by Claire
Super-duper-crazy-busy-week! A quick update on our housing situation. We received an email from our tenants. They want to enter into a “lease-to-own” contract on the house. We have research to do but I always think to come to my readers first. We have no ideas or feelings on this at this moment so I’m opening this up to feedback. On the upside, I guess at least we know they don’t want to move out?
Thanks in advance for the help.
Born and raised in Texas. I’ve at least driven through every state in the US courtesy of a roadtrip loving Dad.
I’m single with two children and a good parenting relationship with their father.
I am a “life is just half full of funny” kinda gal. Humor is my saving grace and I am thankful for it every single day. I have a strong Catholic faith and am thankful for that foundation.
I read a lot for a living but still enjoy a good book. I love biographies but in recent years have found the need for fun fictional books–sadly, for a long time I just didn’t enjoy fiction!
I love live theatre of any kind–from local productions to Broadway.
I love to scrapbook and pride myself in my kids’ albums.
I love being a mom but also love my career. I’m blessed to have found a balance allowing me to be at everything my kids need and want me to be at–while also having a career.
Favorite Quotes: Well behaved women rarely make history.
Behold the turtle. He makes progress only when he sticks his neck out. -James Bryant Conant
It seems like the very first thing you want to consider is whether you want to sell your property…
I don’t think a lease to own would be worth it, personally.
But I don’t really know. We are just now in the process of changing our first house into a rental property…
On first impression, it sounds like a way to gradually work away at another financial obligation. Probably best to consult an attorney on this one.
From the little I know, there is a lease-purchase option. Tenants pay a little more for the option of buying the property within a certain time frame (and probably a certain sales price). I’m not sure if lease-to-own is the same thing with a different name or not.
I think this only makes sense if you want to get out of the landlording business and the proposed sales price makes sense. I would consult an attorney who specializes in real estate.
And there is always the possibility that if you decide not to offer the lease-to-own option, they may decide to move out and move on. Not necessarily but definitely something to keep in mind.
A lease-to-own contract amounts to a call option on the property. If it goes up in value, they get the benefit and you lose it, but if it goes down in value, you get stuck with the downside and they have none. So it’s an arrangement where they do all the winning and you do all the losing.
But it’s not unreasonable, provided both parties understand the issues, and there is some compensation involved.
Owning stock and owning property in this sense are similar, and so it’s beneficial to see how this arrangement works where the details have all be hammered out by others – the stock market.
In a nutshell, to persuade you to enter into an arrangement like this (where all the upside is theirs and all the downsides are yours) the tenant needs to offer you something more than just keeping paying rent. (In today’s market, you can get another tenant without too much trouble.)
The extra value to you might be a long term lease, it might be higher rent, it might be a lump sum, or anything else you can agree on.
In the stock market, the compensation is a lump sum. If I own some IBM stock, you can come to me and buy the option to purchase the stock from me later on at a set price. And that will cost you some money. Not a lot, but more than nothing.
IBM stock sells for just under $200 a share today, and there are hundreds of listed options available. In this case your analogy would be call options. Here is a link showing the various calls available today on IBM stock for delivery in January 2014 (about 18 months away):
http://finance.yahoo.com/q/op?s=IBM&m=2014-01
If you read this after today, the exact numbers might change, because the site is updated constantly.
But if you look at the table, you can see that if you wanted to buy from me the option to buy my stock for $220 in January 2014 (a year and a half from now) you’d cut me a check today for roughly $10 a share. This is over and above the $220 you will pay in January, 2014. That’s my compensation for giving you the right to come and take my stock for $220. If the price then is $250, you will buy my stock for $220 and either keep it as a bargain, or sell it for $250. Including the $10 you gave me to buy the option, you’re out $230 and you pocket a profit of $20. I lose that profit, but in exchange for that I got that extra $10 you gave me when you purchased the option.
If the stock never rises to $220, you will simply let your option expire as worthless. You lost $10, which I get to keep, because I lost the opportunity to sell the stock in the 18 months between the purchase and expiration of the option.
