Rent-to-own investing is a form of creative investing. In short, you purchase a property for under-market value and rent it to a tenant who has the intention of buying it before the end of the lease term.
You collect an option fee from the tenant at the beginning of the lease that is between 3-5 percent of the expected sale price of the home. That fee gives the tenant the option to buy the property but creates an obligation for you to sell exclusively to this buyer throughout the lease term.
When You Should Do Rent-to-Own Investing
You should do rent-to-own when the buyer’s market is slow.
Buying houses under market value and flipping them is profitable when the market is moving quickly. It only takes a few months to flip a house, but in that short period of time, the market can dip. The market of the home could be less than the price you paid for it or the demand for homes within the price range could fall.
You usually have two options when the market dips. You can sell the property for less or hold onto the home until conditions improve.
However, rent-to-own is a viable third option.
When market conditions worsen, people usually have a more difficult time purchasing homes. That doesn’t mean that people want to purchase homes any less; it is just more difficult for them to secure financing.
Rent-to-own gives those people the opportunity to strengthen their economic position to purchase a home, even when the economy is bad.
It also gives you a third option to make a profit. You can lease the property to a tenant and sell it at market value whenever the tenant is ready to purchase, which is usually at least six months down the line.
Related: Rent To Own Homes: How to Profit from a Lease Purchase
By setting the property’s sale price at market value, you can benefit from property appreciation over the lease term. You could also set the purchase price at or above the cost of flipping the home.
However, buyers are less likely to commit to a high sale price when the market is weak. Additionally, the home may not appraise at that value, which would leave even a willing tenant unable to secure a mortgage and purchase the home.
You should rent to own if you want a larger return on investment, but you’re not in a rush.
Rent-to-own is a low-risk way to make extra money from a flipped home. You are guaranteed the extra rental income for the full lease term and retain ownership of the property if it isn’t purchased.
Leasing a property to a tenant and giving them the option to buy helps you find a buyer motivated by the money he or she has invested into the property (the option fee) who will buy if financing comes through.
For you, it’s a win-win. If the tenant doesn’t buy the property, you keep the option fee and the rent money. You can then sell the property to someone else or rent to own it again.
If the tenant buys the home, you return the option fee as a credit toward the tenant’s down payment on the home and keep the rent money and the sale price of the home.
You will make more money from the property if the tenant does not buy; however, both options are more profitable than selling the home immediately after the flip.
When You Shouldn’t Do Rent-to-Own Investing
You shouldn’t do rent-to-own when you need to make the money back fast.
If you secured the funds to purchase a property through creative methods, you may need to pay back financing quicker. While that works well for flipping properties, it does not work as well when it takes longer for you to make a return on investment.
Rent-to-own takes time to yield a return on investment. Ultimately, the ROI is higher than the outright sale of the home, but it is nowhere near as fast.
There are no guarantees of when you will get your money back because lease-option contracts are unilateral. The tenant has the option to buy, and you have an obligation to sell.
The payout could come at the end of the lease term when the buyer purchases or it could come later when the property is sold to someone else.
You will recoup the money spent either through rental income over a long period of time or through the sale of the property.
You shouldn’t do rent to own when it is a seller’s market.
Though it’s difficult to know when you’re at the highest point of a market bubble, flips are most profitable at the top of it. Therefore, it doesn’t make sense to lease-option a home that you flipped at the point of the market when you’ll gain the most money.
If you lease-option your property at the top of the bubble, you risk the bubble popping and the value of your property dropping considerably. The drop in value will likely outweigh any profit you could have made from rent-to-own.
Would you consider rent-to-own? Why or why not?
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.