Why Rent to Own Makes Sense For Newbie Investors

45 Replies

Rent to Own is great for newbie investors. Here are the reasons why:

1. With rent to own, you can buy a property at closer to market value and still make money. The problem in a hot market is that getting good deals is harder and harder (and specially hard if you're a newbie). With rent to own, you can sell the property at a 10-15% premium vs. market value (since you're selling it in 12-36 months), you don't pay any closing cost (when you sell), there's no dickering on the price (this could save you 3-5%) and you don't pay any realtor commissions as well. Below is a comparison of doing a fix-n-flip vs. rent to own and how much you can make on a $200,000 house that you buy-and-rehab for $150,000:

2.  With rent to own, you pay less in income taxes as a percentage of your profit since you're paying long term capital gains vs. ordinary income taxes with a fix-n-flip.

3. With rent to own, you can get passive income while you wait for your tenant/buyer to cash you out. Upfront, you get a $10,000 non refundable option consideration as well. This is great for a newbie investor to build a cash reserve pretty quickly (you can't do that with rentals).

4.  Since you're getting a big chunk of cash upfront, you tend to get better quality tenants (they have more skin in the game and therefore more to lose). You still need to SCREEN your tenant/buyers in the same way you screen a regular tenant. Below are the tenant screening that we use:

- check credit; credit has to be at least 600 specially if you want the tenant/buyer to cash you out in 12 months; also there should be no 90-day lates in the past 12 months
- check criminal history: no felony in past 5 years; tenant can't be a registered sex offender
- check income/ verify employment; salary has to be 3 times the rent
- check civil cases: no evictions in the past 5 years; no BIG civil suits judgments
If you're a newbie, you can't afford to get a bad tenant. With rent to own, you decrease the probability of getting a bad tenant even further because you're looking for a tenant with $10K down or more upfront.

5.  With rent to own, the tenant/buyer is responsible for maintenance and repairs not the landlord. So, with rent to own, you tend to get truly passive rental income even without a property manager. If you're a newbie, you probably don't know how much repairs cost or you don't have good contractors or a good and low cost handyman to take care of the repairs for you.

6. With our rent to own, we get an average of $10,000 upfront plus the first month's rent. With a rental, you get the first month's rent and the security deposit (which is usually, the first month's rent). So if you have to evict a tenant, you will be in negative cashflow territory (i.e. all your rental profit is gone) but with rent to own, you have enough reserves to draw upon(because of the $10K upfront) and you will still make money.

However, you have to do rent to own in the right way. My next post will talk more about this.

What about you BP Nation? Anyone out there who did rent to own? What's your experience with it?

Wow, reading that is really making me debate wether or not I should flip my first house or put it up for "rent to own" @Wendell De Guzman

Account Closed I never thought about this option! Thank you for the coherent and comprehensive breakdown

Your title made it look like you're recommending newbies BUY under a rent-to-own arrangement!

I'm glad to see you're NOT suggesting that. (I do feel sorry for those who feel that going for a rent-to-own option is their ONLY way of breaking into the market. I wonder what the percentage is of rent-to-own aspirants who actually complete their Buy Option when their deadline arrives?)...

Nice post Account Closed- in my experience (nobody has exercised so far on mine) and from what I've read, the % of TBs that actually exercise and purchase LOs is really low.  

Originally posted by @Austin Shuster :

Wow, reading that is really making me debate wether or not I should flip my first house or put it up for "rent to own" Wendell De Guzman

Based on experience and based on the Chicago market (where I am based), the sweet spot for rent to own is $100K to $250K. Below $100K, you tend to get more renters who don't exercise their option and above $250K, the cashflow you get is not good enough.

So depending on the house you're trying to flip, it might make sense to rent to own it or just flip it outright.

Originally posted by @Steve Vaughan :

Nice post @Wendell De Guzman.  Thanks for putting some numbers to a 'real life' example.  There are certainly benefits to using this as the property owner.  Shorter holding times, less sales costs, significant dollars up front, tenants with skin in the game, etc.  

