Rent To Own Homes (RTO)
What Are Rent-to-Own Homes?
How to Rent-to-Own a Home
- A lease agreement, which defines the terms of renting the property
- The renter’s option to purchase, which defines the option fee, the purchase price, and the duration of the option period.
Lease agreements rent-to-own homes also vary from standard rentals by making renters responsible for some or all property maintenance. In a typical rental, landlords cover property repair costs, but in rent-to-own homes landlords may ask tenants to pay for repairs and maintenance.
There are two common option types in rent-to-own homes:
- A lease option agreement, which doesn’t require a tenant to buy the property at the end of their lease
- A lease-purchase agreement, which does require the renter to buy the property.
What Else Goes into a Rent-to-Own Agreement?
For example, let’s imagine a home has a $200,000 market value when the owner and renter sign a rent-to-own agreement. Average home values in that market rise five percent each year. The rent-to-own agreement is for two years. So the landlord lists the purchase price of the property at $220,000 ($200,000 times five percent home price appreciation times two years).
Some rent-to-own agreements don’t state the selling price upfront. Instead, the landlord determines the property cost at the end of the lease by looking at the local market.
Rent-to-own agreements also determine whether part of the rent paid will apply to the property purchase price — the rent premium. For example, a renter pays $1,000 a month in rent for a 24-month contract. Their agreement states that 30 percent of their monthly rent payment serves as a rent premium, which counts toward buying the home. If they make all their monthly payments in full and on time, they’ll have $7,200 for use in purchasing the property.
Upon signing the rent-to-own agreement, the home buyers will pay an option fee, which typically runs between 3 and 5 percent of the home’s purchase price. This fee guarantees the renter the option to buy the property and prevents the property owner from selling the house during the lease agreement.
Keep in mind that most agreements don’t require returning the rent premium or the option money to the potential buyer if they opt not to purchase. If the renter does buy the property, the seller often credits the rent premium and option fee toward the purchase of the home.
Pros of Rent-to-Own Homes for Buyers
Rent-to-own homes also don’t require a mortgage at the outset, which can be an attractive option for people with poor credit. Yes, they’ll likely need a mortgage if they want to buy the home when their lease ends — but the one- or two-year lease term gives them time to improve their credit score while still ensuring they can buy a home they love. In fact, rent-to-own homes can help improve their credit if they make regular, on-time rental payments. However, some landlords require preapproval as part of their rent-to-own agreement.
Some homeowners may require mortgage lender preapproval for potential rent-to-own buyers — meaning they'll need to have good credit at the outset.
The rental agreement also give buyers predictability. Monthly rent for rent-to-own homes is often set, meaning it will not increase during the lease.
Cons of Rent-to-Own Homes for Buyers
The option fee, or option consideration, can be another issue with rent-to-own homes. Renters pay the fee when they sign the contract, but it’s often nonrefundable. The renter will lose the money they paid for the option fee if they don't buy the house.
Additionally, home sales prices can drop. If the rent-to-own agreement negotiated the home purchase price at the contract’s signing, the renter can end up overpaying because landlords usually base the cost on market rates and expected home value increases when the contract is signed. The market purchase price of the home might decrease during that period, but they'll still be stuck paying the higher price.
Another con of rent-to-own homes is that they limit your ability to move. With standard rentals, you can move at the end of their rental period, which is usually one year. Rent-to-own homes often obligate the renters to remain in the property for two to four years — and then purchase it afterward. This lack of flexibility can be a problem if a renter needs to move.
Pros of Rent-to-Own Homes for Real Estate Investors
The option fee can benefit real estate investors, too. If the renters decline the option at the end of their lease, the investor keeps the option fee.
Rent-to-own real estate can be a way to create bigger profit through creative financing. Investors can benefit from the increased rent of rent-to-own homes. Assuming they buy the property, the extra money goes toward the renter's down payment. If they don’t buy the home at the end of the lease term, though, the investor keeps all the rent collected during the contract.
Longevity is another benefit of rent-to-own homes for real estate investors. Rent-to-own agreements tend to last for two to four years. This length of time keeps investors from having to repeatedly secure a tenant.
Also, tenants have a personal and financial interest in the property. So they may treat a house better than they would if it were a standard rental. And real estate investors can make renters pay for some or all maintenance on a rent-to-own home.
There’s another hidden win for smart investors: sandwich leases. What is a sandwich lease? That’s when you go under contract with a low-priced lease purchase agreement and then find rent-to-own buyers who would like to purchase the home.
Cons of Rent-to-Own Homes for Real Estate Investors
Rental prices are often locked-in, too, just like the purchase price. The inability to raise the rent during the life of a lease can cost real estate investors money. That’s why investors need to set the rent price based on the market’s average performance.
Because this is such a unique purchase option, it's especially important for investors to hire a real estate attorney to review the contract.