What’s Better for Rent to Own Real Estate Investing?
Rent to own is when a tenant rents your property with the option to purchase it. They move in with the intention buy it from you in the future. You set their purchase price at the beginning, they pay a fee for the option to purchase it in the future, and a portion of their rent is a credit which builds up over time towards their purchase.
As I discussed in How to Make More Cash from Real Estate, Rent to Own real estate investing generates more cash flow because the tenants are paying a higher than market rent for their property and they are responsible for basic maintenance. You also don’t typically need property management because of the quality of tenants that move in and because they are responsible for taking care of repairs up to a certain dollar amount ($300 in our case but many other investors have their tenants handle up to $500).
We’re also helping fill a gap in the market and our tenants are grateful for it. Our rent to own tenants give us big warm hugs, invite us for dinner, make us handmade thank you cards and invest in fixing up the homes. One of our tenants painted the interior and exterior, built a garage and fenced the back yard of his home.
Typical rent to own tenants are folks who are new to Canada and haven’t established credit, they are going through a divorce and their assets are tied up, they’ve beat up their credit because of a health reason, they haven’t saved enough for a full downpayment to qualify for financing or just one set back has kicked their credit down to a point where the banks aren’t interested. They need a helping hand because the banks won’t help them and the other options available don’t make financial sense for them.
Most investors agree that rent to own real estate investing a great to create more cash flow but where the debate does arise around rent to own is what comes first: the tenant or the property?
No matter which approach you do, screening your tenants is critical. Beyond the usual tenant screening of reference checks, employment verification and credit score review, you must make sure the tenants have income levels that will allow them to qualify for financing in the future. You must review their debt load to make sure a bank is likely to work with them in the future. You also need to review their plan to correct whatever issue they have, to make sure they know what steps they have to take to qualify for financing in the future. Honesty from a prospective rent to own tenant is imperative.
Where rent to own can get a bad reputation is when it’s abused by investors who skip this step. Some are lazy, some don’t understand how it works but some actually do it intentionally. They put a tenant in a home knowing the tenant will never be able to buy from them. They take the deposit and the elevated rent and when the tenant eventually cannot buy they just rent it out again – keeping all the deposits as extra profit. That’s unethical and is not how rent to own should work.
What is property first and tenant first?
Tenant first is when you have pre-screened your tenant. They have passed your rigorous screening process, have the income and the deposit and are ready to go house shopping. You, typically, send them out with your realtor to look for a house that they want you to buy. Your realtor has your criteria of where and what you’ll buy. They find their dream home that meets your criteria and you buy it for them. The theory is that they will be more committed to the home because they picked it. Generally a lot of investors also charge a lot more to the tenant directly such as inspection because the home was picked by them.
Property first is when you find and buy a property and THEN find a tenant who wants to rent to own that specific property from you.
The challenge with property first is that sometimes you don’t find a tenant quickly. The reality is that the pool of people who are suited for rent to own is only a very small percentage of the rental pool. That means sometimes it can take a month or two to fill a rent to own property, and every once in awhile you may find yourself turning it into a regular rental just because it wasn’t attracting a tenant buyer (tenant buyer is what a rent to own tenant is often called).
We have had to turn a couple of rent to own properties into rentals in the last three years because they didn’t fill as fast as we’d hoped, so it happens, but we have decided not to do tenant first.
Why We Generally Do Not Like Tenant First Rent to Owns
We tried to do a few Tenant First deals but we found it hard to do good deals with the tenants and their emotions involved. They fall in love with a house and don’t care that it’s $15,000 over market price. They want that house. You can explain to them all day long that that house is a little over priced and how about this one instead, but they don’t care. You can only say “no” to somebody a few times before they get irritated and move on. But the reality is that if you buy a home that is overpriced at the start you’re setting your tenant up for failure!
In order for rent to own to work if you buy a home for over market you need to set a starting price that is above today’s value.
Right now we’re generally appreciating our properties from today’s value by about 3% and no more than 4% each year.
If we pay market value (And when the tenant and their emotions are involved we find you almost ALWAYS pay at least market value), do we then add closing costs and any improvements to that value? If we don’t, we won’t make a strong return. If we do, the price we set for our tenants to buy from us at may not be feasible and the bank will not loan to that value.
To maximize the likelihood our tenant will succeed AND we will make a great return we need to buy properties for LESS than their market value. We can’t do that when a tenant is involved.
Besides – I am a real estate investor. I love helping people but I make money when I create a great deal. Everything unwinds from there if the tenant is the one in charge.
I am not going to buy a house that doesn’t set my tenants up for success. I am also not going to buy a house that doesn’t have other exit strategies or options for alternative plans.
There are risks and rewards and pros and cons to both approaches but we love to invest in real estate because of the CONTROL we have. Relying on someone else (the tenant) to pick the property is like giving my money to an advisor and just trusting that they’re going to invest it as well as me. I’ve learned that nobody loves my money like I do. My tenant certainly doesn’t. When I pick the property based on location, characteristics, and only buy the types of homes that are much more in-demand by the masses (the starter family home for instance), I set myself and my tenant up for much higher chance of success.
Here’s a video Dave created on the same subject: