Why this article is important: Tenants, driven by FOMO and lack of cost comparison for renting versus owning the same or similar property, consider risky rent-to-buy arrangements to attain homeownership for their family shelter. This article explains the contrasts between rent-to-buy arrangements and protective homeownership transactions structured by seasoned brokers.
Rent-to-buy structure
A tenant dreams of one day becoming a homeowner but lacks the financial fundamentals requisite to ownership: credit score, down payment and household income sufficient to qualify for an FRM mortgage or even a risky non-conforming mortgage.
The tenant sees an advertisement: Rent-to-buy your dream home: low credit okay! Low down payment options!
Upon further investigation, the tenant learns that, in addition to the monthly lease payments, the landlord requires the tenant pay:
- a one-time upfront option fee equal to 3% of the agreed purchase price; and
- a rent premium equal to an additional $400 per month on top of the lease, which the landlord will apply toward the purchase price as a sort of accumulating “down payment” towards the purchase.
Should the tenant default or fail to act to acquire title to the property, the agreement calls for the tenant to forfeit both the option fee and rent premium.
The purchase price set in the agreement is higher than the home’s present fair market value (FMV). The landlord claims the pricing accounts for appreciation expected to occur between the signing of the agreement and the eventual transfer of title — ownership — on closing.
Motivated to obtain homeownership by whatever means possible, the tenant agrees to the landlord’s terms. The tenant enters into a standard lease agreement with an attachment containing option to buy provisions as an addendum, an arrangement commonly known as a lease-option agreement. Entirely separate from the lease agreement, this type of option-to-buy agreement grants the tenant an option to purchase the property with no contractual obligation on the tenant to purchase the property as agreed.
The option to buy contains all terms needed to form an enforceable purchase agreement for the acquisition of the real estate when the buyer exercises the option. [See RPI Form 161]
The tenant holding an option to buy has the discretionary right to buy or not to buy on the sales terms stated in the option. To exercise the option, the tenant does so within an agreed-to time period. No variations are allowed for enforcement of an exercise — which is acceptance — of the irrevocable option to buy offer.
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Standard Option to Purchase — Irrevocable Right-to-Buy — RPI Form 161
Editor’s note — The option to buy is often confused with the right of first refusal, as they share similar characteristics. A right of first refusal refers to an opportunity held by a person, typically a commercial tenant, to purchase the property in the event the owner, such as the landlord, decides to sell it prior to the right expiring. Unlike the option to buy, the right of first refusal rarely contains any terms of a sale (and does not need sale terms for enforcement). [See RPI Form 579]
These crossover types of contractual arrangements for financing the acquisition of real estate become more common in a declining real estate market. Classic mortgage financing tightens and properties for sale linger longer on the market unsold. A property market with excess properties available for sale creates the perfect mix for rent-to-buy schemes to financing ownership to re-emerge, as well as non-conforming mortgages. A harbinger of troubled real estate market pricing soon to take hold.
Pitfalls of rent-to-buy
Continuing our previous example, the tenant who enters into an option to buy while renting the property pays a monthly rent amount greater than the rent commanded by similar properties. The tenant’s monthly payment is the base rent plus the additional $400 premium to apply to the purchase price. Further, the upfront, non-refundable “option fee” paid to “bind” the right to buy the property, called option money, is also forfeited when they fail, for any reason, to exercise the option and acquire ownership.
The option money amount is often equal to or even greater than what a lender requires for a minimum down payment to quality for a fully conforming mortgage based on the household’s ability to pay. For example, an FHA-insured mortgage requires a minimum 3.5% down payment.
Worse, the so-called option money is clearly down payment money received. It has no other economic purpose than to be part of the cost of buying the property. But why is the upfront money handed to the seller labeled option money? A lease agreement entered into is all the consideration needed for the attached option to buy.
