Two buzz topics these days are lease options and rent-to-own. A huge number of posts on many of the real estate forums ask questions on these subjects. About once a week I get a call from a prospect wanting to know if I offer one of these types of transactions.
The explosion of chatter on this topic indicates a need for accurate information for both buyers and seller. This post will discuss the topic from both sides. We will begin by looking at the actual structure of the contract.
What is a Lease Option?
Lease options are real estate transactions. A lease option is simply a lease agreement for a property containing a clause that gives the tenant an option to purchase the property at some time for a specific price. In theory it is a simple agreement. It can become complicated quickly because people are involved that have different agendas.
The first part of the agreement is the lease, a contract where the tenant promises to pay rent to the landlord in return for the use of the property. It is a liability that obligates the tenant to make timely payments.
The second part of the agreement, the option to purchase, may or may not be contained in the lease. It could actually be a totally separate contract with a different timeline than the lease. For example, the lease could cover a two year period and the option to purchase could only be valid during the second year of the lease. The option part of the contract sets out the purchase price the parties have agreed to in addition to the timeline.
It is easy to see how complicated the contract(s) could become because the combinations are infinite. Here is an example of how the terms can go sideways; the lease is for a one year period and the tenant has the option to purchase the property every Thursday during the first year with the price increasing by $500 every week.
Of course that is a silly example but no stranger than what tenants and landlords actually put in writing every day.
Rent to own is actually a misnomer when used to describe a real estate transaction. Rent to own contracts are actually rental/purchase agreements for consumer items such as cars, furniture or appliances. It is easy to confuse the two agreements and landlords may actually draw up a real estate contract and use the words “rent to own” in the body of the agreement. A seller is willing to call it anything the prospect wants to call it, the results are the same. The fact that the tenants/prospects are not aware of the difference shows exactly how dangerous this niche can be.
Why Tenants/Buyers Want to Do This
The primary reason “buyers” want to do this is because they want to be a homeowner but have been turned down or know they are not eligible to arrange a mortgage to actually purchase the property. We are going to refer to the tenant in the rest of this post as a Buyer. They are fairly upfront about why they seek a lease option, they aren’t eligible for financing, usually followed by some excuse as to why they aren’t. In the typical buyer presentation it is only for a year or two, just a temporary situation beyond their control. Their proposition may or may not be true because it is based on a set of assumptions a year or two down the road. Anyone that has watched the news lately should be aware the rules in the mortgage world are changing frequently, it seems like daily to those of us in the industry. The mortgage guidelines in place today will assuredly not be the same next month let alone in a year or two from now.
Another reason the buyer is attracted to this type of transaction is because many sellers do not have the ability to run a credit check on the buyer. Most of the time the buyer has been turned down for a mortgage because of something on their credit report, something the seller won’t see.
Another reason some buyers want to use this method is more sinister than keeping the credit report hidden. They are trying to hide assets. Sometimes the reason a buyer isn’t eligible for financing from a traditional lender is because they have recently defaulted on their previous mortgage, a strategic default where they hide money from their previous lender. I frequently get calls from people that have just gone through a foreclosure and have 20% or more for a down payment. When asked for the source of their down payment it becomes a topic they do not wish to discuss.
The underlying motivation for all of this topic is a fear of being out of the market, a fear of not being a homeowner.
Pitfalls for the Buyer
The biggest problem, perhaps the root of all that follows is a lack of understanding of how the process actually works. Buyers assume they understand everything there is to know about the process, when in reality most don’t even read the contract. I know this is true because buyers don’t read mortgages either. I have attended a couple thousand real estate closings and only once have I witnessed a buyer actually read the deed and the mortgage. One out of a couple thousand!
Most real estate transactions are closed based on trust, not the review and understanding of the actual contracts. This element of trust works for the most part while dealing with a traditional lender because they are heavily regulated. Obviously this is not the case when dealing with a seller.
The buyer becomes so pre-occupied with “the deal” they are unaware their personal level of risk increases when they try to work around the system that provides them protection when dealing with a lender. If you ask any borrower they will tell you the mortgage guidelines protect only the lender. They believe the rules only restrict them for doing something they want to do, finance a home.
The mortgage guidelines actually protect the borrower a lot more than they do the lender. If a mortgage goes in to default the lender will survive, one mortgage represents only a tiny piece of equity for the lender. But from the borrower’s point of view a default is financial ruin and can be a 100% loss. From this perspective the guidelines protect the borrower a lot more than they do the lender.
A desperate buyer that is focused solely on putting together a deal while trying to work around the system is far more likely to overpay for a home. It reminds me of a man I knew that would tell a lie when the truth would have helped more. So much energy and effort gets spent working on finding and putting together the deal that the important facets like value are pushed aside. The checks and balances of the mortgage system are not there to protect the buyer.
The buyer assumes the seller is in better financial condition than they are simply because the seller owns a house. In reality the seller may be in worse shape than the buyer. Truth be known the buyer has little or no experience in determining the financial strength of the seller. The seller could be six months behind on the mortgage for all the buyer knows.
How to Protect Yourself as a Buyer
My first suggestion is to look inward, the real answers are inside all of us if we are willing to listen. That little voice inside of you is screaming “Don’t do it!”
But the desire is so strong most people won’t listen, so if you head down this road, protect yourself at ever turn. Look at the deal the same as a lender would. Lenders weigh four separate segments in every real estate mortgage. The first section is Credit. In this case you should evaluate the seller’s credit worthiness. Not easy to do because you won’t be able to see a credit report. So do the next best thing, look for public records on the seller, visit the county clerk’s office and see if there are any pending law suits. Specifically if there are any liens against the property. Ask the neighbors living on either side of the house what they know about the seller.
The next is Capacity, can you afford the payment. More importantly, can the seller afford the payment they have against the home? Tricky, figure out a way to ask the seller if they owe anything against the home. You should have discovered if there was a mortgage during the visit to the clerk’s office. Now it is simply a matter of a candid discussion about finances. If you are open and honest with the seller they are more likely to be honest with you. Let them know you are concerned if the payment they are making is higher than the one you are paying them. So from the Capacity view, does the financial proposal make sense? Can you afford the payments?
The third section is Collateral, is the house worth what you are paying for it? This is a lot simpler than you think, order an appraisal just like a lender would require. No one does this when they enter a lease option, it will protect you more than you realize. Once you have the appraisal, read it, read every word on every line, every number and then read it again. It would be a very good idea to have a property inspector and a pest inspection as well.
The second part of the Collateral process preformed by a lender is the title report. Order a title report. Read it.
Lenders also review the purchase contract, in this transaction review the lease and the option agreement. Make sure you understand it, have it reviewed by an attorney. Yes, it cost a lot of money, so did the appraisal and inspections. What will it cost not to do these things?
The last section is Cash to Close. Are you betting on the come? Do you have the money to close the deal both now and later? Will you have a cash reserve after making the down payment?
Act as if you are the lender and determine if your position is safe, does it make sense, what is your exit strategy?
Check back, the next post will look at this type of transaction for the seller’s perspective.