I won't use the term RTO. It makes me flinch. I know what you mean, of course, but Rent to Own is addressed specifically as a predatory tactic in recent legislation. I much prefer lease with option to buy/purchase. I will just use LO for 'lease option' here.

I've been on both sides of quite a few LOs. These days I think you have to be more careful as on Optionor to not inflate the PP or 'strike price'. Optionees can look back and determine it wasn't reasonable. I sell at FMV, with reasonable price % escalations the more time passes. They are rewarded with seller concessions up to 3% (not purchase credits!) if they exercise early on, but those decline as well. As the one selling the option, a lot of folks have no 'penalty' for dragging it out. Many are actually rewarded, poorly with rent credits or purchase credit no-no's.

I know you know all this, just wanted it pointed out to newer folks.  You are much more committed than I opening this can o' worms lol.  At least folks are being educated by the experienced.  

Cheers and thanks again for posting! 

@Brent Coombs - in my experience (nobody has exercised so far on mine) and from what I've read, the % of TBs that actually exercise and purchase LOs is really low.  

 Thanks Steve for mentioning the watch outs. I will mention some of them in my next posting so thanks for helping me narrow the list some more :-)

Yes - LEASE OPTION...as in any real estate strategy has to be done in the right way for it to work.

Originally posted by @Madeline Burke :

@Wendell De Guzman I never thought about this option! Thank you for the coherent and comprehensive breakdown

 You're very welcome Madeline.

How's the market in your part of the world? Is rent to own something that other investors do there?

Originally posted by @Michael Randle :

Brent Coombs , the statistics I have read a few places and pod casts have quoted is generally ~8%.

 My experience is much better. 25% to 50% of my tenant/buyer buy or qualify for bank financing specially if you focus on the following:

1.  Collect as much downpayment as you can. Our average is $10,000. The highest downpayment we were able to collect is $27,500. Other investors who have very low percentage of tenant/buyers who exercise their option to buy only charge the first month's rent or $5000 or less.

2. Focus on the $150K to $250K price range (at least for Chicagoland - this range could vary based on your market). Below $150K, I tend to get more renters who usually don't buy and above $250K, my cashflow starts to suffer.

3.  On Day 1 of their Option, have them work with 2 people - a Credit Repair Specialist and a Mortgage Broker. These 2 will formulate a game plan so your tenant/buyer's credit improves and his paperwork and other qualifications are in order for him to qualify for bank financing.

Most investors don't do the above and hence, they tend to get people who are more 'renters' not buyers and hence, they get a very low percentage of their tenant/buyers qualify in 2-3 years.

I have presented this type of financing option to a seller when the numbers on a perspective new property for me fit. The benefit to me when I have successfully executed this in the past was on properties that had great cash flow potential and the seller was just tired of the property or retiring. I could take control of thr property for 12-36 mos, get tenants in there and get it flowing. Tenants pay my obligation to the seller I get cash flow in my pocket and as the property continued to cash flow I pulled the trigger on financing because I already raised the money for closing. Plus the property appreciated during the process because the agreed sales price was based on a contract drawn many months ago. The seller gets cash flow without having to lift a finger and I usually offer 5K down and a monthly rent that works for both of us to sign a contract. If I default the seller knows that 5K is his. You just have to do your due diligence as with any other deal and its just another way to acquire great deals.

I love your posts Account Closed may want to comment..

Thanks for the post!

 @Brian Gibbons . Could you expand a little further into your "Illegal Lease Options" segment? It's illegal to not give rent credits and require tenants to pay for maintenance? 

@David Rawls

Rent Credits give rise to a financing arrangement.  A Dodd Frank "no no".  Seller's concessions perhaps.

You can not contract out of landlord contract law or risk your lease being cast aside by a judge in court.

As alternatives, 

You are in MI, look at contract for deed sales or a lease plus a ROFR, which is not an option (right of first refusal).

MI Land Contract

http://www.legislature.mi.gov/(S(ry4v1rqotoqal15d1ogdly3c))/mileg.aspx?page=getObject&objectName=mcl-565-357

@Bill Gulley may want to comment.

