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The Two Types of Rent to Own: Advantages & Disadvantages

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Call it rent to own, lease to own, lease options, or whatever you like. The strategy has been gaining popularity thanks to the numerous benefits of rent to own for each party in the transaction. There are two fundamental approaches to putting these deals together; the tenant first approach or the property first approach. There are many investors using each strategy and each has its own advantages and disadvantages.

Tenant First Rent to Own

As implied by the name, the first step in the tenant first strategy is to find a qualified tenant-buyer who is going to rent to own a property and intends to buy it out at the end of the lease term. This is easier said than done, and it generally takes a lot of filtering to find qualified applicants with realistic expectations.

Once a suitable tenant-buyer has been located the investor helps them find a property that meets their criteria and pre-established budget.

When the investor has both a tenant-buyer and the right property, they can either close themselves or bring in another investor as a money partner to fund the deal.

Property First Rent to Own

Again as the name implies, property first rent to own means you start out with a property and then find a tenant-buyer. You may opt to use this method if you already have a single family rental and are considering rent to own, if you get great deals on properties through Quickturn style real estate, or if you just have a single family home with good curb appeal that you think would work well as a rent to own.

With this strategy, the specific property is marketed as rent to own and the owner will usually do showings, take applications, and filter prospects similar to the usual rental process. Even with an attractive property, sifting through a large number of applicants is usually required to find the right tenant-buyer for the property. The nice part here is that the property is usually available and your tenant-buyers can get into their new home right away.

Pros and Cons

I tend to prefer the tenant first strategy, but each investor has their own opinion and there is no right or wrong way to do it. Some of the things I like about tenant first rent to own are:

  • Filter tenants first to avoid working with tire kickers
  • Tenants select their own home to suit their needs
  • Can have tenants take on more upfront expenses (eg. property inspection)
  • No vacancy since tenants take occupancy when you close

On the other side of the fence, property first has a few benefits of its own:

  • Purchase below market value
  • Buy in locations you like best
  • Tenants can move in immediately

If you have a large list of tenant-buyers in a specific area, property first can work well. The main risk I see is having the property sitting vacant waiting for the right tenant-buyer to like that specific property.

As a conservative risk adverse kind of guy, the certainty of the tenant first strategy clicks for me.

What is Your RTO Strategy of Choice?

I’d love to hear more on which rent to own strategy readers prefer. Do you like tenant first or property first, and why?

Creative Commons LicensePhoto: House of Joy Photos

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About Author

Andrew is a Canadian real estate investor and analyst who works with Joint Venture partners to create long-term wealth. With a focus on buying and holding positive cash flow properties in Canada's Technology Triangle, Andrew makes the benefits of real estate investment available to those who lack the time or expertise to buy and manage property themselves.

12 Comments

  1. Pingback: The 2 Types of Rent to Own

  2. Andrew,

    Good post that should open up a lot of newer investors’ eyes to the multiple methods that can be involved in a simple ‘rent-to-own’ transaction. Also this post should hopefully help investors evaluate their own risk/reward tolerance.

    I’m big into mobile home investing. Depending whether or not the home is located within a park or on private land will help me determine if I will locate a buyer before I closing or visa-versa. In addition to where the home is located; older mobile homes are near impossible to locate financing for. The result = Many of my rent-to-owns become rent-to-owner-finance for long term cash-flow.

    – John Fedro

  3. Shaune Impey on

    Andrew

    The downside I see from the “Tenant First” policy is that typically the property is bought retail from MLS. The future sale price must then be inflated 3-5% per year in order to make a profit. In a steadily rising market this is easily obtainable. In a flat or declining market the future sale price is now over-priced. The tenant-buyer won’t get a mortgage at the sale price as the appraisal will not support the deal. Therefore the tenant must either come up with the difference in price or walk away. Neither is a winning situation for the tenant. The Owner could extend the terms of the contract which may only delay the pain. My view is that a successful LTO/RTO deal involves selling the property at “today’s price” at a future date. It works well when properties are bought under market (think of them as long term flips) or when the investor has properties in their portfolio that they wish to liquidate over time and perhaps ease some tax burdens. There is good cash flow and the benefits of mortgage pay down over the term of the contract.
    Shaune

    • Hi Shaune, You do have a valid concern. In a rent to own deal it takes an agreement from both the tenant buyer and investor to make the deal work.

