Rent-to-own agreements give buyers who can’t get a mortgage right away (much less pay the cash price for a property) the chance to move in as a tenant and become the property owner later on.
For the seller, these agreements are a way to generate rental income from presumably motivated tenants who have more than a passing commitment to the property, since they intend to own it in a year or two.
Such agreements come in many flavors and names; rent-to-own, lease-to-purchase, and lease with option to buy or purchase are just a few. Their attractiveness depends on the market, of course, and there are significantly different considerations when dealing with a commercial lease or a residential lease. Here, we’ll focus on the latter.
How a residential lease purchase contract works
A lease-purchase agreement is really a rent-to-own kind of deal. The lessee — the tenant — is renting the home and agreeing to buy it at the end of the lease.
The security deposit and an agreed-upon portion of the rent goes toward the purchase of the property at the end of the lease, acting as a down payment that accrues during the life of the option agreement.
A lease-purchase contract generally runs for a year to three years, specifying the price of the house and giving the lessee the option to buy the house anytime during the lease. Alternatively, the lease-purchase agreement may specify the purchase price will be established based on fair market value at the end of the lease.
And unlike a lease agreement that carries no purchase agreement — in other words, the typical residential lease — the leased property cannot be sold to anyone else during the life of the lease-purchase agreement.
The renter also may be required to provide an up-front fee as a lump sum at the beginning of the deal. That deposit and the accumulated rent credit can be forfeited if the renter decides at the end of the lease not to buy after all.
How do lease-purchase and lease-option agreements differ?
The terms are often used interchangeably, but they’re really not the same thing. The “option” in “lease purchase option” means the right to purchase or lease land or other property interests without any obligation to do so.
There are generally two separate contracts in a lease purchase: the lease itself and the contract for sale.
Meanwhile, according to this blog from the Koontz & Associates law firm in Sarasota, Florida: “A lease option operates very similarly to a lease purchase in that it consists of two agreements and theoretically allows for the tenant to ultimately purchase the property. However, the tenant does not sign a contract for sale but instead enters into an option agreement.”
In a lease option agreement like this, the seller is obligated to sell, but the buyer is not obligated to buy. For that privilege and the right to buy the property at any time during the lease, the renter also pays an option fee up front.
(By the way, don’t confuse either of these with a land contract. That’s when the owner is providing the financing instead of a mortgage lender. Land contracts were generally more popular in the 1970s and 1980s, when mortgage loans were harder to get.)
Some pros to a lease-purchase agreement
A fully executed lease-purchase agreement, of course, ends with the landlord no longer being the property owner. But if the owner got market rent and then a fair price for the property, it can be a good deal for both sides.
From the seller-landlord’s perspective, you’re likely to get a more stable renter during that period, and a lease-purchase agreement is often an opportunity to include more of the maintenance and upgrade costs on the tenant side of the ledger during the lease period.
And if the tenant agrees to pay fair market value at the end of the deal, you can still benefit from appreciation while enjoying steady income from the property. You also will already have in hand the average 2.5% to 7% of the agreed-upon purchase price as the upfront, nonrefundable, one-time fee. As for the monthly rent credit, 10% to 15% each month is standard.
Plus, in a down market or in an area not even in an up market, such arrangements can be a good way as a property owner to find both a tenant and then a buyer.
(Here’s a site that offers lease-purchase templates. And here’s one for a typical residential lease. Quite a difference!)
Some cons to a lease-purchase agreement
As the property owner, you’re committing to sell that property. The cash price you end up with could either be set at the beginning of the lease or the end. Either way, you’re committing to not only selling it but to a buyer dependent on getting a mortgage at some point.
Failure to do that means no deal. The buyer could also back out, leaving you with a vacant property that possibly might not be worth what it was when you began the joint venture.
And if you do agree the selling price will be fair market value at the end of the lease period, that price could be less than what you could have gotten if you had set the price at the beginning. Will it be a seller’s market or buyer’s market then?
Those kinds of market vagaries fall under the crystal-ball category of market timing that creates risk in any kind of investing, of course.
What to consider before moving on an agreement
Whether you go lease-purchase or lease-option, these complicated deals require knowledge of applicable local and state regulations.
You can, of course, start your research on the internet. Numerous sites include best practices, warnings, and more from reliable sources, and their advice can vary widely. For instance, some recommend limiting the tenant to a one-year lease, while others say that’s too short.
Others, cautious about equitable interest claims that can arise if a tenant is evicted after paying rent credits, warn against using words like “credit,” “seller,” and “buyer” in the lease agreement itself. You also must know the difference between the agreed-upon price and the market price.
Finally, whether you do a lease-purchase or a lease-option, you’re creating a landlord-tenant relationship, so make it clear who’s responsible for property taxes (probably the property owner) and maintenance (probably the tenant). As to the latter, specify to what extent.
The right deal at the right time? Only if it’s right for you
For a tenant-turning-buyer, these arrangements are a chance to secure a place to live and begin making a down payment a bit at a time every month while saving for closing on the final mortgage later.
For the landlord-turning-seller, a lease-purchase agreement is a way to lock in a buyer and tenant at the same time, a definite consideration in a buyer’s market. You might even be able to get an above-market rent over a traditional lease, and you’ll get a tenant probably more committed to the property than the typical tenant.
Is that worth giving up ownership of the property itself through a lease-purchase agreement or any other? That’s up to you to decide. You can take the money and run or continue the income stream into the future.