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Mar 15

Getting the Basics Right: What is Rent to Buy?

Lease Option

If you are new to real estate, the term “rent to buy” can be quite misleading. It implies you are renting a house and buying it afterwards. That is only half right: A rent to buy contract can be dismantled into 2 parts:

1. A lease arrangement and

2. An option to purchase.

So to be more precise, rent to buy 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 buy 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 / like a deposit). No worries we will drill deeper into these costs below.

A rent to buy contract focuses heavily on the option to purchase the lease is just a standard lease for your state. The finer details are actually laid down in the option agreement.

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 buy paperwork is signed, this sale price will be locked in until it’s time for the buyer to exercise the option to purchase (i.e. time for the buyer to get a bank loan and pay out the seller). This option period should be a minimum of 5 years, which will be the duration of the lease as well.

Let’s say we have a rent to buy agreement for a house with a selling price of $500,000 and an option period of 5 years. The buyer will first have to rent the house for up to 5 years and once they achieve getting their finance he or she will have the right to buy the house for $500,000 (regardless of whether housing prices have risen or fallen during that period of time). Therefore they can payout the owner anytime within the 5 years; you do not have to wait until the final date in the paperwork.

Of course, the buyer has to pay some upfront money to enjoy this option… commonly called the up front option fee( similar to a deposit but not the same).  It is common for the up front 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 deposit on the contract of sale. If the option isn’t exercised and the deal falls through, legally the seller gets to pocket the option fee as it is non-refundable.

Rent Premium:

In a rent to buy 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. This is usually similar to what a loan payment would be on the property.

The rent premium works like this: If the buyer ends up buying the property, this rent premium graduates into a equity 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 the same as building up equity in his or her future home.

To give an example, let’s say we have a $500,000 rent to own house that normally rents for $1,700 a month. The buyer and seller have agreed on a rent premium of $500 and lease period of 5 years… so the buyer will be paying $2,200 each month instead of the $1,700. If the buyer ends up buying the house 5 years down the road, a portion of the premium will go towards the amount the buyer now owes the seller.

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 buy contracts are popular with many buyers who are shut out of the banking system due things like employment history, credit issues from years ago, deposit shortfall, lack of funds for government taxes (such as stamp duty) and many more little problems. 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.