      If both are willing to agree on using an appraised price at some point in the future, that can work. Typically what I do is use a conservative growth rate of half the long term average so that there is a pre-determined buyout price that both the investor and tenant buyer are aware of. People like the certainty of this and it usually ends up being a fair way to do it. A variable buyout price makes sense too, but it is harder to structure the deal upfront since you don’t know how much down payment will be required at the end of the day to ensure your tenant-buyer will qualify.

      • Shaune Impey on

        Andrew

        A variable price in the future is a crap shoot for both parties. The investor needs a certain ROI therefore a pre-determined price is necessary. The buyer needs price certainty so the goal is known (how much down payment to save and mortgage qualifying amount). If the market appreciates faster than anticipated and the price is above the strike price of the option then the buyer is a winner. If the market stays flat and strike price is higher than the value then both parties need to have considered the options up front and have a contingency plan, i.e. an extended LTO period. It makes no more sense for a seller to dump the property for no gain than it does for the buyer to pay an over inflated price (if they can even swing the deal with the bank).
        I do agree with your comments on the lawyer article. The good LTO investors protect not only themselves but their clients (buyers) as well. Out west where I live we have seen many scam artists use LTO as a cash cow by picking on unsophisticated/desperate buyers. It’s given the LTO business a bad name.
        When I do my LTO presentations I always bring up this subject first and explain the pitfalls of doing a LTO with unscrupulous people. Then we discuss how our LTO will address the issues. I also explain that they still have a contract to fulfill and if they renege on the terms (i.e. missed/late payments) they are out the door. Market anomalies affecting the price are never a reason to terminate the deal unless the buyer elects to do so.
        Shaune

    • Hi Lucas, this is a good article and I like what Bob Aaron has to say. He does a great job in warning people about the pitfalls of various real estate deals like pre-construction condo investing, rent to own, etc.

      That being said, nearly every strategy has its pitfalls. To me, rent to own makes a lot of sense for both the investor and tenant-buyer. Let me address a few of Bob’s concerns with rent to own.

      #1: Lack of standard forms – This can cause some confusion but does not make rent to own a bad strategy. We always have our clients seek independent legal advice to ensure they understand the terms of the deal, and that those terms are acceptable to them. Not having standard forms means there is room for negotiation on the terms, but keep in mind the investor must still agree so any changes need to be reasonable.

      #2: Pricing – This one goes either way. If the buy-out price is too high the buyer walks away from the deposit because it doesn’t make sense to exercise their option. If it’s too low, the investor leaves too much on the table and achieves a lousy return. We aim for a conservative middle ground and do our best to setup win-win situations for both the investor and client.

      #3: Above market rent – The additional amount above market rent goes towards option credits which can be deducted against the eventual purchase price. We never intend for a client to walk away from the deal and look to work with those who are committed to owning the home so we hope for this to be a non issue. From the investor perspective, we need to ensure there is some skin in the game to keep things moving along according to plan.

      #4: Unlicensed real estate agents – This can be a risk in the industry, but my company only works with licensed Realtors to find homes for our rent to own clients.

      #5: Defaulting tenants – I have not dealt with this yet, but we have structured our deals with separate agreements meaning the standard rental lease can be enforced by the LTB. In the case of a lengthy eviction process at least the investor has the option deposit when working with rent to own, whereas they are usually out of luck with a straight rental here in Ontario where it is illegal to collect a security deposit.

      The most important thing in putting together rent to own deals is to screen well and only work with the best clients. Questionable deals will inevitably produce headaches down the road, so look for those who you know you can honestly help and who are committed to owning their own home.

      As Bob says, rent to own is not for everyone, but for many people that cannot qualify for traditional financing today, it can be an incredibly worthwhile strategy.

  4. This article is the best information I have found on the the tenant first strategy which I found highly effective and in the current environment of rising home prices, home shoppers that are out of the mortgage market are very motivated by the prospect of home-ownership using lease options.

    I have been testing this strategy for about 4 weeks using poor credit purchase leads form Mortgage Leads Network an l and have already got several deals in the works in various parts of the country.

    I see this as the release valve for the pent up “sub-prime” mortgage market, We have a few good years of this business model moving ahead.

    The information in the article and comment are extremely useful for me and I thank Andrew for so generously sharing the information.

    -Ted Schmidt

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