However, consider income tax reporting. Here, the seller avoids reporting the income and paying taxes on it until the tenant becomes the vested owner, if an audit catches it. Tax avoidance is one aspect of rent-to-buy contracts, but one the seller must confront, not the buyer whose accountant simply adds the option money to the cost of acquisition for proper tax reporting.
Further, the tenant has agreed to purchase the home at a higher price than FMV. This presents problems when exercising the option to buy and the home appraises below the agreed-to-price, which is portended for future evaluation situations when going into any recessionary period. Thus, it becomes impossible for the tenant to qualify for a mortgage without paying additional down payment money to make up the difference between the lower property value and the higher purchase price agreed to at the peak of the past boom.
The tenant/buyer also learns they need to secure and pay upfront mortgage origination costs, including an appraisal fee, transactional fees and mortgage origination fees — or else bundle these costs into their mortgage payment.
When the sale does go through, the landlord/seller avoids the transactional costs associated with a typical sale, including brokerage costs to market the property for sale.
In the meantime, the buyer knowing (hoping) they are to become the owners, makes improvements to components of the home to improve its utility, and of course its value.
Here, the tenant is wiser to save their 3% option fee and additional $400 monthly premium paid to the seller and simply continue to rent. Thus, the tenant retains in their savings account the down payment, adding $400 monthly to the savings while they build up their credit to qualify for a mortgage — and pay market rent rates for the family shelter, a further savings.
Economics of ownership versus renting
Tenants who enter rent-to-buy contracts are, without exception, driven by FOMO for homeownership. They willfully abandon all, not just one or two, procedural steps which are designed to protect the buyer of real estate of any type. Far from the rent-to-buy mentality is any financial reasoning behind the decision. [See RPI Form 320-4]
The best option for a tenant is to simply wait until they can purchase a home with all the steps and considerations a buyer broker provides a buyer in a transaction.
Time is usually on the tenant’s side under economic conditions of a coming recession. They retain and save all the monies paid in excess of simply continuing to rent the same or similar property at market prices for rent, not the premiums paid in a rent-to-buy scheme.
Here, the tenant builds up a 20% down payment needed as a minimum to save huge amounts of money on the conventional purchase of a home. Until then, the tenant digs in to improve their credit score, paying down debt while the landlord reports their on-time rental payments to credit agencies, as required by statute.
Related article:
Mandated landlord credit-reporting offer to improve tenant credit scores
Another arrangement is to pursue a carryback sale by submitting a purchase agreement offer with properly structured carryback financing. Here, the seller also extends credit (carries back) documented as a note and trust deed. Ownership is conveyed in exchange for the buyer’s down payment and future monthly payments of accrued interest and amortized principal, usually with a due date not less than 10 years in the future.
Sellers often choose to extend carryback arrangements in exchange for achieving their asking price. In these cases, the seller often looks past a lower credit score or even a low down payment. Beneficially, the buyer avoids the monthly penalty of just under 1.0 percent premium for default insurance — MIP/PMI — a huge charge mandated by a lender funding a mortgage to cash out the seller on a low down payment.
Experienced buyer brokers can locate sellers in a position to consider a carryback arrangement during a real estate recession when their property lingers on the market. Sellers most likely to consider carryback financing own their home encumbered by no mortgage or a low ratio of mortgage to value.
Another risky scheme with similar math as the buy-to-rent setup is a land sales contract, also known as an installment sale, an antiquated statutory mortgage structure. [Calif. Civil Code §2924i]
A land sales contract refers to a buyer as a vendee and the seller as a vendor. They enter into a written agreement for the sale of property for an agreed price payable in monthly installments with a due date for full payoff. Here, the buyer takes possession of the property and makes payments called for in the agreement. In most instances, the risks in these transactions are the lack of a formal escrow, title insurance and all the seller disclosures mandated for property conditions and the nature of seller financing. [See RPI Form 300 and 300-1]
Vested title does not pass to the buyer by grant deed until the buyer pays the seller in full, on satisfaction of the buyer’s obligation under the land sales contract.
