The Market Has Investors Turning to Rent-to-Own For Predictable Returns
Do you know what your rental might sell for in 3 years?
After months of soaring house prices, rising interest rates is cooling the market, leaving investors unsure where their portfolio values will end up. To add some stability, some investors have begun looking at Rent-To-Own deals to diverse their portfolios because they provide predictable returns.
On the flip side, employed home buyers with down payments are still struggling to qualify and have begun looking for new and creative ways to get into their own home; RTOs is one solution.
Essentially a Rent-to-Own agreement works very similar to a regular landlord and tenant rental agreement with a purchase agreement attached for the end of the term. The investor/landlord and the tenant/buyers agree to a future purchase price, a deposit amount and a monthly payment that will include both the rent and an amount that will be put towards the purchase.
Here’s how a Rent-to-Own works:
- a Landlord/Investor screens Tenant/Buyer applicants to find the right fit of someone who will both make a good tenant for the next couple years and will be in a position to purchase at the end of the agreement. A Mortgage Broker is usually involved in the process to pre-qualify the buyer and confirm current income, expenses and credit.
- the Investor purchases a property in their own name that fits with what the Tenant is looking for and will be in a position to purchase in the next 3-5 years.
- both a rental agreement and an RTO agreement are both signed – it’s vital to ensure you’re using both these agreements separately. The buyer provides a deposit, which may or may not be refundable depending on the agreement and the monthly payment consists of rent that will ensure the Landlord cashflows, plus an extra payment that will go towards the purchase.
- the Tenant/Buyer lives in the house making the monthly payments and in most cases covering the costs of repairs and maintenance.
- at the end of the term set out in the RTO agreement, the Buyer qualifies for a mortgage and the formal sale goes ahead through lawyers as a normal purchase would. The initial deposit and additional monthly payments are combined and used towards the down payment on the purchase.
Example Case Study:
Lisa is a real estate investor with a line of credit she’s looking to invest in a Rent-to-Own.
Sue and Bob are looking for their first home but because Sue had been out of work, their credit card balance is a little high, their credit score a little low and she doesn’t have enough time at her job to qualify for a mortgage. They have $10,000 saved for a down payment and pay $2,200 for a 2 bedroom apartment.
Their Realtor Kevin who was prepared to show them properties instead introduces them to Lisa, who after reviewing their situation and having a mortgage advisor confirm they’re on the right track to purchase in a couple years, agrees to work with them.
Lisa uses the Realtor Kevin to find and purchase a specific property that fits with what Sue and Bob would be looking for and could afford in three years. Lisa, Bob and Sue sign both a lease agreement and a Rent-to-Own agreement with an $8,000 non-refundable deposit. Sue and Bob will pay $2,150 in rent each month (that will provide Lisa a positive cashflow), plus an additional $1,000 that is put towards the purchase. They are also responsible for repairs and maintenance.
The house is purchased by Lisa for $600,000 and the couple agree to purchase it from her for $670,000 in three years. At the end of that term Sue and Bob qualify for a mortgage and have accumulated $44,000 towards the down payment ($8,000 deposit plus $36,000 in monthly payments). A lawyer handles the transaction as a normal house sale using the original purchase agreement.
For illustration purposes, Lisa earned $70,000 from the sale, around $3,600 in cashflow plus $19,500 in mortgage principal pay down by the end of the term.
How is This a Benefit?
- this strategy allows investors to predict the returns on the investment because they know exactly how much they will cashflow through the term, what the sale price will be and usually have no ongoing maintenance costs. They can predict the profit several years down the road.
- they save Realtor fees on the sale of the house because the buyer in already in place
- they sometimes cashflow more because of the reduced expenses
- they have more security with a larger deposit at the beginning of the term with additional monthly security payments
- less risk of having bad tenants because the house will become theirs and have far more invested themselves in the property
- get into a home of their own sooner
- forced savings plan, knowing monthly payments are going towards their purchase
- lock in a purchase price earlier
- able to get into a home with a lower initial deposit than a traditional down payment
- avoid tight mortgage rules if they’re dealing with temporary financial issues
- make upgrades to the house that benefits them, not a landlord
What Are The Drawbacks?
- negotiated price may be lower than the market value at the time of sale
- Tenant/Buyers may have work/financial issues come up and may not be able to close
- purchase agreement may need to get extended beyond initial plan
- extra screening required for find both a good tenant but also valid buyer
- extra work and costs setting up contracts
- negotiated price may be higher than the market value at the time of sale
- finances or work situation may not allow for mortgage qualification
- fewer lenders work with RTO and initial interest rates may be higher
- higher monthly costs than renting because additional principal payments and maintenance costs
- upfront deposits often non-refundable
What to Watch Out For:
Not all RTO agreements are the same or created equal. It’s important that a real estate lawyer who is experienced with Rent-to-Own deals has reviewed the agreement for both parties. Each side should have their own independent lawyer.
There are two types of agreements – purchase agreements and purchase options. Purchase agreements are formal offers to purchase and are legally binding, just like any real estate purchase. Purchase options, however, allow the Buyer/Tenant the option to walk away from the agreement at the end of the term.
Everyone needs to understand the deposit and payment agreements. In many cases the initial deposit is non-refundable, whereas the additional monthly payments above rent is refundable should the purchase not go through.
Investors are encouraged to include conditions in the RTO agreement that allow the Tenant/Buyers and extension should they still need a bit of time to close on the purchase. In many cases market conditions and changing mortgage rules provide hurdles at no fault to the buyer and it makes business sense to do the right thing and work with the buyers.
A Rent-to-Own agreement and a rental agreement must be separate documents, otherwise the Landlord Tenant Boar can nullify the purchase agreement and force the landlord to repay the deposits with interest.
As an investor focused mortgage advisor with over 10 years owning and managing rental properties I can help you ensure you’re buying the right home, finding the right tenant/buyer and help calculate and maximize your returns.