Courtesy of The Mortgage Professor
June 1, 2012
Of the 700 or so articles on my web site, the article accessed most frequently over the last year has been one I wrote in 2004 on lease-to-own home purchases. This is a combination lease and purchase where the renter/buyer occupies the home as a tenant but has an option to purchase it within a specified period at a specified price. I will call these “LTO” deals.
Interest in Lease-to-Own by Wannabe Home Buyers
The intense interest in LTO deals today partly reflects the more restrictive and rigid mortgage qualification requirements that emerged after the financial crisis. This has created a large body of wannabe home buyers who can’t qualify for the mortgage they need to make it happen. An LTO gives them a shot.
LTO buyers are hopeful that they can remedy their shortcomings as mortgage borrowers within the option period. This could mean repairing their credit, accumulating the cash required for a down payment, increasing their documentable income, or placing more distance between themselves and a prior bankruptcy or foreclosure.
Interest in Lease-to-Own by Anxious Home Sellers
On the other side of the table are home owners looking to sell but, because of the decline in home prices, don’t have the equity in their homes that they had been counting on. The LTO gives them a chance to sell at a better price in the future than they can realize in the current depressed market, and in the meantime they collect rent.
Why Deals Don’t Get Done
This simultaneous increase in interest by both buyers and sellers should result in a thriving market, but as far as I can tell – nobody collects data on LTOs – this has not happened. A major part of the reason is that LTO deals are extremely complicated, combining features of both lease and purchase contracts, plus features that are peculiar to LTOs.
The party who develops the contract, usually the seller, tends to structure the deal in ways that are favorable to themselves, which creates a hazard to the other party. For example, I once saw an LTO contract in which the buyer lost the purchase option if the rent payment in any month was 5 minutes late. A well-justified fear of being taken advantage of puts a damper on transactions.
My initial plan for dealing with this problem was to work with a lawyer to develop a model LTO contract that was fair to both parties, but that turned out to be impractical. Because real estate law varies from state to state, I would have to develop 50 model contracts.
Instead, what I have done in collaboration with Jack Pritchard is to develop a checklist of all the major provisions that might be included in an LTO, explaining the implications of each for both buyer and seller. The checklist can be used as a negotiating platform for the two parties, who can turn the results over to a local lawyer for conversion into a contract. If one of the parties has already developed a contract, the other party can use the checklist to assess its fairness.
Rent Credit, an Important Provision That is Frequently Misunderstood
The list of LTO provisions is provided in an appendix note, but there is one provision that warrants special attention because it is unique to LTO deals and has great potential but is the source of much confusion. This is the rent credit, an amount above the market rent paid by the buyer, which is credited back to the buyer at closing. Rent credits can be used in two different ways which are not always distinguished.
The simplest approach reduces the sale price at closing by the total rent credit paid by the buyer. This reduces the required down payment only slightly. For example, if the sale price is $100,000 and the rent credit totals $5,000, the sale price becomes $95,000 and the down payment required at 5% falls from $5,000 to $4750.
The rent credit is much more useful to the buyer if it can be used for the down payment in its entirety. If the rent credit of $5,000 in the example above is used in this way, the price of the house would remain at $100,000 but the buyer would receive $5,000 from the seller at closing which could be used as down payment.
For this to work, however, the lender must accept the rent credit as legitimate savings by the buyer. To be sure that the rent credit is an amount paid above a fair market rent, the lender will require that the market rent be documented by an appraisal. To be sure that the buyer actually made the payments, the lender will want to see the cancelled checks that evidence the payments. There is more detail about the rent credit in the appendix.
Appendix Note on Lease-to-Own Contractual Provisions
Appraisal: An appraisal of house value by a licensed and neutral professional should be part of every lease-to-own (henceforth LTO) contract. The appraisal facilitates negotiations over the contract sale price. Further, if the LTO includes provision for a rent-credit (see below), an appraisal of the rental value of the house is needed because the credit must be an amount above the appraised rental value.
The cost of the appraisal may be borne by the seller, the buyer, or shared between them.
Appraisal cost paid by seller:____%
Appraisal cost paid by buyer:_____ %
Both parties should have confidence in the integrity of the appraisal. The mortgage professor is available to order appraisals anywhere in the country through reputable appraisal management companies. Email the professor at email@example.com,
Option: The prospective buyer receives the right to purchase the subject property at the specified sale price, within the option period, in exchange for an option fee.
Sale price: $_____
Option period: _____monthshe seller in exchange for the purchase option.
- Option fee: $_____
Refund of Option Fee: This fee is generally not refundable if the buyer does not exercise the option. However, the fee might be refundable if the seller violates the contract in a material way.
Refund of option fee: Contractual violation by seller triggering refund.
Loss of Option: The buyer could lose the option to purchase by violating the contract.
Loss of option: Contractual violation by buyer triggering option loss.
Lease Period: This is ordinarily the same as the option period.
Market Rent: This is the amount the buyer agrees to pay for the right to occupy the property. If the contract includes a rent credit, the market rent should be based on the appraised rental value.
Market rent:$_____per month
Rent Credit: This is the amount above the market rent paid by the buyer, which can be treated in two different ways. One way is to treat it as a credit to the price. At closing, the sale price is reduced by the total rent credit paid by the buyer. This reduces the required down payment only slightly. For example, if the sale price is $100,000 and the rent credit totals $5,000, the sale price becomes $95,000 and the down payment required at 5% falls from $5,000 to $4750. If the option is not exercised, the buyer loses the rent credit.
The rent credit is more useful to the buyer if it can be used for the down payment in its entirety. For this to work, the seller must return the rent credit to the buyer at closing, and the lender must accept it as savings by the buyer which constitute a legitimate down payment. To be sure that the rent credit is an amount paid above the market rent, the lender will require that the market rent be documented by an appraisal. The lender will also want to see the cancelled checks that document the rent credit payments from the buyer.
Rent credit is used to reduce sale price_____
Amount per month $____.
Rent credit is returned to buyer at closing____
Amount per month $____
If option is not exercised, rent credit is retained by seller____
If option is not exercised, rent credit is returned to buyer____
Total Rent: The sum of market rent and rent credit.
Rent Payment Obligations and Penalties: This provision specifies when the rent payment is due and the penalties if the obligation is not met.
Total Rent due date:____day of the month.
Grace period after due date:_____days
Late charge for payment after grace period:$_____.
Other penalties for failure to pay rent on time:_________.
Payment For Utilities: Either the buyer or seller is responsible for payment of utilities.
Buyer is responsible:____.
Seller is responsible_____.
Property Use by Buyer: Ordinarily the property will be used as a residence, with any other use specified in the contract, or subject to permission of the seller.
Property Inspections: The buyer may wish a home inspection and/or a termite inspection as part of the transaction. The costs may be borne by either party or split.
- Buyer pays for home inspection____.
- Seller pays for home inspection_____.
- Cost is split, buyer pays ___%, seller pays ___%.
- Buyer pays for termite inspection____.
- Seller pays for termite inspection____.
Cost is split, buyer pays ___%, seller pays ___%.
Maintenance: Ordinarily buyers are responsible for maintaining the property in as good condition as they found it aside from normal wear and tear, and are responsible for damages caused by them or their guests. The seller may require a security deposit that, if not used, is returned or credited to the price.
Buyer posts security deposit of $_____.
Alterations: Ordinarily buyers are barred from altering the property without the written consent of the seller.