How Does Rent to Own Investment Work?

You buy a property at below market value. You have the option of rehabbing the property to increase its value. Then you rent it for a lease term, allowing the property to appreciate. At the end of the lease term – or whenever your tenant is ready – you sell it at a greater price than what you bought it for.

When you rent to own a property, you collect an option fee from the tenant at the beginning of the lease, which is anywhere from 3-5 percent of the price you and the buyer set as the purchase price for the home. That fee gives the tenant the option to buy the property. While the tenant has the option to buy, the seller must sell to that buyer if they opt to purchase and cannot sell to anyone else until the end of the lease term.

The option fee goes into an escrow account, if the tenant purchases the property, he or she can use whatever money is inside the escrow account toward the down payment of the home. If the buyer does not buy, the seller keeps all the money in the escrow account.

Additionally, rent credits can also go into that escrow account. Rent credits are not required of any rent to own deal and, thus, are not discussed in the profit section below. They serve as further motivation for your tenant to purchase the home at the end of the lease. There are three types of rent credits:

1. Rent Credit – In a pure rent credit, the seller credits the escrow account with a certain percentage of the rent payment.
2. Premium Payment – The tenant pays extra money on top of rent each month. The extra money goes into the escrow account.
3. Matching Payment – The buyer makes a premium payment each month and the seller matches the payment. The sum is put into the escrow account.

The buyer and seller determine whether to use rent credits during the negotiation process. Again, the seller keeps all money in the escrow account if the buyer does not purchase. Thus, if this system is used and the buyer does not purchase, the seller receives additional revenue from the deal.

The tenant is responsible for all small-scale repairs on the property. You and the buyer should set a maximum cost for repairs in the contract. For example, the buyer pays for repairs under $200, and the seller pays for repairs greater than $200. The money spent on repairs also further motivates the tenant to follow through with purchasing the home.

How Do You Profit from Rent to Own?

Rent to own is a win-win for an investor. If the buyer buys the home at the end of the lease, you should make 30 percent of the home’s after repair value, plus the rental revenue from the lease term. If the buyer does not purchase the home, you will get 3-5 percent of the home’s after repair value plus the rental revenue, but you can rent the home to a new tenant and make more. The difference is you receive a return on investment quicker in one scenario than the other. However, in the situation that takes longer, you receive more money from the investment throughout time.

Below are examples of the different paths rent to own can take and the net/gross revenue you can expect from them.

1. Revenue from an Executed Lease-Option:

You purchase the house for $50,000, make $20,000 worth of repairs and sell for $100,000. You will make $30,000 from the sale of the home.

You rent the property to the tenant for two years at $800 a month. You earn $19,200 from rent throughout the lease term.

Through this example, you net a total of $49,000. You would receive $24,500 per year of your time and effort.

2. Revenue from an Unexecuted Lease-Option:

You purchase the house for $50,000 and make $20,000 worth of repairs. You and the seller agree to a purchase price of $100,000.

You rent the property to the tenant for two years at $800 a month. You earn $19,200 from rent throughout the lease term.

You keep the seller’s option fee, which was 5 percent of the agreed upon purchase price for the home, which is $5,000.

Off of this deal, you have made $24,000 gross, but you spent $70,000 to purchase and fix the property. It sounds like you’ve lost money, but you have not exhausted the revenue you can make from this property because you still have ownership of it.

3. Second Lease-Option – Executed

You can do another rent to own on the property. If the buyer purchases this time, you will make an additional $49,000. The total net revenue would be $73,000.

You will have made $18,250 per year for your time and effort. You will have spent four years on the investment and can make no further profit from it.

4. Second Lease-Option – Unexecuted

If the buyer does not purchase, you will make an additional $24,000. Thus, gross revenue will be $48,000, which is less than what you spent purchasing and fixing up the property. It will take three unexecuted lease options before you break even (i.e. 6 years). Like the original unexecuted lease option, you can continue down the funnel and make a profit. While it takes longer for you to break even, you profit for a longer period of time and earn a greater amount from your investment in the long term.

5. Sell the Property After Unexecuted Lease Option

You could opt not to rent to own the property and sell it immediately instead. In which case, you would earn the $30,000 from the sale of the home plus the $24,000 from the rent to own investment. Your gross revenue will be $124,000 and you will net $54,000.

 6. Convert into Rental Property After Unexecuted Lease Option

A fourth option is to rent the property for the long term. If you convert the property into a rental property and do not offer lease-options, you will earn $9,600 per year every year. That is in addition to the $24,000 you earned from the original unexecuted lease-option. You will have paid off your investment within 6-7 years of purchasing the property. Everything you earn after that will be net revenue.

Rent to Own Strategies

There are two strategies to renting to own: property-first strategy and tenant-first strategy.

In property-first strategy, you find a property selling below market value and prep it for rent to own. Then, you find a tenant. In tenant-first strategy, you find a tenant looking to rent to own. Then, you help that tenant pick out a property, which you will then purchase and lease-option to him or her.

Property-first strategy is the more common strategy of the two. Its benefit is that you have control over which property you buy. Therefore, you look for the property you can get the best deal on. The drawback is it might take you a while to find a tenant for it and, thus, your investment might sit idle without earning profit until you do find a tenant.

Tenant-first strategy is beneficial because from the moment you purchase the property it is bringing in revenue. The downside is that you cannot purchase the best deal. Instead, you must purchase the property your tenant is most interested in.

In my experience, I’ve attempted tenant-first strategy about 15 times. Typically, the tenant disappears before the contract is signed and wastes your time. Some investors charge the tenant a down payment before the search for the property begins. That reduces the likelihood of the tenant walking away or, at least, compensates you for your time. However, ever since the market crashed in 2008, new laws have been introduced that make the down payment process much trickier.

Additionally, I’ve found there is never a shortage of potential rent to own tenants, but there is always a shortage in properties that are a good deal. There are many people interested in renting to own from a buyer’s perspective, but not many people are selling their home as rent to own or know what rent to own is. Tenant-first strategy is great when there is low demand, but there is no reason to use it when supply is below demand. Property-first strategy increases supply, which will be met by the demand.