Real estate investors are looking to rent to own as a means for adding cash flow to their businesses. They look for homes that are selling under market value and require minimal repairs. The goal is to make rental income off of the property for a year or two and then profit from selling the home at or above market value.
It's beneficial because tenants take care of minor maintenance themselves and are usually more consistent with payments as they're on the edge of qualifying for a mortgage to buy a home.
The investor should screen potential rent to own tenants to ensure they will qualify for a mortgage at the end of the lease. Otherwise, the tenant will lose a lot of money when they don't qualify for a mortgage to purchase and the seller's payout moves down the timeline until someone does purchase the home.
While the goal is to sell the home at the end of the lease, the real estate investor makes more money if the home does not sell. If the home does not sell, they keep the option fee, the premium payments and the rent credits, in addition to the profit they made from rent. Then they can rent to own the property to someone else to make even more money. This is completely legal, but not always ideal. The investor is looking for a big payout a year or two down the line. If the person who rented to own the property does not buy, that payout is further away.
There are two strategies in the rent to own investment industry:
- Property First Strategy
- Tenant First Strategy
What is the Property First Strategy?
In property first strategy, an investor purchases a property and then looks for a person to rent to own it. This is the most common rent to own investment strategy.
The benefit to this strategy is that you maintain control over which property you buy. So, you get the ones that are sold under market value and sell them for market value or higher.
The drawback is that you might end up with a property that potential tenants do not want. Then, you might be stuck selling the property in the event that no one rents it from you. Thus, you wouldn't be able to sell the property at above market value or make rental income off of it.
What is the Tenant First Strategy?
In tenant first strategy, an investor finds a tenant looking to rent to own a property and then buys a property well suited for them.
The benefit to this strategy is that there's no downtime when you're not making money. From the second you buy the property, you have a tenant to occupy it and start paying you.
Additionally, there aren't as many properties available to rent to own as there are to rent or buy. Many tenants who want to rent to own end up settling for something available. When you use tenant first strategy, the tenant has a much wider selection of homes to choose from. Therefore, they can find a property they really want. So, there's more of a chance they will become emotionally attached to the property and buy it at the end of the lease term.
The drawback of this strategy is that you do not control where you buy or what price you buy at. In property first strategy, you looked for the property that was going to get you the best value for your money. However, in tenant strategy, you look for the best property for the tenant, which may not be under market value. It's difficult to get a tenant on board with picking something under market value so they can buy it above. You're more likely to end up purchasing a property at market value and making a smaller profit on it.
Additionally, this rarely works. Most of the time you spend a lot of time with a tenant and they disappear through the woodwork. If you charge a down payment beforehand the clients are more likely to purchase. However, the legality of this has become more complex since the market crashed in 2008. Therefore, it's easy to run into legal trouble if you charge a down payment.
While this strategy sounds appealing, it's difficult to be successful with it.
Are Rent to Own Investments Worthwhile?
Rent to own property investment is not the typical route people take, and it is not necessarily the best route to take. While the income throughout the rent to own deal is guaranteed and the home will likely sell, the appreciation of the property is speculative at best.
Rental income from rent to own is nice, but it's the smallest portion of the rent to own investment pie. The biggest cash return is buying the property below market value and selling it at or above market value. However, two years down the line it may not appraise at such. Even if your client signs off on the price at the beginning of the lease, the bank did not. If the bank does not appraise the property for what you want to sell it for, your client cannot purchase it because they won't have the finances to do so.
Worse, the bank might appraise the property as cheaper than what you bought it for. While you may opt not to sell below the price you and the buyer agreed on, that buyer will not be able to purchase. Other buyers may be unable to purchase too. Bank appraisals are pretty consistent from bank to bank. So, if your current client isn't appraising for the mortgage, other clients will not appraise either. You may need to transition the property to a rental property to continue to make a profit from it. Rental income provides great cash flow, but it isn't the intent of rent to own investments.
That being said, rent to own investment can be a great way to make money. However, you should be prepared to alter your plan as needed.