﻿How Lease-to-Own Works in Real Estate (Commercial and Residential)
There are many different avenues that you can take to get started investing in real
estate. These pathways can differ depending on many factors:
* your financial standing * your risk tolerance,
* and even your availability of debt around you
If you are low on capital or prefer to keep your cash as liquid as possible,
one option you may be able to pursue is a lease-to-own approach. So, here are the pros
and cons of the lease to own strategy. What is a lease-to-own strategy?
A lease-to-own (or rent-to-own) agreement is a contract between an owner and a tenant
where the tenant has the option to purchase the property before the end of the lease (or within
a predetermined time period). So, just think of it like your typical real estate lease with an
option to purchase the property, too. They may be more commonly found when leasing a car, but their
use in real estate has been growing in popularity in recent years as the market becomes tougher and
tougher to break into. As part of the agreement, the tenant not only pays the monthly rent, but
they also pay a one-time fee at the start of the lease or an additional amount each month, which
will be applied toward the purchase price of the property if and when the tenant elects to buy it.
So, why might an investor use this strategy? Well, one reason is that they may be low on cash.
In this situation, it could be an individual who is newer to real estate investing or even
a seasoned investor who simply cannot attain additional funding. The lease-to-own strategy
grants an investor extra flexibility and gives them time to build up their savings toward a down
payment. Another reason why someone might pursue a lease-to-own option is that they are unsure if the
surrounding community is where they want to live or work. Being able to occupy the property before
purchasing it allows an individual to be sure of their decision. Let’s dive into the advantages of
using a lease-to-own agreement. What are the pros?
One benefit is that there is a pre-negotiated sale price. You will know exactly what you will
have to pay to purchase the property going into the agreement and the owner of the house cannot
inflate the purchase price on you at the last minute. Additionally, the value of the property
could increase substantially while you are renting it, which could allow you to purchase
the property for a below market price (since you negotiated that on the front end) and find better
financing terms or flip it for a profit. Another pro for utilizing lease-to-own is
that a portion of the payments, whether you made them on the front end or negotiated to make them
each month, will apply towards your down payment if you opt to move forward with
the purchase. Since these payments can apply to the total price, they can significantly
decrease your down payment at the end of lease and help you maintain your cash on hand.
Another advantage is that the current owner will still be responsible for maintaining the property
(unless, of course, your lease says otherwise). As a tenant, you will have the opportunity to test
out all of the mechanical, electrical, plumbing, and more before you buy the site and move in.
Never hurts to know exactly what you’re getting yourself into. Now, let’s now take a look at some
of the downsides to a lease-to-own agreement. What are the cons?
Well, one issue with a lease-to-own deal is that the option fee, if you paid one, is likely
non-refundable. Typically, the option fee is a notable portion of the overall property value that
is applied towards your down payment should you exercise the option. However, if you choose not
to exercise the option and buy the site, you could lose out on that money. For instance, if you could
not afford to pay the rest of the down payment on or before the expiration of the lease option,
your opportunity to purchase could be taken away and then you would be left with nothing.
No investor wants to lose out on money like that, it’s kind of the opposite of why you got into
investing in the first place, so lease-to-own options can be a little riskier than others.
Another downside with a lease-to-own agreement is that the monthly rents are more expensive than
they would be with a typical lease since a portion of the rents would be applied towards the purchase
price. This structure protects the current owner and ensures that they will be paid the correct
rent amount, regardless if you exercise the option. The above market rental rates do
not matter if you do end up buying the property because some of it is going towards your required
equity. However, if you choose not to, you’ve just paid higher than market rates with no return.
A final drawback is that until you’ve bought the property, you’re still a tenant. And
that can prove frustrating for some since you may feel like the property is already yours,
but you will need to wait until they have actually purchased the property to make any major changes
(unless, of course, you’ve negotiated something differently). The current owner will still have
full control of the property until the end of your lease and you will need to abide by the
rules of that legal document. Now, are there different types
of lease-to-own agreements? Of course there are! Just like almost
any scenario in real estate, everything is negotiable. In fact, many of the aspects of
the lease-to-own strategy that we just discussed could be completely different, depending on what
you and the seller are comfortable with signing. A standard agreement consists of a lease and an
option fee as we previously discussed. Another type of lease-to-own agreement is a lease-purchase
agreement. In this arrangement, a tenant is obligated to purchase the property upon expiration
of their lease. Think of it like you’re putting the property under contract and you are allowed to
pay rent and occupy the space in the meantime. There are really an infinite number of ways to
structure these deals, depending on how creative you’re willing to get.
So, should you buy real estate using a lease-to-own agreement?
Well, that completely depends on your situation. A lease-to-own agreement is a great tool for
investors who are either low on cash or have maxed out their ability to get new capital.
There are several benefits to it, including the opportunity to test out a property before
buying it, the ability to purchase a property at below future market rates, and less cash
out of pocket all at once because of how the deal is structured. There are some downsides,
of course, because if you decide not to purchase the property, then you will have paid far more
than necessary every month for rent. That being said, if you are looking to
get into real estate and want to pursue a lower risk option for your first deal,
a lease-to-own agreement is a great way to start your real estate journey. If you’d like to explore
other low to no-money-down options for investing in real estate, check out this video here.