner.

First and foremost, while these agreements tend to favor the landlord, they are not foolproof. A landlord truly hoping to sell risks a tenant walking away from the property at the end of the contract period, and thus having to put the property on the market all over again. Landlords often find themselves in hot water if tenants were responsible for repairs and maintenance, but then walk away from the deal without taking those duties seriously. Finally, landlords risk agreeing to sell the property for a set price, only to see the home appreciate in value during the contract period.

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However, for some owners, a rent-to-own contract can be a great option. This tends to be the case when an owner is relocating from a cool market and wants to buy in a new market, but they cannot afford to carry two mortgages at once. Renting the home they’re trying to sell will help to offset their debt-to-income ratio and make it more likely that the sellers will qualify for a mortgage on a new home once they relocate.

Moreover, someone who’s renting a home with the intention to purchase it may care for it better than the average tenant, who only plans to stay for a finite period of time. People who lease a rent-to-own home have a vested interest in keeping it in good condition—at least in theory.

Rent-to-Own Homes: Contract Details to Consider

Because there’s no standard rent-to-own contract, some property owners are unsure of which details to include in their agreement. At a minimum, owners should consider the following elements:

• Security deposit: Collect a security deposit as if you were signing a traditional lease as a protection against any potential damages.
• Lease option fee: Some rent-to-own landlords charge an upfront lease option fee in addition to the security deposit. These fees tend to be 1 to 2% of the purchase price. These funds are credited to the tenants if they complete the sale; otherwise, they’re generally forfeited to the landlord.
• Ability to evict: Landlords should absolutely include language that gives them a right to evict the tenant, even if that tenant is planning to purchase the home down the road. Doing so safeguards the owner in the event that the tenants stop paying rent or need to be evicted for another reason before the lease period ends.
• How money will be held: The contract should be clear about how funds will be held and by whom. If the landlord is planning to hold funds in an escrow account, does interest need to be paid to the tenants? If so, how frequently? At what point will funds be returned to tenants (if at all), and under which conditions?
• Details of the sale: Some landlords assume that they can coordinate the details of the eventual sale at a later date, but this is a big mistake. It’s in the interest of all parties to be abundantly clear about the terms and conditions of the sale in advance, including an agreed-upon purchase price. Yes, the property may appreciate in value over time. Conversely, it may depreciate. In fairness to both parties, the price should be set in advance nonetheless.
• Repairs and maintenance: This is where many landlords get hung up with rent-to-own properties. Some forget to include language in the agreement about which party is responsible for R&M. This can cause major, deal-threatening disputes down the road. Be explicit about who is responsible for what, and to what extent. For instance, maybe a tenant is responsible for all routine repairs and property maintenance up to a certain dollar amount each year, at which point the costs are covered by the owner (or shared between both parties). Capital improvement costs should be included in this provision.

As always, we suggest that any landlord who is considering a rent-to-own agreement consult with their real estate attorney first. The information provided here is just a guide. Rent-to-own transactions are complicated, and regulations (where they exist) can vary from state to state. An attorney will be able to advise you on how best to proceed.