Over the years, we’ve been asked dozens of times about Rent-to-Own properties and how they work, mostly from Tenants. Many of them see it as a chance to potentially get into the housing market and grow some equity.
So this article is designed to explain the pros and cons of Rent-to-Own, who should (and shouldn’t) consider it an opportunity, and what dangers exist for Landlords and Tenants.
How Rent-to-Own Works
UPFRONT: The very first thing that we mention to Tenants is that they’ll either need an upfront downpayment, or they will be paying above-market rent (or both).
Basically, an agreement is made where the Tenant, over the course of the lease, which is typically three years (36 months) but could be anywhere between 2-5 years, must come up with a minimum of a 5% downpayment that will be used towards their purchase.
They may pay the money upfront, or they may contribute an additional $500 per month, for example. At the end of the time period, they would have accumulated $500 x 36 months, or $18,000.
There may also be a combination of the two methods. Maybe 2.5% upfront, and the additional 2.5% spread over the three years.
ONGOING: Standard lease terms often apply here. The Landlord could pay for any ongoing repairs and maintenance, as they would if it was a regular lease… but we have also seen agreements where the Tenant is the one that pays for these expenses.
END OF LEASE: At the end of the lease period, there is usually an agreed-upon value where the Tenant can buy the property. Or there could be an agreed upon METHOD for determining value.
For example, the Landlord and Tenant may agree upon the present value of the property, and the Tenant will have the option of buying the property at the end of the term at a value of 5% per year appreciation. Or they may agree that two appraisers will be hired independently at the end of the term, and the sale price will be the midpoint value between the two appraised values.
As you can see, there are MANY different ways these Lease-to-Own Agreements are made. It’s not a standard one-size-fits-all method.
The bottom line is that there needs to be clarity about the beginning, middle and end of a Rent-to-Own agreement.
How it Benefits Tenants
The most common profile Tenant for this situation is someone with POOR CREDIT who has some cash in hand. While their credit is building or rebuilding, they are getting a step ahead by building towards homeownership.
This can be a good program for:
- Someone recently separated or divorced who is rebuilding credit
- New to Canada with no established credit history
- Someone who just started a new job and can’t be approved for a mortgage
- Self-employed people
- Individuals who receive a large portion of their income from cash that may not be reported in full on their income taxes
We also see Rent-to-Own situations where a homeowner has equity, but they get into financial trouble and would sell their home to a new Landlord, and make monthly payments to get back into the position of being an owner. That way, there’s no disruption to the family.
How it Benefits Landlords
Landlords receive a longer-term Tenant, who will likely take good care of the property, knowing that they may one day be the future owner. The Landlord may also save money by selling to the Tenant/Buyer directly, instead of paying commission to list the property on the MLS system.
Some agreements are structured so that the Landlord receives some (or all) of the downpayment if the Tenant does NOT agree to buy.
Other agreements ensure that ALL housing expenses (principal and interest on the mortgage, property taxes) are covered by rent, plus a set profit (cash flow) for the investor.
More often than not, we see the written agreements are much more in favour of the Landlord than the Tenant.
There are some Landlords who are predatory, and seek out Tenants that they KNOW will forfeit their savings and downpayments.
So Tenants… beware! Don’t say we didn’t warn you…
What could go wrong?
The risk in these agreements is all about how they’re written.
If the market tanks, and the agreement says that the Tenant MUST buy the home at the end for a set price, they are faced with the possibility of either buying the property above market value, or walking away and losing a sizeable deposit.
On the other hand, Landlords who agree upon a 3% per year appreciation and the market increases at 8% per year might find themselves walking away with less-than-ideal profits.
For this to truly be a win-win strategy, it’s very important to get lawyers involved that know what they’re doing… for BOTH parties.
Steps should also be taken by all parties to make sure the Buyer/Tenant’s credit is being repaired so that they can complete the purchase – perhaps by regular check-ins with credit counsellors or a mortgage specialist.
When it DOES work well, a Rent-to-Own can be a chance for a Tenant to create stability for their family and get into the housing market sooner, and for a Landlord to make a fixed profit with a low-cost exit strategy.
The devil is really in the details for this type of agreement. If it sounds too good to be true, pause and get some advice from a professional.