So the option (call option on stock and lease option on property) is something with tangible value. You can’t give it away for free. If you had the IBM stock in the example, would you give me the right to buy your stock for $220 in 2014, with no compensation? I would take all I could at that price, because I have nothing to lose.
In like manner, if your property never reaches the value you agree upon in the lease option, the tenant will simply not buy it – he/she will be better off paying market price for the property or buying something else. The reason he has an out is that “option” word. That means he (or she of course) has the option to walk away from the contract.
But you don’t.
And so, in the stock example, any “lock” costs the buyer money. When you apply for a mortgage, you pay for a “lock” on the mortgage rate – same principle.
Sacrificing a future benefit is something of real, tangible, dollar value. The question you have to ask yourself: “how much will it take for me to surrender that value?”
It has to be more than nothing, or else it’s a no brainer for the tenant – he/she has nothing to lose. And every tenant will come knocking on your door for one.
Someone else with more real estate experience can tell you more. This was just a theoretical background to show you you’re talking about something with tangible value – don’t enter into it lightly and certainly don’t give it away for free.
Presumably you own the asset for some future benefit.
Granting an option such as this costs you. You will forgo any upside beyond.
this is interesting. all the info here is right. if you decide to look into it you must must consult a real estate attorney, no questions asked. my understanding is that these contracts can be kind of shaky in texas.
something to ask yourself – is why the tenant would want to do this. the likely answer is that they want to buy the house, but they can’t currently qualify for financing. then ask yourself – are they likely to qualify at the end of the option term? if they don’t qualify, what sort of legal mess does that drag you into?
also need to ask yourself – why not just let the tenant lease for a year or two, and then they can make you an offer at the market price when they are ready to purchase? the risk for the tenant is that you sell it to someone else in the meantime or kick them out at the end of the lease.
the risk for you is that the tenant doesn’t take care of the property if they are just leasing it and they move out at the end when there is a lot of maintenance required.
to me, this is an interested option for someone who wants a house but can’t afford to finance it. but the benefit over just simply leasing until you can make a bona fide offer is questionable.
Good points, Adam. It might be nothing more than a handshake agreement to give them right of first refusal. You promise not to sell to somebody else, in exchange for a two year lease. And at the end of the lease, you can mutually either extend the arrangement or they buy. At the average price of their appraiser and yours. Or something like that.
I’m not a real estate professional, but in California if you want a lease to buy, you have to put up some non-refundable money; usually a percentage of the purchase price. So since a first time buyer can currently get a loan with 3% down I would charge at least that much. Then, as others have pointed out, since it’s likely that the tenants don’t qualify for a conventional loan, you would charge an additional amount over and above the normal rent that would go toward the purchase price (the rent doesn’t) IF they go through with the sale. If they don’t, you keep the everything. Thereby making it somewhat worth your while. Other than markets like San Francisco and Los Angeles, the real estate market in CA is flat and looks to remain that way for a few more years at least. I might consider your tenants a “bird in the hand”. Just a thought.
One thing to consider is that if you sell the rental straight out then you take you profit immediately and you’re free to use that money straight away.
If you do a lease to own you will take the profit over a very long time period and the value of that monthly payment will decrease in value with inflation. If ever you needed money in a hurry you can’t just sell the property as you can with a regular rental.
You’ll also be tied up legally with these people for many years to come.
Generally speaking, don’t do it. Listen to Dave Ramsey for more information – he addresses this topic occasionally.
If you want to sell your house, just put it on the market through the normal process and sell it. Get all the money at once and be done with the home. Don’t put yourself or your huge asset at risk through some long-term lease deal that could fall through or could have other complications.
Also, generally when people want to lease-to-own, it means they can’t really afford the house. You don’t want one of your largest assets tied up with people who can’t really afford to buy it. And you’re not blessing them by helping them make a stupid financial decision.
Just sell it outright to someone who can afford the house. You’ll know they can afford it if a bank will give them a standard mortgage.
