Recently, a person who was looking for a new place to live told me she was thinking of doing a lease-option–a rent-to-own–to buy a place. Her credit wasn’t that good, and a lease-option sound like a good idea. The rent-to-own was being offered by a real estate investor. This was going to be her first home purchase, and she figured she should be asking a lot of questions. But she didn’t know where to begin.
I provided some suggestions, and some explanations for why she should be asking those questions. Here’s what I told her to ask, and why.
What is the length of the option? [Aim for a minimum of 2 years. Longer is better–3, 4, or 5, for instance. It often takes more than a year to clean up your credit, accumulate sufficient option credits, and position yourself to buy a home. And in today’s economic climate, refinancing/purchasing in just a year may be difficult if not impossible.]
Is there a provision in the agreement that allows me to extend the option if I’m unable to get financing during the option period? [There should be. It probably would come at an extra cost, such as $1,000 or $2,000 to extend the option period.]
If the price of the home declines below the option strike price, what protections do I have? [Possibilities include extending the option period to allow home prices to climb again, or renegotiate the purchase price of the home so that the purchase price doesn’t exceed its true value.]
What will be the purchase price of the house? [That should be specified in the option agreement. Usually that’s specified as an exact price–for example, $425,000. It’s also permissible to say that the price will be determined upon exercise of the option. In that case, though, the exact method should be specified.]
What happens if the property owner can’t make his payments and there’s a foreclosure? [Straight answer: You’d lose out. The option would become worthless. An honest real estate investor will tell you that.]
How can I make sure the owner is making his mortgage payments? I don’t want to lose the property to a foreclosure. [There’s a document called “Authorization to Release.” It’s signed by the home owner, allowing the investor to contact the owner’s lenders and verify account balances, payments, and so on. Real estate investors typically have owners sign an authorization so they can make sure that there isn’t a looming default or foreclosure. Usually the tenant-buyer doesn’t request such a document, or even know of its existence. But someone should be monitoring the owner’s mortgage status to make sure that all is OK.]
Is this a sandwich lease-option? [It probably is if there’s an investor involved. That means the investor has negotiated a deal with the seller regarding monthly payment, purchase price, and other details. The investor then seeks a tenant-buyer. Generally the investor charges the tenant-buyer more per month than the investor is obligated to pay the seller. And the option price that the tenant-buyer pays is greater than the price negotiated between the seller and the investor. There’s nothing wrong with that arrangement. But it’s important to understand the role of all the players.]
Who is responsible for repairs on the property? [Often, it’s set up so that the tenant-buyer is responsible for the first couple hundred dollars of any repair, with the owner responsible for the remainder. The owner should keep his/her insurance in place on the property, to cover any insurable problems. And sometimes one of the parties–the investor or the tenant-buyer–will purchase a homeowner’s warranty to cover other problems and failures.]
How much of my rent payment is credited toward the purchase price? [It’s whatever you negotiate. Very roughly, 20% is often considered fair. If it’s much less, there may not be sufficient incentive for the tenant-buyer. And if it’s a lot more, that could cut into the seller’s (or investor’s) profits. But I’ve seen it as low as 10% and as high as 110%.]
How much up-front option money do I need? [That’s negotiable. Often, it’s the equivalent of 2-4 month’s rent. Generally, it shouldn’t be much more than that.]
If I don’t buy, what happens to my up-front option fee and my monthly option credits? [Honest answer: You lose them in most cases. Virtually all lease-options are written so that the tenant-buyer forfeits any option fees and credits if he/she doesn’t exercise the option.]
I know I need to improve my credit to buy. What would you suggest? [If the investor knows what he’s doing, he’ll suggest that you begin working immediately to clean up your credit. Often, the investor will have a mortgage broker or lender on his team, and will refer the tenant-buyer to that lender. It is NOT adequate to say “We’ll worry about that later” or “If you make all your payments on time, there shouldn’t be any problem.]
Since I’m buying, do I get to claim the taxes and interest on my tax return? [This is a question to determine the investor’s honesty and knowledge. The answer is “no.”]
How often do people like me buying a house on a rent-to-own actually end up buying the house? [We’re testing the investor’s honesty and knowledge again. The answer can vary anywhere from a low of 10% to as high as perhaps 70%. It depends on the conditions of the lease-option, the screening process used to select tenant-buyers, and the credit clean-up and restoration process of the tenant-buyer. Even in the best of circumstances, the figure seldom exceeds 70%.]
How can I make sure the owner doesn’t sell the home to someone else while I’m in it doing a rent-to-own? [The investor should have filed a “Notice of Agreement” with the local county or city records office. That notice will “cloud the title” of the property. Thus, whenever a title search is done on the property–which would occur if the owner attempted to sell the property to someone else–the notice will appear, clouding the title. The notice would have to be resolved before the seller could convey clear title to a new purchaser If a tenant-buyer is working directly with the seller, the tenant-buyer should have the seller sign a “Notice of Agreement” and file it.]
Won’t a rent-to-own trigger the “Due on Sale Clause” in the seller’s mortgage? And if it does, what happens to me? [If there’s a mortgage on the property, a rent-to-own can trigger the “Due on Sale Clause,” thus making the mortgage due and payable immediately. Frankly, that seldom occurs. Many lenders don’t notice the signs that possibly indicate that a lease-option has occurred. And even if they do, there isn’t much incentive for them to call a performing mortgage due. Currently, they have more than enough non-performing mortgages to worry about. But, technically, a lease-option or rent-to-own could trigger the Due on Sale Clause.]
Can I take the rent-to-own documents to my lawyer so he can review them? [The answer must be “YES.” Absolutely. If any investor, or any homeowner, shows any reluctance about allowing a tenant-buyer to have all documents reviewed prior to signing, then run away from that deal. And don’t settle for “That’s not our policy” or “We’ve never been asked that before” or “Sorry, but these are proprietary documents.” The answer must be “YES.” Period.]
Well, those are just a few of the questions a tenant-buyer should be asking the investor (or home owner, when an investor isn’t involved). Rent-to-owns actually can be win-win situations for everyone: owner, investor, and tenant-buyer. But the investor and the tenant-buyer both need to understand what they’re doing.