Rent-to-own, the often ill-perceived home-buying strategy of the cash strapped in the 1990s, has been gradually re-emerging as a successful win-win way to invest in real estate. Its waning popularity was due in primarily to the relaxed lending environment wherein it was easy for many more people (and in the States, almost anyone!) to get a mortgage. Today, its re-emergence in popularity is due to the tightening of lending policies.
Rent-to-own, also called lease options, has two parts: starting with the lease or “rent” part and finishing with the option for the tenant to purchase.
The tenant is often looking to purchase a home but is unable to usually due to sullied or no credit, or not enough down payment capital. Whereas the investor – the original purchase of the property – would have the down payment available and wants to make a fixed profit on the property after a certain term.
Investors using the rent-to-own strategy often work with tenants/buyers who:
- qualify at the bank for a mortgage but have been turned down by CMHC;
- have a house up for sale and want to buy another one but can't qualify for two mortgages at the same time;
- are new to Canada and do not have established Canadian credit;
- recently started a new job so have not established and employment track record that satisfies the bank;
- are self-employed and therefore have a tougher time proving income to the bank; or
- have gone through a divorce and are now rebuilding credit and equity.
These are perfect candidates for rent-to-own.
This win-win strategy helps the tenant/buyer move from renting to owning faster than they could do on their own and can also be very profitable to the investor.
Investors can either find a tenant/buyer for a home they already own or select a home with them that suits everyone’s needs (often a more successful strategy). Desired houses are often more upscale than an average home and frequently located near good schools.
The investor then agrees to a future price on a home within a period of time (say two to five years), paying serious attention to the housing market and likely price appreciation. A fairly typical increase would be three per cent increase per year from purchase price.
This is, of course, where the risk lives for both parties as the agreed upon price is part of the contract. If the market tanks, the tenant/buyer is on the hook for the agreed-upon purchase price (unless they choose to walk away and lose their deposit). But if the market skyrockets, the investor will still only received the agreed upon price, even if they could otherwise get thousands of dollars more.
Although there are variations, in its simplest form, the payments work as follows. A monthly rent is calculated, which covers all of the housing expenses (principle and interest, property taxes, utilities, etc), as well as a profit (cashflow) for the investor, AND what’s called an option payment. This serves as a savings account towards the future down payment of the home. The tenant also pays all of the repairs and maintenance costs. Should the tenant/buyer choose NOT to proceed with the purchase of the home at the end of the term, the option payment is forfeited and the investor keeps it.
Two things are very important for this to truly be a win-win strategy. The investor must not deliberately work with people who could never be able to complete the sale in order to keep the option payment. And it is in the investor’s and the tenant/buyer’s interest to make sure that steps are being taken by the purchaser to repair their credit so they are able to complete the purchase. Referrals to credit counsellors and regular check-ins on progress are helpful.
