LEASE/OPTIONS

Rent To Own Contract: What Lies Hidden In A Rent To Own Form?

by Allan Cole  August 17, 2010

A rent to own contract can be a win-win situation for both the buyer and seller... but only if you know exactly what you are signing. Read on as I dissect a rent to own agreement slice by slice and highlight what are the pitfalls to avoid.

Getting the Basics Right: What is Rent to Own?

If you are new to real estate, the term "rent to own" can be quite misleading. It implies you are renting a house and buying it afterwards. That is only half right: A rent to own contract can be dismantled into two parts: A lease arrangement and option to purchase. So to be more precise, rent to own is in fact renting a house now with the exclusive right to buy it at a fixed price sometime in the future (so it's not a must to purchase it).

Now a rent to own agreement sure seems like a good deal for the buyer... who gets a place to stay and reserves the exclusive right of buying it in the future. Of course there's never a free lunch in real estate, and the buyer has to fork out extra for these perks and privileges... in the form of extra rent (rent premium) and a lump sum for the option to purchase (option fee). No worries we will drill deeper into these costs below.

A rent to own contract focuses heavily on the option to purchase and often only lays down a rough outline for the lease. That's why you will need to pair it with a separate rental agreement to work out the finer details of the lease.

Option to Purchase: How Long and How Much?

Just like a normal property sale, the buyer and the seller will first have to agree on a selling price. Once the bargaining is over and the rent to own form is signed, this sale price will be locked in until it's time for the buyer to exercise the option to purchase. This option period is often between one to three years, which will be the duration of the lease as well.

Let's say we have a rent to own contract for a house with a selling price of $500,000 and an option period of two years. What happens is that the buyer will first have to rent the house for two years and once the 2twoyears is up, he or she will have the right to buy the house for $500,000 (regardless of whether housing prices have risen or fallen during those two years).

Of course, the buyer has to pay a price to enjoy this option. Most folks call it an option fee although lawyers label it as “option consideration” in a rent to own contract. Either way, they are the same thing and what matters more is how much it will cost. It is common for the option fee to be between 1 to 5% of the property's sale price.

If the buyer chooses to exercise his or her option to purchase, this option fee will become part of the down payment. If the option isn't exercised and the deal falls through, the seller gets to pocket the option fee as a consolation prize. Both ways, the option fee is still non-refundable.

Rent Premium: Extra Rent that can be Recovered

In a rent to own agreement, a buyer has to pay higher-than-market rent - That's because on top of the normal rent rates, he or she has to cough up additional money as rent premium.

If the buyer ends up buying the property, this rent premium graduates into a rent credit... which goes toward paying off the purchase price of the house. In eyes of a person (who exercises the option to purchase), paying rent premium is akin to building up equity in his or her future home.

Example: let's say we have a $100,000 rent to own house that normally rents for $1,000 a month. The buyer and seller have agreed on a rent premium of $200 and lease period of two years... so the buyer will be paying $1,200 each month instead. If the buyer ends up buying the house two years down the road, all of the rent premium ($2,400) will go towards the total selling price so the buyer now owes the seller $97,600.

If the buyer fails to close the deal and purchase the house, this rent premium will be swallowed up by the seller. In this case, the seller is acting as a landlord who leased out his or her property at a gainful rate.

Rent to own contracts are popular in a housing downturn where buyers are few and far between... and the seller needs someone quick to cover the stifling mortgage payments. This same arrangement will benefit buyers who are not yet able to get their hands on a mortgage loan... so the lease period buys them precious time to build up equity and repair credit scores.

Allan Cole has been drawing up reliable real estate contracts for property professionals on http://www.free-real-estate-forms.com/ - Click here for your sample rent to own contract and other free real estate forms: http://www.free-real-estate-forms.com/rent-to-own-contract.html. Reprinted by Permission. Copyright © 2004-2013 BiggerPockets Inc. All Rights Reserved.