Rent to own is quite rare in NYC due to co-ops and banks having strict financial requirements around debt-to-income ratios and post closing liquidity. However, if a rent to own transaction were to happen, the tenant should have a high level of income with a clear path to saving enough for a future down payment, closing costs and post-closing liquidity.
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Rent to own is an arrangement where a tenant rents a property with either the option or the obligation to buy the property at the end of the lease term.
As you can imagine, a rent to own transaction is more complex then simply buying or renting a home. That’s because there will be multiple contracts involved instead of just one. You’ll need a lease or rental agreement, a purchase contract and/or an option to buy contract.
No two rent to own deals are the same, and the term of the rental period can vary from one to three years on average.
Depending on how the deal is negotiated, the seller may also charge an option premium or fee that can range up to several percent of the pre-determined purchase price.
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There are two types of rent to own transactions, one where the tenant has the option to buy the property at the end of the lease term, and another where the tenant has the obligation to buy the property at the end of the lease term. The former is known as a lease option and the latter is called a lease purchase.
Lease Option Contract
A lease option contract gives the tenant the choice of whether to buy the property or not at the end of the lease term, typically at the current market value of the home at the time of lease signing.
The amount of the monthly rent charged will vary, but will typically be a premium over the market rate. The owner may also try to charge an option premium for the right to purchase at the end of the lease term.
Depending on negotiations and what banks will allow, the rent premium (i.e. the amount of the rent above the market rental rate for the apartment) and the lease option fee can go towards closing costs or the down payment if the tenant decides to buy.
If the tenant waives the right to buy, then the lease option contract expires and the owner keeps all the rental income plus the option premium.
Lease Purchase Contract
A lease purchase contract obligates the tenant to purchase the property at the end of the lease term, and will be quite similar in length and complexity as a regular purchase and sale contract in New York.
Depending on how the deal is negotiated, some, none or even all of the rent payments may be credited towards the buyer’s down payment.
Keep in mind that at the end of the lease agreement, the tenant is obligated to buy the apartment at a pre-determined price. This price may be the market value of the apartment at the beginning of the lease term, in which case the seller may demand a premium for that option value. Or the price could be formulated based on some other metric, such as an appraisal done at the end of the lease term.
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When rent to own makes sense for buyers
Rent to buy can make sense for buyers who don’t have enough money saved up yet for a downpayment or who aren’t financially qualified for a mortgage yet, but who have already identified a home they wish to “lock in” and buy in the future once they have the money and become qualified for a loan.
Rent to own can also obviously make a lot of sense if they are negotiating with a desperate seller who will allow the tenant to credit some or even all of the rent payments towards their future downpayment.
Rent to own may also make sense if they’re able to get a conforming loan with very low down payment requirements.
In this case, it may not be a stretch to be able to quickly save up enough to buy in the near future.
When rent to own makes sense for sellers
Rent to own can make sense for sellers of condos, houses or even co-ops with lenient coop financial requirements if they simply can’t find anyone else to sell to, and aren’t in a rush to sell.
Why? Because of the ability to earn higher than market rate rent plus potentially an option premium, and the ability to keep all of it if the tenant doesn’t exercise the option to buy or defaults on the purchase contract.
Essentially, the seller will get paid above market for renting their apartment even if the tenant doesn’t come through on the purchase at the end of the lease term.
Why lease to buy generally doesn’t work
While rent to own is a great concept, it usually doesn’t work in practice simply due to the complexity and the fact that the tenant simply isn’t financially qualified enough.
Think about it, if the tenant doesn’t have the down payment saved up now, wouldn’t it conceivably be harder for the tenant to save up enough for a down payment and closing costs if they start paying above market rent and an option premium (assuming these aren’t credited towards a future down payment)?
Furthermore, many co-ops will have stricter financial requirements than even that of banks. Co-ops will want to see not only 40x income for the sublease, but they’ll then typically require a minimum of 25% and sometimes 30% in debt-to-income ratio, plus sometimes a couple of years of post-closing liquidity.
Unfortunately, these requirements are typically too much for someone who is already financially precarious to handle. Especially for co-ops, the chances of co-op board rejection are simply too high.
Closing costs for purchases are significant
Tenants don’t often realize that there are significant closing costs in NYC when you buy or sell. Unlike a rental, a purchase can incur 1.5% to 6% of the sale price in taxes and fees, depending on the property type.
Make sure to utilize our interactive Buyer Closing Cost Calculator for NYC to estimate what your closing costs might be. Keep in mind that these closing costs are in addition to the down payment you’ll need to save up.
Attorney fees will be higher due to the complexity
Attorney fees for a rent to own transaction will necessarily be higher due to the multiple contracts involved and the sheer complexity of the negotiating process.
While you might see a flat fee of $2,000 to $3,000 for your ordinary purchase transaction, your lawyer may charge multiples of that for a rent to own transaction.
We estimate a minimum of $5,000 in attorney fees due to the necessity of negotiating and drafting a minimum of two, and possibly three or more contracts.
Your rent may be higher than market
Depending on how negotiations go, the seller may expect to be paid a premium in rent in return for your right to purchase the property in the future. However, if the deal is structured as a lease option and you don’t go through with the deal, then obviously you will have paid more rent than necessary for nothing.
The same applies if you end up paying an option premium upfront. If you don’t end up buying the apartment, this option fee will typically be forfeited.
Stick to a normal rental
If it isn’t abundantly clear after reading this article, we highly recommend sticking to a normal rental and simply saving up until you have enough money to purchase a home properly. You’ll pay less in fees for a significantly less complex transaction, and you won’t risk losing a significant amount of money in additional fees and higher rent.
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Seems like it could be spun as a profitable option for a seller in any market – on the lease option lock in the price at the time of the paperwork signing, or on the lease obligation as well.
I don’t see an upside for a buyer though, but for the seller, as long as the buyer/lessor can afford a rent high enough to meet the 10% FHA down payment (if using part of the rent payment to meet the down payment), that’s 1-2 years of rent as well as potential interest in an escrow account for the part of rent meant for the down payment, and if a purchase doesn’t happen, keep a good portion of that cash and still have a house to sell.
It’s only the 25% down for co-ops that make it “hard”. But otherwise, it’s a bit of a win-win for sellers.
One thing I need to correct, since I just thought about it. The NYS rental reform made taking holding escrows for co-ops technically rental deposits subject to the law.
I want to rent a two bedroom home but I am on a fixed income. I can’t afford a down payment as I am elderly and disabled. I wonder if this is an option for people like me.