Rent-to-Own or Lease-to-Own is a 2 part strategy for the tenant and the landlord. Typically these tenants are highly motivated to settle down, or they simply prefer home ownership to renting. Something is preventing them from qualifying for a conventional mortgage. The new mortgage rules are blocking a lot of people, but sometimes life circumstances have created a temporary barrier. An example is a parent who is newly divorced or still working through the legal aspects of divorce. This person may desire a stable second home for their kids, and they may even have good credit and a good job. Tier 1 lenders will often deny any mortgage application until a divorce is finalized. Another circumstance that prevents home ownership is a new job or new business of less than 2 years. Again, these folks may have good credit, good employment, and mayeven have a substantial down payment. And a third category of Rent-to-Own candidates is people with weak credit scores, sometimes due to a simple phone bill that was never paid—yet remains on their credit report.
Landlords take on any of these potential Rent-to-Own candidates to
- Give them time to save up for a larger Down Payment
- And/or give them time to clean up any credit issues
- And/or give them time to build job or business history and tax returns
- And/or give them time to work through a divorce agreement
In part 1 of this strategy, the candidate begins as a tenant and has a lease— they are subject to the Alberta Tenancy Act rules and regulations. The tenant pays “market” rent and has regular inspections—just like any other tenant. In part 2, the tenant is planning to BUY the home from you, at a pre-determined time, and at a pre-determined price. This is separate paperwork: the Option to Purchase. This paperwork involves an initial deposit—usually about 5% of the ultimate purchase price—AND monthly “Option” payments. Every month, this tenant pays a little extra to “save up” more down payment; often the option payments are $200-$500 per month IN ADDITION to their market rent. So if market rent is $1500, the tenant-buyer may be paying $1700-$2000 per month. All of these monthly payments are documented: in a few years, the tenant buyer can go back to the bank, or the mortgage broker, with a solid work history, payment history, improved credit AND larger down payment. At this time, it is usually much easier for them to qualify for their mortgage and achieve their goal of home ownership.
Why do Real Estate Investors like this strategy?
- Your exit plan is built right into the agreement from the beginning. (Of course, all smart investors have multiple exit strategies!)
- The tenants are much more committed. Typically, these tenants mow the lawn, shovel the snow, and are responsible for minor repairs. Because they plan to own the home, these tenants typically take better care of all aspects of the property. They already have some “skin in the game.” This means fewer maintenance bills for the landlord/owners and lower property maintenance costs.
- Monthly cashflow is better than a straight rental (and who doesn’t love better cashflow?!)
- Some Investors simply love the opportunity to help deserving candidates succeed at home ownership
What are the risks of using a Rent-to-Own Strategy?
- This is a short or medium term investment, 2-5 years. Rather than receiving the benefits of a long-term buy-and-hold, your inventory (houses) is turning over on a regular basis—and needs to be replenished.
- The profits or income from this strategy may be taxed as active business income rather than capital gains—please check with your tax specialist to see how this implication may apply to your portfolio.
- There is a risk that the property may appreciate more than the pre-determined amount. In this case, the tenant benefits from the extra equity—which helps them qualify for their mortgage. The Investor would lose this equity—compared to a simple Buy-and-Hold.
- There is also a risk that the property may appreciate less than the pre-determined amount. In this case, some re-negotiation with the tenant may be required.
- Yes, life happens and some tenants can’t qualify in the pre-determined time. Now the owners/investors have some choices to make and can extend the Option to Purchase (more time renting, means more mortgage paydown for the investor, and another year(s) of property appreciation—simply increasing profits).
- Worst-case scenario: the tenant defaults before they even get to home ownership. We always do everything in our power to help set a tenant-buyer up for success, but we can’t control everything. If this happens, eviction can be more complex. As co-investors, Mountains Edge Developments would take care of this process with as much respect and time-efficiency as possible.
