By Dr. Teresa R. Martin, Esq., REIA NYC
One creative way to get started in real estate investing is to use a lease option, also called a rent-to-own agreement. Lease options can be used as a flexible, low risk, highly leveraged strategy in real estate investing that requires little to no money down. But order to truly capitalize on the benefits of a rent-to-own agreement, you need to know what to look out for before you start the process.
How Does a Lease Option Work?
If you can’t find a way to finance a real estate investment, due to poor credit, insufficient income, or because you don't have enough money for a down payment, you can do a lease option. The lease option allows you to get into the house for little to no money down as a renter, but it gives you the right to buy the property down the road at a specified price- typically, in two or three years time. This grace period will give you ample opportunity to secure the necessary financing. Another benefit is that you may be able to use a portion of the monthly lease payment towards the balance of the home.
One of the most important elements to a lease option for an investor is its flexibility. During the lease period, the owner is not allowed to raise the rent, rent the property to anyone else, or sell it to another buyer. And, it gets better. You also have the right to buy the property in the future for the specified price. If you decide to exercise your option to buy, the owner has to sell it to you at that price. This, however, does not obligate you to buy; you could just walk away from the deal. So, ultimately, it's you, the buyer, who will decide if the purchase will actually happen when the lease period comes to an end.
Some savvy real estate investors can get even more mileage out of a lease option. If the lease option contract includes the ability to sub-lease, the investor can actually rent out the property to another tenant for the duration of the lease.
The Pitfalls of Rent-to-Own Agreements
Sounds like a situation where you can't lose, right? Well, not so fast...
Though they may seem pretty straight forward, rent-to-own contracts are complicated transactions that involve many diverse variables and players. Investors who go in to such an agreement without doing their due diligence may get some unwanted surprises instead of the property they are hoping to buy. Here are a few things to consider:
The potential loss of money.
If you do not exercise your option to buy at the end of the lease, you will lose all of the extra money you paid. The money you give up-front or in addition to the standard rental fee is non-refundable.
You may not qualify for a loan before the lease ends.
Usually, the people who opt for rent-to-own contracts are dealing with credit issues or lack of sufficient income. If you can't realistically clean up your profile in time, you may have a hard time securing the necessary financing.
The owner of the property may foreclose.
If the owner isn't making mortgage payments, then he or she may lose the property through foreclosure. To avoid this you can setup an escrow which can collect your payment and make the seller's mortgage payment for you.
If property values decline, then you may end up paying more than the market value.
While you don't have a crystal ball and can't be certain what the future will hold, you should nevertheless do some research on the market before you agree on a price since you probably won't be able to renegotiate later on.
There may be hidden problems with the property.
Though there are laws in place requiring owners to disclose certain facts about the property, such as health hazards, make sure you send in qualified professionals to do a thorough property inspection before signing a lease agreement.
Bottom line, lease options offer a tremendous opportunity to real estate investors who, for whatever reason, may have difficulty securing financing. But, nothing is a given. In order to really take advantage of this opportunity, you need to go in to the process making an informed decision.