In this post I consider some examples of rent-to-buy houses (lease options) which were provided by the people who promote them. Even these positive examples offer very little benefit to an unsophisticated ‘buyer’ in exchange for significant financial risk.
It appears that the only ‘buyers’ who have a hope of eventually owning a lease-option house are those who can afford to pay rent and put aside enough for a house deposit over 2-3 years – that is those who could own their own home without a lease option.
I have previously described some “creative property” strategies, including lease options and outlined the risks.
What is a lease option?
A lease option is combination of a lease (property rental) and an ‘option to purchase’. The ‘option to purchase’ gives the tenant the right to buy the property for an agreed amount before the end of the term of the contract (usually 2-5 years). While some people in the industry have concerns about the use of lease options, they appear to be widely used.
The tenant pays a fee for the option to purchase. The option fee is made up of an upfront “deposit” and monthly payments. The total option fee may be between $20,000 – $70,000 or more. Rent is paid in addition to the option fee. The rent amount is unlikely to be below ‘market rent’ and is often higher.
If the purchase proceeds, the option fee (or sometimes just part of the option fee) is credited towards the purchase.
Problems and Risks
The property price may be too high, or the increase in value too small, to give the tenant adequate equity to qualify for finance. Within these short periods, property values can stagnate, or even decrease.
Some of the other risks for potential “buyers” are:
- Paying an amount that often equals double rent, and paying rates and maintenance, may not be sustainable for the ‘buyer’;
- The ‘buyer’ may not be approved for mortgage finance at the end of the period, which usually means the buyer will usually lose the entire option fee paid;
- If the seller has outstanding debts, the house could be sold by creditors, and the ‘buyer’ may lose all payments made (lease options are sometimes promoted to sellers with debt problems, so it’s not unusual for “sellers” to be in financial difficulty).
The complexity of these agreements makes it easy for a seller, or intermediary, to exploit someone who hopes to own their own home. Unfair elements of contracts may include:
- above market rent (in addition to the option fee);
- high option fee (both up-front payments and monthly payments);
- only part of a large option fee may be credited towards the price of the house;
- it may be foreseeable at the time of signing the agreement that the tenant will never be able to purchase the property.
Some of the claimed benefits of lease options are:
- rent is ‘dead money’ but using ‘rent to buy’ your rent is going towards your own home (but it is only the option payment, which is in addition to rent, that is credited to the property price)
- once you sign up to a lease option, you are buying your own home
- payments to a ‘rent to buy’ can be used to show good payment history to a bank (actually any rent payments or savings can do this)
- you can “lock in” the price (this is true, but the property may be worth less when you need to get finance)
- at the end of 5 years you will be better placed to purchase if you’ve been in a ‘rent to buy’ (the examples below suggest this is not the case).
Personally, I’ve only seen lease options that have gone bad – which is no surprise given my background is in consumer legal services.
So in this post I’m examining details of examples of lease options provided by the people who promote them.
Rick Otton tends to promote the benefits of lease options to people who want to make money from property without investing their own money. His students often become intermediaries in these deals and (according to Otton) take a lot of money out of each deal.
In Otton’s book “How to Buy a House for $1” he gives a few examples of lease options, including this one (page 185-186):
House had been on market for $370,000 for 6 months, but wasn’t selling, although Otton says “houses in their street are easily worth $450,000”.
The “buyers” had a “reasonable deposit” and were “both on very good incomes” but “this wasn’t good enough for the bank.”
- “Buyers” paid deposit (part of the option fee) $15,000 cash
- $855 per week rent (includes an amount for the option I assume)
- Option to purchase in two years time for $418,000
- Within 3 months the “buyers” bought the house outright
- Intermediary made $33,000
Happy ending for everyone? Does it make sense? The bank or other mortgage lender is apparently prepared to lend $403,000 for a house that has been hard to sell for $370,000 just three months before. If this couple has become eligible for a mortgage in just 3 months, they could have simply waited for 3 months – and had no need to pay a $48,000 premium for the house.
This lawyer who has appeared at Otton’s seminars, has a lot of information about these strategies on his website. He gives an example of how a lease option works.
- Up front deposit $10,000 cash
- Option fee $200 per week (total $50,000 approx over 5 years)
- Rent (including rates) $300 per week
- Term 5 years
- Purchase price $300,000
Cordato says “at the end of 5 years, [the “buyers” can] borrow $240,000 (which is 80% of the price) and pay the outstanding amount due to the seller.”
If this “buyer” can’t refinance for any reason after 5 years, up to the full $60,000 option fee could be lost. The “buyer” could avoid all that risk by avoiding a lease option, renting elsewhere and simply saving the $60,000 (and the money paid for rates and maintenance) and rented elsewhere, then bought a house in 5 years. The risk might be worth it if the sale price of the house was very cheap, or if the value increased significantly in 5 years. This “buyer” is basically taking a very big gamble on the future value of a house.
This website has some lease option examples provided in videos.
Immigrant family with limited credit history.
- Price $600,000
- Deposit $10,000
- Rent $500 (weekly)
- Option fee $300 (weekly)
- Term 5 years
- Rates & maintenance over 5 years $15,000 (my estimate)
- Personal savings $32,000 saved over the 5 years.
These “buyers” are risking up to a total of $78,000 if, for some reason, they can’t get finance at the end of 5 years. They have also paid about $15,000 in rates and maintenance which they wouldn’t pay if they were tenants.
Again, these “buyers” could have saved $135,000 for a deposit (including the savings on rates and maintenance) in those 5 years if they had been renting elsewhere.
It might be argued that these “buyers” benefited from living in the home they eventually hoped to buy – but risking that sort of money for that does not make sense.
While lease options are promoted as assisting people into the housing market who are excluded, all of the ‘buyers’ above would have been able to save for a deposit during the period without the lease option.
Locking in a price is no advantage unless the house is worth more than the price at the end of the term.
Problems arise for hopeful home “buyers” from a range of “creative strategies”. A broader question is, whether even with a change in the laws, any of these strategies can provide adequate protection and benefit for consumers while at the same time providing profit for the other party/s. I suspect the answer is “no”, and this would be particularly the case where intermediaries also expect to take a ‘cut’ of any profits.
I have focused on lease options because it is clearer that these don’t provide benefits for all parties. For a start, there is a question about the fairness of an arrangement where the ‘seller’ can retain tens of thousands of dollars if the ‘buyer’ doesn’t qualify for a mortgage, when this could often be foreseen – or where failure to qualify may be due to the house being overpriced.
I am not suggesting that any of the examples are true – in fact I suspect they are not – but they do represent the industry’s best examples of lease options. The examples suggest that at best a lease option is a gamble on house values – but it’s a big gamble – and the “buyer” has more to lose than the seller.