What is “rent to buy” and how does it work?
I have written about the downsides of “rent to buy” (for homes) – also called “rent to own” or “vendor terms”, so what is it?
There are many different ways that these agreements are put together. I will focus here on the three main set-ups based on cases I’ve seen:
- vendor terms
- lease with purchase option; and
- transaction engineer (using vendor terms)
Examples and names are fictional – dollar amounts are used to more clearly illustrate each ‘strategy’. They don’t relate to a particular case, but are generally indicative of the types of deals I’ve seen.
1. Vendor Terms (often referred to – inacurately – as “Rent to Own” or “Rent to Buy”)
Investor Andrew buys a home for $400,000. His mortgage is $350,000 and he pays bank interest of 6%. Andrew advertises “buy my house, no bank loan needed”. Barry can’t get a bank loan (or any other mortgage loan for that matter) and is attracted by the advertisement. Under the agreement, Barry pays $450,000 for the house. Barry pays $10,000 deposit and the remaining $440,000 at an interest rate which is 2% more than the current rate on Andrew’s mortgage (initially 8%) over a period of 25 years. Barry’s monthly payments are about $3,400, but will change if Andrew’s mortgage rate changes. The agreement also requires that Barry maintain the property and pay land rates. Andrew’s name (not Barry’s) will remain on title until Barry is able to get finance and pay Andrew in full, until the contract comes to an end (for example as a result of payment arrears) or until the end of 25 years.
2. Lease with Option to Purchase (“Rent to Own”, “Rent to Buy”)
See more about lease options here.
Starting with a similar scenario, Anne buys a home for $400,000. Her mortgage is $350,000 and she pays bank interest of 6%. Anne advertises “buy my house, no bank loan needed”. Bree can’t get a bank loan (or any other mortgage loan) and is attracted by the advertisement. However, the agreement offered is different to a vendor terms agreement. Bree signs an agreement to rent the property from Anne and to pay monthly rent of $1600. Bree also signs an “option to purchase” agreement.. this gives Bree the right to purchase the property from Anne in 2 years time for the price of $450,000. For this option, Bree pays a total of 31,400 – $5,000 ‘deposit’ up front, $1000 per month for the first year and $1200 per month during the second year. Bree also pays $300 per month to cover rates and maintenance. If Bree is able to get mainstream mortgage finance within two years and purchase the property outright, $20,000 of the option fee will be credited to the purchase price. If Bree is not approved for credit, or the sale doesn’t go ahead for any other reason, Bree loses everything she has paid. If this occurs, Anne is free to advertise the home again and arrange a similar deal with another ‘purchaser’.
3. The Transaction Engineer
In this third example, the ‘investor’ doesn’t actually invest in the property herself, but makes a profit from finding a buyer and seller and arranging an agreement between them. This non-investing intermediary is sometimes referred to in the ‘industry’ as a “transaction engineer”.
Carol attends a seminar about making money from property without investing any money. Carol advertises that she “buys houses quickly”, or she uses other means to find sellers who are in financial difficulty. Carol approaches the potential seller Anthony. Anthony is struggling to pay his mortgage and is worried that the bank will soon foreclose. He has tried to sell his house but was only offered $400,000 for it. This would just pay out the mortgage, but Anthony believes it is worth more. Carol says she can solve this problem, and that she can sell the house for $430,000. She tells Anthony that the only thing is that he may have to wait a while before the sale is finalised – Carol may say “this could be one or two years” – but says that she can arrange to have mortgage arrears paid, and mortgage payments and rates paid until the sale is finalised.
Carol enters into an agreement with Anthony which is headed “Joint Venture”. The agreement says that in exchange for Carol providing her expertise to sell the house, Anthony agrees to accept the price of $430,000 for the property (regardless of what the home is sold for) and to accept monthly payments at bank interest (currently 6%) on that price, and to allow Carol to retain anything received above this amount. Carol will be responsible for the rates and necessary maintenance costs. Anthony moves out of the house and rents elsewhere.
Carol advertises the house “buy my house, no bank”. Belinda hasn’t been able to get finance to buy a house, and Carol arranges for Belinda to sign a contract whereby Belinda purchases the home on vendor terms for $460,000. Belinda pays a deposit of $10,000, and is to pay the balance over 25 years at 2% more than bank interest (8%). Belinda also pays a fee of $500 per month, which includes payment for land rates and maintenance (there are provisions for this amount to increase annually).
The link above shows how the funds received might be allocated if Belinda obtains a loan in two years time and pays out her contract in full (although this outcome here is a very optimistic one for seller and buyer). It would give Carol about $58,000 profit, would sell Anthony’s house in two years for more than the $400,000 he’d been offered earlier and would allow Belinda to buy her own home. Of course there are many risks for buyer and seller, and clear reasons why this deal might go wrong.
While an astute seller may negotiate to receive some of the profits from such a deal, my experience suggests that a desperate seller may receive none of the profit.
There are endless variations and combinations of the above three arrangements. These include the ‘transaction engineer’ being in the middle of a lease option, entering into a lease and option to buy with Anthony and entering into a similar agreement with Belinda, but on better terms (sometimes referred to as a “sandwich lease”).
Other parties are often involved in the first two scenarios, either providing advertising, finding buyers for a seller, or even arranging the contract and collecting payment.