Greetings! This is Claire’s husband. After watching my wife bare her financial soul and diligently post day after day, it is long overdue for me to introduce myself and comment. Especially since I am a beneficiary of the advice shared so freely both directly and indirectly. First of all, I just want to take a minute to let the blogosphere know how much I adore and respect this woman. She is truly in a league of her own. Her dad once said that he created the perfect woman and I am very thankful to him for this beautiful gift I have the privilege of calling my wife.
Secondly, thank you to the followers of the blog that offer such great advice. Your comments are the source of many meaningful discussions we have and weigh in the decisions we make. Your voice counts, a lot.
Now for the lease to own discussion. I realize this is beyond my expertise so your suggestions are well received. Before she and I get too involved in the decision, I should mention that we do not have confirmation that the terms of the mortgage would allow for any such arrangement. Once we have a better understanding of the flexibility, or not, we have with the mortgage contract we can then pursue the options with a professional in the field. Should we have a green light to move forward, one option that seems to hold the most promise for our circumstances is a wraparound mortgage. This is an attractive option because it is hard for buyers to qualify, we have relatively no equity in the property and the tenants (prospective buyers) have been reliable (knock on wood). Basically, the reasons why the housing market has been in a funk make it viable to owner finance. The calculators I find all indicate this is very doable. Downside is the housing market is a moving target so there is risk but possible reward. This exercise is very eye opening though. It quickly showed me how lucrative it can be to use higher end financial vehicles to build wealth. I can just hear her now and see her eyes roll at me as she wonders what crazy ideas I will come up with as a result. Laughing, thank you for your patience and understanding, Love.
I would suggest giving them an option to buy instead of a lease purchase. The tenant would pay you x amount for the right to purchase it at the end of a specified term. If they don’t exercise the right you keep the money. If they want to another option to buy then they would have to put up more money. I think that you can use this to see how serious they are about actually purchasing the home. Just my thoughts.
BriGuy, you and I are on the same page. This is what I thought they were talking about but now all of this other info has me wondering. I am NOT willing to enter into a legal relationship with these folks for the next 20-30 years. Frankly, the only people I am willing to enter into a relationship for that amount of time are people I am related to by blood or marriage! We have asked them to bring proposals to us and vice versa. We should at least have an idea of what they are thinking this week.
I would be willing to put the option money towards the purchase if they exercised the option. I would love to use this strategy on my house I own in Nashville. I needed a renter really badly and they asked me for the right of first refusal at the end of the 1 yr lease. So, maybe they’re enjoying the house “test drive” and will want to buy it.
You do a great job on your blog by the way. It’s very insightful. Keep it up!
I don’t think your lender will permit a wraparound mortgage. Even if they do, you shouldn’t do it if the buyers can’t qualify for a mortgage on their own. If a big lender won’t lend to them, they’re not worth the risk to your credit.
As to the lease-purchase, this is NC information instead of TX, so take it for what that’s worth. As one of the commenters above said, a substantial deposit is required. Unless you’re willing to pay closing costs, I’d request at least 3% of purchase price + estimated closing costs as the deposit. I’d also ask that the purchase be completed within a year. I know your repayment plan is 2 years, but you don’t know what the real estate market will be like in that time.
If the buyers are currently paying market rent, and they want part of their rent to go toward the purchase, you need to raise their rent. Otherwise, you’re losing money monthly on the lease-purchase.
This strikes me as a similar situation as co-signing a loan. In this case, it appears your tenants would not qualify for a conventional loan. Professional lenders have judged them unworthy. Do you know anything about their financial situation? If professionals have judged them uncreditworthy, do you know better than these pros?
Beeen thinking about your BOA credit card. Now that you have paid off 8k is debt, go back to your credit union and show them your progress, Perhaps you could get a signature loan to pay off your 2 credit cards with high balances?
Keep up the great work!
Best,
Steve
I know very little except what the old neighbors in my old neighborhood went through. They had bought a second property and had a lease to own deal on it with a tenant on a 10 year balloon thing. The 10 years are just about up. The tenant wants to renew rather than pay the balance, and the owners haven’t seen the inside of the property in that time. There is some indication the place is trashed. Not sure if the lease part gives the owner fewer rights to keep an eye on the place? Seems like more risk for the owner. But I don’t know more than what I caught in a driveway conversation.