Within the segment of consumers who want to be homeowners, there’s a subset who cannot qualify for a loan, and will therefore not be a homeowner until they can. Typically, these folks have a credit profile that precludes them from qualifying for a loan that can work within the parameters of their income and debt. In the past, the only alternative to buying was to continue to rent while working to fix credit issues, and decrease debt (and if income happened to increase along the way – a bonus).
Today, this segment of folks have the ‘Rent to Own’ option available to them. Popular with conservative investors who want the advantages of appreciating investment property, but without the hassles of rental income, the Lease-Option is an arrangement whereby an investor leases a property to a tenant, who is also extended an option to purchase the property within a certain time frame (two years is typical in the Puget Sound market). For an investor, the Lease-Option playbook is extensive – there are multiple approaches to this type of investment.
However, a program that seems to be growing in popularity is the ‘Pick Your House’ program that agents offer potential homeowners. The scenario the agent shares with the tenant is that they can pick the house in which they want to live (as long as the price of the home – rather, the monthly costs associated with the home – falls within the tenant’s budget). The agent then finds an investor to purchase the property. The rent is structured to cover all the investor’s monthly costs (PITI). Additionally, there is typically an option fee that the tenant pays to the investor up front. I’ve seen it fall into the 1% of property market value. Though non-refundable, this fee is applied as a credit toward the purchase price should the tenant exercise the option. Sometimes, a small portion of the monthly rent is applied toward the purchase as a credit as well. The option price is calculated under certain assumptions (such as 8% annual appreciation), and the price therefore might be set at 10% over current market value at the end of two years. This allows the tenant to capture some equity upon exercise, assuming appreciation is higher. Additionally, the tenant is contractually obligated to manage small repairs (where a renter would just call the landlord), with the investor taking care of larger repairs (in excess of some agreed upon dollar amount).
It’s a good way for a potential home buyer to get his foot in the door – as a matter of law, they have an interest in the property with the option (this can and should be recorded with the county to protect the tenant’s interest).
The option can be lost if the tenant defaults on the terms of the lease, or if he chooses not to exercise the option. Here’s the kicker – I’ve read/heard that the default rate for lease option tenants hovers near 70%. The biggest reason seems to be that bad habits are hard to break. If the tenant is counseled correctly, the lease period is an opportunity to repair credit, pay off debt, and position the tenant to qualify for a loan needed to exercise the option. The reality is that tenants don’t pay their rent, continue to over-extend themselves, or decide upon a different direction with their life that requires a move.
Unscrupulous investors and scammers will take advantage of these tenants and pull the option from underneath them for the smallest deviation from the lease terms. In fact, Lease Options were outlawed in Texas due to the scams. However, if the investor enters the transaction and deals with tenants fairly, it’s a win/win for the investor and the tenant/optionee.
I am wondering about the ethics of an agent working with a tenant to pick a house, then bringing in an investor to purchase it. At first glance, it seems that there is a clear conflict of interest. Isn’t there? Maybe not. The tenant is informed and gives consent to the process from the start. The agent is there to help find the home, but the investor is actually purchasing it. However, since an option – and therefore an interest in the property – is involved, does this create a technical conflict of interest? The investor is more concerned with the profile of the tenant, and with making sure that the numbers work for the transaction. The tenant is more like a client to the agent. They are driving around with the agent, evaluating neighborhoods, and picking the home, subject to investor approval.
Are ‘Pick your Own’ Lease Option programs a win/win/win for the tenant (who may successfully purchase the home by exercising the option), the investor (who gets a fixed return assuming an exercised option) and the agent (who gets the commission from the transaction)? A fourth party, adding another ‘win’, is the mortgage broker who may very well finance the deal for the investor, and create a relationship with the tenant that leads to financing the exercise of the option down the road.
Full disclosure – as an investor, I have purchased four properties with tenants who had options to purchase. However, none of them were acquired in the ‘pick your own’ method discussed above. I acquired the contracts by paying an assignment fee.