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Property management: Deconstructing rent-to-own

Rent-to-owns tend to become more popular in a buyers’ market as sellers seek alternative ways of selling their properties. However, sellers, investors and tenants often make common, yet predictable mistakes. Understanding what a rent-to-own is, how it works, where it fails and how to protect yourself as a seller, an investor or as a tenant, can make all the difference.

I have been involved with rent-to-owns as an investor since 2003 when I started The Original Rent To Own. Today, we continue to offer investors complete turn key rent-to-owns from tenant placement and screening, asset selection, contracts, financing, due diligence, purchasing and ongoing support and assistance including closing the final sale. Our investors receive passive investments backed by physical assets with high rates of return. Over the past seven years, I’ve heard and seen it all.

The rent-to-own is a layman’s term which refers to a combination of a Lease Agreement with an Option to Purchase Real Estate Contract. Under the lease agreement the tenant is referred to as a tenant where as in the option contract they are referred to as an optionee. The tenant occupies the home under a tenancy agreement for a specified length of time ranging from six months to five years with most completing in two years.

During this tenancy, the tenant has the option to buy the property as outlined in the option contract even though they are not obligated to do so. When the tenant is ready to buy the home, they exercise their option, pay out the balance of the sale price, the title transfers and they remain in the home.

When entering into the option contract, the price or method of determining the future price is established upfront. The tenant typically puts up a deposit which is often non-refundable if they decide not to exercise their option. If they do exercise their option within the timeframe specified then the deposit is applied towards their down payment.

There are no exact ways of setting up a rent-to-own. One seller may inflate the total rent amount and use a portion each month to build up a credit for the tenant’s future down payment. Others will charge regular rent with additional payments on top of the rent. The additional payment can be monthly and/or balloon payments for those who may be on commission, receive bonuses or tax refunds each year. Between the initial deposit, monthly credits and/or balloon payments, the plan is to have enough built up towards a down payment for the tenant’s future purchase.

The main reason people buy a rent-to-own is because they cannot qualify for their own mortgage financing. Reasons include not enough down payment, self-employed income, cash business, credit blemishes, no credit, short job history, new residence to Canada, owning another home that is not selling, and the like.

Sellers tend to be more open to selling this way during a buyers’ market when sales are slow. From a sellers’ perspective, rent-to-owns can solve double mortgage payments on vacant property, deferring a large mortgage prepayment penalty, using the rental income to qualify for a new mortgage on another home or capturing a higher price over a conventional sale.

When comparing the rent-to-own strategy to a traditional long-term rental, sellers and investors consider the following:

A long-term lease eliminates vacancy, advertising and turnover costs.
Property management is reduced as a higher caliber of tenant interested in home ownership is attracted to a rent-to-own.
Property maintenance to a certain dollar amount is absorbed by the tenant thus reducing nuisance calls and maintenance expenses.
A non-refundable deposit shows commitment and provides the investor with a buffer.
Premium rent can be collected since the investor is offering the tenant the opportunity to own their own home.
Additional payments on top of the rent can be collected each month therefore increasing cash flow.
Defined exit strategy with a shorter timeframe.
Pre-calculated profit from the beginning.
Higher cash flow with less variables.
Helping someone get into their own home.

Tenants benefit by having a clear plan towards home ownership, minor renovations are acceptable during the tenancy and they do not have to worry about the landlord selling the property at an inconvenient time during a tenancy.

The most common mistake I see homeowners, investors and tenants making is trying to save money by not having a proper and enforceable agreement in writing. A proper written Option to Purchase Real Estate Contract outlines the parties and the property, price(s), option timeline(s), consideration, credits, repairs, renovations, terms, conditions, default, jurisdiction, how the option is exercised, the closing procedure, insurance, representation and warranties, transferability and the like. It is imperative to obtain professional accounting and legal advice from those with experience in this area.

Another common mistake is that many homeowners, investors and tenants do not spend enough time upfront planning the eventual purchase or even whether the tenant is even capable of purchasing the property in the future. I’d recommend having a mortgage broker pre-screen the tenant ahead of time and assist with this step.

And finally, I see rent-to-owns fail when the seller or investor does not have a back up plan if the tenant decides to vacate. Consider if the property is one that you can turn into a typical rental. If so, will it cash flow as a typical rental. Can you fix it up and flip it or can you set up another rent-to-own?

As an investor, the rent-to-own strategy is one of my personal favourites when executed properly. The tenant is given the opportunity of home ownership with a structured plan. The investor makes a profit with less expenses, less variables, predictable cash flow and a  defined exit plan, all while helping someone out.

Thoroughly research the rent-to-own strategy to see if it’s right for you. Seek professional advice, obtain proper training by someone who has prior experience and ask for references. If it’s right for you, then get out there, help others get into homes and get paid handsomely for doing so. Now that is successful investing.

Paul M. Hecht is an investor, seminar leader, mentor, real estate agent and author of Everyday Real Estate Millionaires: How Average People REALLY Do It.

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