What Nobody Talks About: Three Reasons Rent to Own Investing Can Stinkby
I’m not against them. We still do rent to owns. We’ve done a lot of them in the last four years. We have a training program to help our coaching clients learn how to do rent to owns. However, I am against the fact that I hear nothing but great things about rent to own deals in the education sphere and the reality is that there are some things you should understand before you dive in.
There are some really lousy things about rent to own deals, even when you do everything right.
Rent to own is when a tenant rents your property with the option to purchase it. You set their purchase price at the beginning; they pay a fee (which can become part of their down payment) for the option to purchase it in the future; and a portion of their rent is a credit that builds up over time towards their purchase. There are two approaches to rent to own – tenant first and property first (learn more about property first and tenant first here).
Both approaches generate more cash flow because the tenants are paying a higher than market rent for their property in exchange for credits that build up towards their purchase, and they are responsible for basic maintenance. Also, you typically don’t 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.
When I quit my job, we evaluated all of the options for cash today. Wholesaling requires constant marketing and funnel management. If you’re not constantly finding sellers and buyers, you aren’t making money. Flipping is stressful and higher risk. It also requires you to be consistently working on a flip or you won’t be filling your cash needs. We felt being a realtor would reduce the focus from our own deals and since we were planning to do a deal every month or so, we knew we’d need a lot of focus for that. And property management is not something we really enjoy, so we didn’t want to create a business around it.
That left us with rent to own as the best solution for us.
By changing a few of our existing rentals to rent to own, and adding just a handful of rent to own properties to our portfolio, we were able to boost our cash – with the option fees and the increased cash flow – to a point where we were comfortable financially from our real estate holdings. We also liked the fact that rent to own helps good people get into home ownership. 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.
We like rent to own because if we want to take a month off from working on our deals, we still make money. We can’t say that about any of the other strategies I noted above.
However, rent to own is not a perfect strategy, and I’m not a huge advocate anymore. When we started doing them, I was excited. I loved that we were helping people and making a great income doing it. Four years later, I like it as an exit strategy. It’s a great tool for your tool box but I don’t think it’s a great business model. If you only do rent to owns right now, you will want to read this carefully. Maybe it’s working today but it has some serious challenges. Let me explain why.
Three Reasons Why Rent to Own Investing Isn’t Always Great for Your Business
First, you can’t always do rent to owns.
The market conditions have to be right. If you are in a very hot market, you will end up selling your property for quite a bit less than you could have made, had you sold it on the market normally. On the other hand, in a market that is flat or heading downwards, pricing a rent to own in a way that is fair to a tenant and that will still make you money is extremely difficult.
And, even if the market in your area is doing okay; if the overall economic sentiment is poor, people will have a hard time believing the house will be worth the same as it is today, let alone slightly more when you sell it to them in 1, 2 or 3 years.
If rent to own is your only strategy in your business, what are you going to do when the market is not good for doing rent to own? And what are you going to do if your cash flow suddenly drops dramatically because of a market shift that makes new rent to owns difficult and existing ones fail?
Second, it really sucks when someone walks away from $15,000 or more!
If you’re a sensitive person who cares about other people, you’ll never find comfort in the fact that you still make a good profit when a rent to own fails. There’s nothing to celebrate when a family leaves hard earned money behind, even when you’ve done everything in your power to make it work.
Our first failed rent to own weighed so heavily on us. It was a couple that I would have bet my own house they were going to buy their rent to own home from us. They were pretty much the ideal rent to own tenant, or so I thought. Less than a year into it, they walked away from $18,000 in deposit and credits. We tried everything to work with them but their minds were made up. It made absolutely no sense to us why they walked away. We still don’t understand. And it weighed on us. Eventually we came to terms with the fact that we’d done everything we could do to make it work and the tenants understood the contract and still chose to walk. But, coming to terms with something is very different than actually feeling good about it.
The market has softened where we invest and we’ve had more people walk (from their rent to own…and all their credits) in the last twelve months than we’ve had close on their deals. It gets a little easier to swallow, but it never feels good. It also makes it harder and harder to want to do more. I’m less excited about the prospect of helping people with a rent to own because I am starting to see that no matter what we do, we’re only going to help half the people we work with.
Plus, while we explain the potential of a failed sale to our investment partners and we always have a plan B of being able to rent it out as a regular rental if we need to, it still feels like we’ve failed our partners when the deal doesn’t go through. They expected to have their investment capital returned to them in 2 years and that doesn’t happen if the tenants walk. Most of our partners understand and realize their return remains strong despite the failed rent to own, but some of our partners are really disappointed when the property doesn’t turn over. Disappointing someone feels terrible too.
Third, there’s minimal wealth creation in rent to own.
Rent to own adds cash flow to your business, it’s a great way to sell a home without a sales commission and it can generate a solid return for a money partner but you aren’t getting wealthy. I love buy and hold real estate because you make money with mortgage pay down, cash flow and appreciation. You also enjoy great tax benefits. With rent to own you make money mostly from cash flow. The appreciation in the property largely goes straight to the tenant as you credit their rent and recover their deposit when you sell. The mortgage pay down is always minimal at the start of a mortgage so you never really get much benefit from that. And, the tax benefits are reduced by the fact that rent to own is considered an active business and not taxed the same as regular rentals (which is usually taxed as a Capital Gain/Loss when you sell).
I’ve grown tired of the churn required to run a rent to own business. We did a deal every month because we had to keep the deals coming in to continue to fund our business and make up for the cashflow we lost when one would sell. It’s tiring. I love collecting houses. I am a fan of building wealth and knowing my financial future is secure because I have a monopoly board full of little green houses. With rent to own, we’ve bought some really great houses that we no longer own. It was so much work to find those great deals, fix them up, find and educate the tenants, only to sell the property before we really realized all the financial benefits. I am thrilled I helped some really great people buy a wonderful home in a great area but now I can only drive by and say “I used to own that house.”
I am grateful for the cash flow that rent to own’s give us. It also allowed us to transition from my salary to our real estate business in a much shorter time frame and with fewer properties than a buy and hold strategy ever would have. I’m not against rent to own – I am sure we’ll use it again when we’re ready to exit from a property – but I am not going to pretend it’s the greatest business model ever because I don’t think it is. I think it’s an important tool for your real estate investing tool box. I think it can be a great way to sell a property, help a family and give your business a little more cash flow. I just don’t think it should be the only thing you do as an investor.
1st Image Credit: Julie Broad
2nd Image Credit: © Alain Lacroix | Dreamstime.com
3rd Image Credit: © Nilikha | Dreamstime.com