I remember running into a successful entrepreneur who was the CEO of a public Rent-to-Own (RTO) furniture business many years ago. I was young and having had the chance to talk to someone like this was extremely helpful but I sometimes wonder what he’d think of the growth in Rent-to-Own as it relates to real estate.
I see and hear ads for RTO more frequently now and, while I’m happy that there are investors out there applying this level of creativity to their investing, I’m equally concerned about the renters who may not know any better and can potentially be damaged by this strategy when not applied by ethical investors. RTO is not inherently problematic nor does it need to be set up to hurt anyone. But, if it’s not done properly right from the start, someone is going to be very unhappy later.
First, let’s understand the basics. An investor owns a property and seeks a tenant/buyer to move in as a tenant with an option (but not the obligation) to buy the home at some time in the future – usually at a preset price. Normally the tenant pays a monthly rent, plus the RTO premium which accumulates over time to build up a down payment that gets credited toward the tenants’ purchase. Additionally, the chosen tenant is (most often) required to put up an initial $5000, $10,000 or even $20,000 before moving in. It’s considered a reservation premium. Savvy investors are careful to not call this a deposit as that infers an interest in the property. The reservation premium is paid up front and is added to the total sum of RTO premium the renter pays over the period to form a down payment.
Investors helping renters? Awe, so nice…not always. Renters need to read the fine print here. First, most of the time renters given the option to buy are signing a lease, and a purchase option agreement for which they pay a reservation premium (up front) and a monthly a RTO premium each month. But if they don’t or can’t exercise their option and complete the purchase as planned, THEY FORFEIT ALL THEIR MONEY. Also, the purchase price offered to the renter is a projection of future value. The investor will guess at what the future value will be (and will likely err on the side of optimism) then grants the renter the option to buy at that inflated price. That works for the renter only if the market appreciates at a rate consistent with the investors’ projection. If not, the renter will be unable to complete their purchase because the value won’t be there to justify a loan - no bank will lend $300,000 on a property that’s only worth $250,000.
And it gets better…for the investor. Often investors don’t own the property they’re offering to renters on a RTO deal. Here’s how it works – legally. Hal has a house that he wants to rent. Sam is a savvy investor and approaches Hal with a modified rental agreement to pay the rent Hal is asking; but explains that in order to rent this property Sam MUST have the right to buy the home (at a preset price, within a predefined period of time). For our example let’s say Sam agrees to rent Hal’s place for $1200/month; and he’s given the right to buy the house for $300,000 any time within the next 2 years. To sweeten the deal Sam even assures Hal that if anything goes wrong with the property he’ll fix it – as long as the repairs don’t exceed a cost of $200 per incident.
So Hal thinks he’s found a perfect renter, but the modifications to this sort of rental agreement include clauses that allow Sam to sub-lease the property to someone of his choosing. Sam can also forfeit the lease and give Hal his house back at any time without penalty; and Sam gets to exercise his right to buy the home (at the agreed price) any time within the agreed period (2 years).
Sam the crafty investor promptly advertises Hals home for Rent To Own. Sam is looking for someone (anyone) with a few thousand dollars to put up as a Reservation Premium, and an option to buy the home from Sam (he doesn’t even own it) at a set price of $320,000 within 1 year, perhaps with an option to extend for another year (normally for a price). The rent will be $1400/month which nets Sam $200/month profit while being set up to make BIG MONEY if the renter ever buys – if not, Sam still wins because at the end of the lease he can simply give the keys back to Hal and say goodbye, walking away with the forfeited reservation premium (from the renter) and $200/month for his time. Obviously if the renter can and does plan to exercise his option (at $320,000) then Sam exercises his option to buy from Hal at $300,000 and Sam makes off with $20,000 profit! Oh, and the maintenance? That gets passed onto the renter too – they are given an obligation to maintain the home as if they owned it. Anything that needs fixing is their responsibility – to a maximum of $500.
Also, investors don’t often care to qualify the renter. As long as they have some cash up front and can make the monthly payments – that’s good enough. But if this renter can’t qualify today, how will they qualify in a year or two? Is the RTO premium plus the reservation premium going to be enough to help the renter become a buyer?
Sam understands the difference between the words OPTION and OBLIGATION very well and uses the difference to win big by using other peoples’ money. None of what I’ve explained here is illegal if done properly. It’s not even unethical if done with the right intention and reasonable forecasting. The problem is that not all investors are genuinely trying to help renters break the rental rut. Renters need to be aware and, wherever needed, they need to exercise extreme caution before getting involved with a RTO deal.