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Rent to own: A good solution for a troubled housing market?

With a glut of homes on the market and credit as tight as a drum, a rent-to-own option would seem a perfect solution for many buyers and sellers.

Cash-strapped buyers would get a chance to save for a bigger down payment or make themselves more creditworthy. Financially strapped sellers would be able to get out from under a house, with someone else paying the mortgage and eventually taking it off their hands.

But these arrangements often work better in theory than in practice, attorneys and real-estate agents say.

"It can be a nightmare on both sides" if one party doesn't fulfill its end of the bargain, says Doug Malan, managing partner with Las Vegas law firm Deaner, Malan, Larsen & Ciulla.

How they work
Traditionally, lease-purchase agreements have been executed by an owner interested in giving a long-term tenant a shot at homeownership or those interested in expanding their pool of buyers in a tough market.

You can often find this option on a home's multiple listing service (MLS) description, with the line, "Seller will consider a lease-purchase." It also can be found in a home's advertising or marketing materials.

Typically, a potential buyer will agree to a set lease term, with an agreed-upon date at which he has an option to purchase the home, either for a specific amount or by some agreed-upon method of determining value.

The renter will pay some kind of consideration upfront for the right to buy at the end of the lease, such as a nonrefundable deposit of several thousand dollars.

However, these days, says Joe Manausa, broker-owner of Century 21 First Realty in Tallahassee, Fla., underwater owners are taking far less upfront for this option, giving renters less to lose if they decide not to buy the property.

"Now, with a flood of inventory, they are just lucky to get (any consideration)," he says. "Most sellers, by the time they consider a lease purchase, are well into the desperation period."

The risks
Of course, these agreements are not without huge risks for both sides. Buyers can pay, only to find that the owner has stopped making his mortgage payments during the lease term. And owners can wind up with a deadbeat tenant who has no interest in completing a purchase.

That's what happened with real-estate agent Viji Sashikant's client six months into a lease on the client's house in Columbia, S.C. After trying and failing to get a loan to buy the property last fall, a bidder on the property asked Sashikant's client to lease it to her for six months, while she polished her credit.

He agreed. But the tenant's credit score got worse after she moved in and she skipped out, changing the locks and demanding her $5,000 back. Only now, three months later, are Sashikant and her client regaining access to the property to try to lease it again or put it back on the market.

"I will never do a lease-to-own again," says Sashikant, of ERA Wilder Realty. "If (a seller) can't get the right price, I will just advise them to rent it out for a year or two. That is the cleanest way to go."

Indeed, another lease-purchase agreement she worked on for a different client also looks to be on shaky footing, she says, with the renter making demands for repairs but not agreeing in writing that they were done to her satisfaction.

"Most of (these agreements) don't even make it to the closing table because they are not crafted correctly," Manausa says.

Who should consider this?
Risky as these deals are, Manausa says we will probably see a lot more of them being inked over the next year, because they are a good transitional step to healing the housing market's woes.

"We are grossly oversupplied," Manausa says. "Sellers are going to have to discount their homes." And in his market, Tallahassee — where there is more than a year's worth of inventory on the market — some owners will have to consider a lease purchase to stave off foreclosure.  "It's better than some other solutions," he says.

Part of its allure is that it allows owners to shake the responsibility of being a landlord sooner than they might be able to otherwise.

For buyers with good credit but not enough cash for a down payment, this is a great option, he says, as long as the contract is executed properly. And in the past, it has worked well for small-business owners setting up shop in a new market, who have cash but can't show enough proof of income there yet to gain financing, Malan says.

However, for owners, it can be risky if they enter into an agreement with the wrong kind of tenant.

"You really need to weigh the risks of leasing to someone that you wouldn't sell to today," says Janet Portman, real-estate attorney and co-author of "Every Landlord's Legal Guide."

In particular, Portman doesn't recommend leasing to people who need time to repair their credit in order to purchase your home. There's no guarantee that they can do it, she says. Indeed, depending on their financial situation, it could get worse, costing you time and money.

In her experience, Portman says, it seems to work out best if the two parties involved in these transactions have a long track record or something more at stake: for instance, if a long-time tenant, family member or friend has fallen in love with your house but needs time to save for a down payment.

However, owners and potential buyers should always have an attorney look over their lease-purchase agreement before they sign to make sure that they are adequately protected should the other party — family or no — neglect to fulfill its end of the bargain.

And Malan says that owners and buyers should be wary of committing to a long lease term if they have already specified a purchase price in the agreement. A lot can happen to the real-estate market — for better and worse — in the space of two or three years.

As with so many other things, the devil is really in the details of a lease-purchase agreement. A solidly worded contract will save both parties a lot of grief down the road, Malan says.

A solid contract
Here are some precautions that our experts suggest buyers and sellers take when putting together a lease-purchase agreement:

  1. Know everything you can about your potential buyer. In addition to pulling a credit report, owners should know if a potential buyer intends to move in or sublease the home. Manausa recommends having the potential buyer fill out a loan application so an owner can be familiar with the buyer's full financial history.
  2. Get a home inspection. Before move-in, potential buyers should get a home inspection from a licensed professional. Tenant and owner also should do a walk-through together to sign off on the condition of the house and any small repairs needed.
  3. Treat the lease like any other lease. That means owners should shoot for a security deposit, plus first and last month's rent. That way, if your tenant/potential buyer skips out — or worse, skips out after trashing the place — you aren't left in a financial hole. Make sure this contract is separate from the purchase option.
  4. Give the tenant some incentive to buy. If lease payments and the purchase-option consideration are low, so will be a buyer's resolve to purchase when the lease term expires. Make sure the buyer has some "skin in the game" in the form of slightly higher rent or a significant option payment upfront, Manausa says.
  5. Protect yourself. Fully outline the "conditions precedent," or things that must happen in order for the purchase option to go through; for example, the tenant must be current on lease payments.
  6. Be clear on price — or at least on how the parties will determine it. If you don't set a purchase price upfront, you should outline a mechanism for determining it at the end of the lease, such as having the buyer and seller nominate real-estate agents to come up with a "fair market value" for the house, with the two agents nominating a third to settle a bargaining impasse.
  7. Disclose everything you need to about the house. A lease-purchase agreement does not excuse an owner from standard seller disclosures about such things as lead paint, mold and flood-plain location. "If you have a duty to disclose and didn't do it, it could undo the whole deal or expose the seller to damages," Portman says.
  8. Know where the money is going. Malan suggests setting up an independent collection account with a loan-servicing company to assure the potential buyer that the mortgage, insurance and taxes are being paid on time during the lease term. "Your buyer has to be assured that at the end of the day he or she will be able to buy the home," he says.