Of the 700 or so articles on my website, the article accessed most frequently over the last year has been one I wrote in 2004 on lease-to-own home purchases. This is a combination lease and purchase where the renter/buyer occupies the home as a tenant but has an option to purchase it within a specified period at a specified price. I will call these "LTO" deals.
The intense interest in LTO deals today partly reflects the more restrictive and rigid mortgage qualification requirements that emerged after the financial crisis. This has created a large body of wannabe homebuyers who can’t qualify for the mortgage they need to make it happen. An LTO gives them a shot.
LTO buyers are hopeful that they can remedy their shortcomings as mortgage borrowers within the option period. This could mean repairing their credit, accumulating the cash required for a down payment, increasing their documentable income, or placing more distance between themselves and a prior bankruptcy or foreclosure.
On the other side of the table are homeowners looking to sell but, because of the decline in home prices, don’t have the equity in their homes that they had been counting on. The LTO gives them a chance to sell at a better price in the future than they can realize in the current depressed market, and in the meantime they collect rent.
This simultaneous increase in interest by both buyers and sellers should result in a thriving market, but as far as I can tell (nobody collects data on LTOs!) this has not happened. A major part of the reason is that LTO deals are extremely complicated, combining features of both lease and purchase contracts, plus features that are peculiar to LTOs.
The party who develops the contract, usually the seller, tends to structure the deal in ways that are favorable to himself, which creates a hazard to the other party. For example, I once saw an LTO contract in which the buyer lost the purchase option if the rent payment in any month was five minutes late. A well-justified fear of being taken advantage of puts a damper on transactions.
My initial plan for dealing with this problem was to work with a lawyer to develop a model LTO contract that was fair to both parties, but that turned out to be impractical. Because real estate law varies from state to state, I would have to develop 50 model contracts.
Instead, what I have done in collaboration with Jack Pritchard is to develop a checklist of all the major provisions that might be included in an LTO, explaining the implications of each for both buyer and seller. The checklist can be used as a negotiating platform for the two parties, who can turn the results over to a local lawyer for conversion into a contract. If one of the parties has already developed a contract, the other party can use the checklist to assess its fairness.
The list of LTO provisions is too long and boring to present here, but there is one provision that warrants special attention because it is unique to LTO deals and has great potential, but is the source of much confusion. This is the rent credit, an amount above the market rent paid by the buyer, which is credited back to the buyer at closing. Rent credits can be used in two different ways that are not always distinguished.
The simplest approach reduces the sale price at closing by the total rent credit paid by the buyer. This reduces the required down payment only slightly. For example, if the sale price is $100,000 and the rent credit totals $5,000, the sale price becomes $95,000 and the down payment required at 5 percent falls from $5,000 to $4,750.
The rent credit is much more useful to the buyer if it can be used for the down payment in its entirety. If the rent credit of $5,000 in the example above is used in this way, the price of the house would remain at $100,000 but the buyer would receive $5,000 from the seller at closing, which could be used as down payment.
For this to work, however, the lender must accept the rent credit as legitimate savings by the buyer. To be sure that the rent credit is an amount paid above a fair market rent, the lender will require that the market rent be documented by an appraisal. To be sure that the buyer actually made the payments, the lender will want to see the canceled checks that evidence the payments. The Web version of this article will explain how to set up an LTO to meet these requirements.
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.
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