As we hit the colder months real estate investors are starting to get anxious about the properties they have on the market. With this anxiety comes alternative strategies to liquidate inventory. One of the most popular is ‘rent to own’. Rent to own is a great exit strategy if done correctly. Here are three reasons this is a great strategy and three things you need to do to remain bullet proof to lawsuits.
Why use rent to own:
- Easy to manage rentals
- Your buyer is already in place
- Higher profit on your deals
Make yourself bulletproof:
- Use a separate lease and option agreement
- Classify money received correctly
- Use an entity
Before we get started and need to say that I am not an attorney nor am I giving legal advice. This article is intended for educational purposes only and should not be viewed as advice of any kind. We strongly recommend you consult your legal counsel before embarking on any strategy discussed in this newsletter.
Why use rent to own:
- Easy to manage rentals
Rent to own tenants will generally take better care of the property because they have a sense of ownership and will take more pride in your property. When you structure your rent to own you will want to be clear to your tenant that they are buying the property and that in exchange for that right, you require that they take care of the maintenance. If you do get a call for a maintenance issue you can simply remind them of your agreement.
- Your buyer is already in place
This can be tricky but you want to do everything you can to be sure that your tenant buyer actually follows through and buys your property. The most important issue here is that you qualify them with a competent mortgage profession to be sure they will qualify. It is also a good idea if you can structure the terms to where your lease payments are higher than what their mortgage payment will be. This will create a powerful incentive for them to buy.
- Higher profit on your deals
Because you are offering terms to a buyer you can often demand a higher price for your property. Not to mention that you may be forced to sell at a steep discount if you had to sell it today. You will also be collecting rent until they buy the property adding to your bottom line.
Make yourself bulletproof:
- Use separate Lease and Option agreements
You have probably heard this before but you may not understand the reasoning behind it. If you have both the Lease and the Option in one agreement it looks very similar to an actual purchase transaction and could be viewed as such by a judge in a court room. You want to be as clear as possible that it is a Lease agreement with an Option to buy. Having a separate lease accomplishes this. You should not mention the Option in the Lease anywhere. You can, however, mention the Lease in your Option Agreement. My Option Agreement becomes void if there is a default under the lease terms and expires at the end of the lease. I also reference benefits in the Option for on time rent payments.
You want to be sure that your transaction is not viewed as a purchase transaction because there are laws that protect homeowners and it could create problems for you if there was a default or disagreement.
- Classify money received correctly
I am specifically referring to two items here; option consideration and rent credits.
- Option consideration – this is the upfront money you receive for giving the tenant the right to by your home. It is much like a non-refundable premium paid by them. It could easily be viewed as a down payment which once again makes the transaction appear like a purchase transaction.
- Rent credit – same goes for this. Many landlords offer a portion of each month’s rent as credit toward the purchase of the home. I recommend establishing a credit to help pay for closing costs or loan fees for your buyer and not credited towards the purchase price. If the credit is reducing the purchase price it appears as loan payments instead of rent payments. If there is a disagreement the tenant could be awarded all rent credit and force you to refund it. Another option could be to credit a portion of the rent by increasing the non-refundable option money. The key here is to not credit the actual purchase price.
- Use an entity
When all else fails using an entity should protect any assets that are not part of the entity. For example, let’s say you run your real estate business in the name of an LLC and the LLC looses a lawsuit and has a judgment placed against it. If this were true all the assets inside the company would be at risk but your personal bank accounts, your personal home and other personal assets are completely safe. If and when your company gets sued, you will more than likely also be listed on the lawsuit. It will be your job to prove that it is a legitimate business and that your personal name
should be removed. If your company is not set up and run correctly the judge has the option to leave you personally as a defendant, defeating the purpose of the company. Please pay special attention to what I just said. It is crucial that your company is set up and run correctly. Part of this is having an Operating Agreement even if you’re a single member company and even if your CPA tells you don’t need one.