Originally posted by @Terrell Hill :

I have presented this type of financing option to a seller when the numbers on a perspective new property for me fit. The benefit to me when I have successfully executed this in the past was on properties that had great cash flow potential and the seller was just tired of the property or retiring. I could take control of thr property for 12-36 mos, get tenants in there and get it flowing. Tenants pay my obligation to the seller I get cash flow in my pocket and as the property continued to cash flow I pulled the trigger on financing because I already raised the money for closing. Plus the property appreciated during the process because the agreed sales price was based on a contract drawn many months ago. The seller gets cash flow without having to lift a finger and I usually offer 5K down and a monthly rent that works for both of us to sign a contract. If I default the seller knows that 5K is his. You just have to do your due diligence as with any other deal and its just another way to acquire great deals.

 Terrell, what you are talking about is sandwhich lease/options but that's a cool strategy too. Thanks for sharing.

Account Closed I agree! I think that LOs are great for newbie investors, and I also think it is great for hot markets that are potentially nearing peaks. I completed my first two deals this year and both are semi-LO deals. I love this strategy, and I will continue to search for LO-type dealsuntil I build more experience and I see a large dip in the market. Once there is a huge dip then I will build my long-term retirement portfolio.

Account Closed

As a wholesaler I have decided to use lease options as an alternative for sellers with with low or no equity. However, I do not want to use this strategy until I fully understand it, obviously. Wendell, you mentioned a benefit of having the tenant, buyer responsible for repairs but I think this is a not allowed anymore. Am I wrong?

Hi Vincent,

If you need help in MO with low equity pretty houses, PM me.

Best Wishes,

Brian

Originally posted by @Brian Gibbons :

I love your posts @Wendell De Guzman but I have a few issues with this one.

1. "Rent to Own" on residential property since the CFPB and predatory lending issues w Dodd Frank - Safe Act is not great marketing language (Rent then Purchase with Lease and Option to Buy, better).  @Steve Vaughan and I are on the same page with this,

2. Get your TBers through the Home Ownership FHA online course if you care about them. See

http://portal.hud.gov/hudportal/HUD?src=/topics/bu...

3. Protect the tenant buyer by getting the payment monthly payment through a servicer, I recc www.notecollection.com

4.  Get the TBer to a bank that likes mortgage origination, like wells fargo, chase, b of a, and get a forced savings deposit out of every pay check. This will help them with Verification of Down Payment when they get the mortgage.

5. Predatory -

http://www.consumerfinance.gov/about-us/newsroom/t...

6. Illegal Lease Options - No rent credits, no maintenance paid by tenants, reasonable rent, reasonable sales price (I like "sales price will be equal to new appraisal at time of sale.")

@Bill Gulley may want to comment..

 Brian, not a problem. I am open to other ideas and my way is not always the best way (I even voted for your reply to my post). There's always a better way. That's what cool about Biggerpockets is that one can always learn and improve. There is no place in BP for the know-it-alls (or those who think they have nothing else to learn).

1) On the language to use - we'll use that from now on (Lease option or Lease with Option to Purchase). I am notifying @David Perez, our VP of Lease Option Sales.

2) Good idea to get our tenants through the FHA Homeownership online course.

3) Great idea on getting a servicer. We'll look into this.

4) Forced savings deposit - again, we'll look into this.

5) The way we do lease options is that we truly encourage and work with the tenant/buyer to buy the house and we don't over-charge them the rent or the price. All the properties we sell rent to own are rented at market rents and the price premium of 10% is all disclosed as well.

6) We don't give rent credits - I know that's not allowed by Dodd Frank unless the property becomes owner financing. In terms of repairs, our properties are renovated and are "like-new". 

Thanks Brian for your great inputs.

I've said this before and I will say it again, BP Nation - listen to Brian Gibbons - he is a master with Lease Options :-)

Originally posted by @Tyler Hodgson :

@Wendell De Guzman I agree! I think that LOs are great for newbie investors, and I also think it is great for hot markets that are potentially nearing peaks. I completed my first two deals this year and both are semi-LO deals. I love this strategy, and I will continue to search for LO-type dealsuntil I build more experience and I see a large dip in the market. Once there is a huge dip then I will build my long-term retirement portfolio.

