Rent-to-own, lease/purchase option, lease-to-own. How does it work?
It's pretty simple, really. Someone who is interested in buying a property, but isn't in the position to do it today, can purchase an option to buy at a later date and have a portion of rents applied to the purchase.
Every RTO transaction is different, but there's a general framework that we can use as a starting point for negotiations. Of course, this is only a starting point to give an idea of what to expect on both buyer and seller sides, and since it's real estate, EVERYTHING is negotiable.
- Buyer buys an option to purchase the property at a later date, usually between 18 and 36 months
- Option prices vary, but are generally about 2% of the "pre-agreed-upon" price of the property
- Buyer and seller agree on a price at which the option can be exercised. The price can be a set price, or it can vary based on an index (like CPI or a local real estate valuation, e.g.), or it can be at a price determined today with an escalation like 5% per year until the option is exercised.
- At the end of the option period, the buyer must have 5% of the purchase price in an escrow account in order to qualify for a mortgage. A portion of the rent, usually around 33%, funds that escrow account.
- At the option expiration, the tenant has the right to exercise the option or decline, but they lose the funds in the escrow account if they decline.
Hypothetical Example
Bill owns a condo valued at $200,000 today. Scary-credit Mary is interested in a rent-to-own option on the property. They agree that the market is likely to increase 5% per year over the next two years, and that a purchase price of $220,000 is fair 24 months from now. Mary pays 2% of that price up front, or $4,400, for the right to exercise the option to purchase in 24 months.
In order for Mary to have 5% of the agreed-upon purchase price, she'll need $11,000 in the escrow account in 24 months. If one third of her rent is escrowed, the amount of rent necessary to have $11,000 in 24 months is $1375 per month, of which $458 per month goes to escrow. In 24 months, Mary has good credit again, and a 5% down payment sitting in the escrow account, and has the right to buy the property for $220,000, even if it's now worth $250,000. If the property has not increased in value and is worth only $200,000, she can either walk away and lose her escrow money, or go ahead and exercise the option (assuming she has the extra cash, since the property won't appraise at $220,000).
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