How to Structure a (real) Rent-to-Own Agreement

how to structure a lease purchase

In today’s economic climate where renting is becoming more prevalent, and homeowners are renting out their homes instead of taking losses, I have seen an uptick in rent-to-own interest.  A true rent-to-own structure can be a powerful tool to help a renter become an owner, and to help an accidental landlord sell their property.

A good rent-to-own structure should provide a real incentive for the renter to overcome the obstacles that are getting in the way of ownership.  For most renters, the obstacles are either lack of a downpayment, bad credit or both.

I think the following structure provides a fair rent-to-own structure for both the tenant and landlord.  I call it the 50/50 match. Simply put, this structure allows the tenant to rent the property at a premium, which premium is held in an escrow account for the tenant to use as a down payment. In order to provide a strong incentive to the tenant, the landlord matches the monthly premium. If the tenant purchases the property, then the escrow funds are dispersed to the tenant for use as a down payment. If the tenant does not purchase then the escrow funds are forfeited to the landlord.

There are four things that have to be defined and clearly outlined in the escrow agreement:  1.  Market Rent, 2. Rental Premium, 3. Landlord Matching, and 4. the Length or Term of the agreement.  There are many other provisions as well, such as the conditions under which the funds are forfeited, etc.  Consult an attorney to learn more about other provisions that should be considered.

Find some comparable properties that have rented recently in your neighborhood.  Seek the input of a realtor, or do some research to determine an estimate of the market rental rate.  There are many resources that can be used to determine the market rental rate, for example http://www.zillow.com/local-info/

A word of caution when using Zillow:  Zillow indicates average rents by neighborhood according to the number of bedrooms.  I recently rented a 3 bedroom condo in Wicker Park for $2700/mo.  When using this as a benchmark to compare Zillow data, I realized that Zillow does not hold data for Wicker Park; they lump Wicker Park in ‘West Town’ which indicates an average monthly rent of $2,100 for a 3 Bedroom.  Conversely, the zillow ‘z estimate’ of market rent for a 3 Bedroom property in Albany Park is $1,787…this is too high.  Zillow might be a good starting point, but definitely find some comparable properties that have rented recently in your neighborhood.

Rental Premium and Landlord Match

Figure out how much the tenant needs to save every month in order to purchase the property. For example, if the tenant needs to save $6,000 to have an appropriate downpayment, then he should be socking away $500 month to have the downpayment saved in one year.  The rental premium + landlord match needs to be at least $500 a month.  At a 50/50 split, the rental premium is $250 and the landlord match is $250.

Length or Term of the Agreement

This can be a real sticking point in the negotiations.  The landlord needs to exercise patience, and the tenant has be comfortable with some risk of losing the rental premium. If it

will take one year for the tenant to save the downpayment, then the term needs to accommodate enough time beyond one year for the closing to take place.  In this case a term of 18 months to two years might be appropriate.

Let’s say you are trying to sell a 3 Bedroom Condo in Albany Park.  You’ve had it on the market for several months at $215,000 with zero interest.  You are ready to move on, and now you are considering renting the property.  A rent-to-own might be a good structure to consider to increase the likelihood of a sale in the near future.

Zillow indicates a market rental rate of $1,787 a month, but you find some comparable properties that have rented for $1,500-$1,600 a month.  You market it for rent at $1,500 a month, and you indicate a rent-to-own option is available, and after a few days a potential tenant emerges that is interested in the rent-to-own option.  You walk him through the 50/50 match structure, and he is excited to move forward.  The tenant applies for the property, and the credit check reveals a low credit score, but he has paid off all collection accounts and he says he is working with a credit repair company.  The candidate believes his credit score will be high enough to get financed within 18 months, but he needs a down payment of 5% and he has no savings.

You and the tenant agree to a strike price of $190,000 for the property.

At $190,000, the tenant needs a 5% downpayment and approximately $4,000 in closing costs for a total of approximately $13,500.  Since he has no savings, he needs to accumulate $13,500 in 18 months, or approximately $750 a month. You both agree to a rental premium of $375/month with a landlord match of $375/month, and a lease term of two years lease.

The tenant pays $1500 + $375 = $1,875 a month in rent + premium, and you deposit $750 of this in an escrow account every month.  After 18 months the tenant will have a sufficient down payment, and the rent could then drop to the market rent.

After two years the renter risks losing $6,750 if he does not go through with the purchase.  If the tenant does not move forward, then you will gain $6,750 which is arguably appropriate compensation for essentially selling a put option on your property for 24 months.

I have had tenants push back on the idea of losing the rental premium. If you encounter opposition, then explain that an option is very valuable.  Anything can happen in 18 months.  The property values could go up significantly, in which case the tenant will benefit from the appreciation, and they could go down significantly, in which case the tenant can walk away and avoid the loss.  The tenant also benefits from living in the property for an extended period of time with obvious benefits.

It is critical that both parties seek the advice of an attorney when entering into such an agreement!  Absolutely critical.  I am not an attorney, and this advice is no substitute for sound legal counsel, but feel free to contact me with any questions.  I’ll be happy to share my experiences.

Source: livebytransit.wordpress.com

Category: Credit

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