 This is a very smart strategy. Depending on your market, LOs make sense - specially in a rising market where rents remain strong and rising  as well. When the market goes down (BM 1 or Buyer's Market Phase 1) LOs don't make sense anymore as it's difficult to profit from it when your values are depreciating vs. appreciating. Below are the different market phases: (LOs make sense specially in S 1, S2 and B2)

Originally posted by @Vince Mayer :

@Wendell De Guzman

@Brian Gibbons

As a wholesaler I have decided to use lease options as an alternative for sellers with with low or no equity. However, I do not want to use this strategy until I fully understand it, obviously. Wendell, you mentioned a benefit of having the tenant, buyer responsible for repairs but I think this is a not allowed anymore. Am I wrong?

 I agree with using LOs to wholesale houses with little to no equity. I call it Lease option facilitation. 

I will look into the tenants should not be responsible for repairs but the way we do our lease options, we renovate the houses to like-new condition that we rarely have maintenance and repair issues anyway.

Hi folks interesting topic. Could someone tell me what types of properties you use the lease option? Is this for a property you are trying to buy? Or is this for a property you already own and trying to sell.

Also what is a rent credit?

Thank you

Originally posted by Account Closed:

Rent to Own is great for newbie investors. Here are the reasons why:

1. With rent to own, you can buy a property at closer to market value and still make money. The problem in a hot market is that getting good deals is harder and harder (and specially hard if you're a newbie). With rent to own, you can sell the property at a 10-15% premium vs. market value (since you're selling it in 12-36 months), you don't pay any closing cost (when you sell), there's no dickering on the price (this could save you 3-5%) and you don't pay any realtor commissions as well. Below is a comparison of doing a fix-n-flip vs. rent to own and how much you can make on a $200,000 house that you buy-and-rehab for $150,000:

2.  With rent to own, you pay less in income taxes as a percentage of your profit since you're paying long term capital gains vs. ordinary income taxes with a fix-n-flip.

3. With rent to own, you can get passive income while you wait for your tenant/buyer to cash you out. Upfront, you get a $10,000 non refundable option consideration as well. This is great for a newbie investor to build a cash reserve pretty quickly (you can't do that with rentals).

4.  Since you're getting a big chunk of cash upfront, you tend to get better quality tenants (they have more skin in the game and therefore more to lose). You still need to SCREEN your tenant/buyers in the same way you screen a regular tenant. Below are the tenant screening that we use:

- check credit; credit has to be at least 600 specially if you want the tenant/buyer to cash you out in 12 months; also there should be no 90-day lates in the past 12 months
- check criminal history: no felony in past 5 years; tenant can't be a registered sex offender
- check income/ verify employment; salary has to be 3 times the rent
- check civil cases: no evictions in the past 5 years; no BIG civil suits judgments
If you're a newbie, you can't afford to get a bad tenant. With rent to own, you decrease the probability of getting a bad tenant even further because you're looking for a tenant with $10K down or more upfront.

5.  With rent to own, the tenant/buyer is responsible for maintenance and repairs not the landlord. So, with rent to own, you tend to get truly passive rental income even without a property manager. If you're a newbie, you probably don't know how much repairs cost or you don't have good contractors or a good and low cost handyman to take care of the repairs for you.

6. With our rent to own, we get an average of $10,000 upfront plus the first month's rent. With a rental, you get the first month's rent and the security deposit (which is usually, the first month's rent). So if you have to evict a tenant, you will be in negative cashflow territory (i.e. all your rental profit is gone) but with rent to own, you have enough reserves to draw upon(because of the $10K upfront) and you will still make money.

However, you have to do rent to own in the right way. My next post will talk more about this.

What about you BP Nation? Anyone out there who did rent to own? What's your experience with it?

 Can you do this with a property with a mortgage without triggering due on sale clause? I don't want to throw a monkey wrench on this method but it seemed like the leasee is one phone call away from creating a big legal hassle. Don't most new mortgages forbid this practice now? Selling/rto a home 10% above market is that below DF threshold? thanks!

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