However, as part of the process under a land sales contract, the buyer still fails to exercise their full benefits of ownership, such as:
- interest deductions, though their accountant can calculate the amount;
- the ability to further encumber (such as through a HELOC) or otherwise use the equity in their property; and
- property tax homeowner and veteran exemptions and end up with an escaped assessment lien recorded by the tax collector for failure to submit a Change of Ownership Statement when the buyer took possession under these equitable ownership agreements.
A carryback sale documented as a note and trust deed — not a lease/option or land sales contract — provides all the protections provided in a conventional mortgage situation for a buyer. A buyer broker is involved when the buyer wants the protection of an advisor on a purchase, and the extra cost of PMI is avoided. A mortgage is a mortgage, but a lease option or land sales contract are not trust deed mortgages, they are two-party mortgages which must be judicially foreclosed to wipe out the buyer’s equitable ownership interest in the property — untidy conditions for all involved.
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Purchase price dispute
When a buyer-tenant and seller-landlord operating under a rent-to-buy agreement disagree on the purchase price due to conflicting appraisals, who prevails?
Consider the normal use of a lease-option arrangement. A commercial tenant enters into a long-term lease with an option to purchase the property at FMV as indicated by an appraisal. The commercial tenant exercises their right to purchase the property during the period permitted in the option to buy.
The landlord and tenant each order appraisals, which produce very different FMVs for the property. The tenant seeks to purchase the property at the lower FMV indicated by their chosen appraiser, while the landlord insists the tenant purchase the property at the higher-priced appraisal amount.
The landlord and tenant each seek to enforce the contract at their chosen FMV. The court hires a court-appointed appraiser who reports to the court with their evaluation of the FMV. The court determines the FMV and instructs the tenant to pay the purchase price as set by the court determined FMV.
However, the tenant claims that since several years have elapsed since they exercised their option to purchase, the rent paid to the landlord after they exercised the option to purchase needs to offset the purchase price.
In other words, the tenant is considered a buyer with a purchase agreement and occupancy on the date they exercised the option to purchase (thus, no longer a tenant required to pay rent but an owner entitled to occupancy which they had).
Here, the tenant may offset the purchase price by the rent paid in the intervening years due to the delay in the seller’s performance.
Further, the landlord is entitled to payment from the tenant for the value of the landlord’s lost use of sales proceeds the landlord was entitled to receive on exercise of the option and received on conclusion of the litigation.
Thus, the tenant pays the FMV price determined by the court, minus the offset for rents paid after the option was first exercised (since the tenant was entitled to occupancy as an owner), plus the money due the landlord to cover the loss of use for the money due the landlord at the time the option was first exercised. [Petrolink, Inc. v. Lantel Enterprises (2021) 81 CA5th 156]
Here, the contract was structured poorly, allowing for a loose definition of FMV. Instead, the price might be set:
- as a fixed dollar amount possibly adjusted for the rate of annual consumer inflation, or
- by an appraisal arrangement in an evaluation provision which sets the price as the average valuation of three evaluations, by appraisers or BPOs: one by the landlord, one by the tenant and one by an appraiser or BPO selected by the two the seller and buyer selected.
Foreclosure risk
Consider a tenant making lease payments under a rent-to-buy agreement. The landlord defaults on the mortgage encumbering their fee interest in the property. The property is sold to the highest bidder at a trustee’s sale, the tenant unable to qualify with cash to bid. Remember, these contractual situations arise mostly during recessionary periods in the real estate market — excessive inventory for sale or for lease.
Does the tenant have any remedy to enforce the rent-to-buy agreement?
The Protecting Tenants at Foreclosure Act (PTFA) provides some remedy in terms of shelter. However, it does nothing to return the tenant’s investment or acquire fee simple ownership of the property.
When the property is foreclosed upon, the tenant has the right to enforce the terms of their lease agreement (not the rent-to-buy provisions) entered into with the prior owner. Further, a tenant at the time of the foreclosure sale is entitled to live out the remainder of the lease term when:
- the tenant holds a bona fide lease agreement;
- the lease agreement was entered into before title was transferred to the owner-by-foreclosure; and
- the owner-by-foreclosure is not going to occupy the property as their primary residence. [Public Law 111-22 §701, §702, §703]
A lease agreement is bona fide when “the rental or lease agreement calls for rent that is substantially the fair market rent for the property.” [12 United States Code 5220]
On the other hand, the owner-by-foreclosure (whether the mortgage holder or a different person) may choose to occupy the property as their primary residence, or they may sell the property to buyers who will occupy the property. When a buyer will occupy the property, the tenant is then served with a 90-day notice to quit due to foreclosure. [CC §2924.8(a)(1); see RPI form 573]
The tenant defaults on the lease-option
Consider a tenant who enters into a rent-to-buy agreement. On entering into the agreement and accepting occupancy, the tenant makes a substantial initial payment to the landlord akin to a nonrefundable “down payment.”
Later, the tenant is unable to continue making lease payments.
On breach of lease payments, the landlord uses the unlawful detainer laws to notice, file a UD action and evict the tenant under standard eviction laws. The landlord did not treat the lease option agreement as a security device by first foreclosing to eliminate the buyer’s equitable ownership and on prevailing seek to evict the buyer.
Editor’s note — Occasionally, a rent-to-buy agreement is structured as a lease-purchase (rather than the more common lease-option). In these rare cases as with a land sales contract, since the tenant holds equitable ownership to the property, judicial and trustee’s foreclosure rules apply to tenants who default on payments.
For example, a tenant who breaches their lease may be served with a Three-Day Notice to Perform, stating what the tenant needs to do to rectify or cure the breach to remain in possession. [See RPI Form 576-1 §4]
When the tenant is unable or unwilling to cure the breach, the landlord, on expiration of the Notice to Perform, prepares and serves the tenant with a Three-Day Notice to Quit. [CC §1946.2(c); See RPI Form 577-1]
Further, when a tenant becomes unable to pay rent, the landlord uses a Three-Day Notice to Pay Rent (with or without related fees). These notices include sections which identify the tenant as being under a lease which requires just cause to terminate the tenancy and indicates their failure to pay rent constitutes just cause for eviction. [See RPI Form 575-3 and Form 575-4]
Once the three days have passed and the tenant has still not paid the appropriate amount(s) – a curable breach – the landlord may serve the tenant with a Three-Day Notice to Quit without the further opportunity to cure the violation. [See RPI Form 577-1]
These rules cover tenants of properties subject to just cause eviction laws, which cover most types of properties. Read more about exempt rentals.
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Under provisions in a traditional rent-to-buy agreement, the tenant has no right to reinstate on a default, unless the contract includes terms for a reinstatement or a trustee’s power-of-sale provision (which automatically permits the rights of reinstatement and redemption). [Petersen v. Hartell (1985) 40 C3d 102]
Rent-to-buy fraud
At its best, rent-to-buy is a risky and expensive path for a tenant to become a homeowner. At its worse, it’s an all-out scam.
In an extreme variation of the rent-to-buy scheme, fraudsters instruct homeowners struggling with mortgage payments to surrender title to their homes as part of a deal that allows them to rent the property and buy it back later.
The fraudsters claim that surrendering title will let a borrower/investor with a better credit rating get new financing and prevent foreclosure.
But the terms of these deals are often so unfavorable that a buyback does not become impossible — they are already incapable of making payments. The previous owner loses the home. Worse, when the new borrower with title defaults on the mortgage, the original owner is evicted — the exact result they were trying to avoid.
In another variation, the fraudster takes title to the property and immediately raises the rent intending to force a beach of the lease and evicts the former homeowner, leaving the “rescuer” free to sell the house.
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