Happening NowLease Options (Rent-to-Own)

Structuring the rent credit and strike price on a lease option with a long term tenant

Take a townhouse, 3 bed, in a mid price suburban pocket, comps around $268k, with $141k owed on a fixed loan the owner will never beat. Rent is $1,725 and a tenant of three years, reliable on the 1st, has asked about buying it. A tenant who intends to stay and eventually purchase is close to ideal for an owner who wants the income without a second job, but the structure has to be settled carefully. Credit structure: either 25% of rent, $431 a month, or a flat $300. Over a 24 month term that is $10,344 versus $7,200. An option fee of $6,500 applied at close is reasonable either way. Strike price: either a fixed $285k, about 3.1% a year off today's comps, or appraised value at exercise minus 3%. Tenants generally prefer fixed because they want a known number, while an owner often prefers appraisal to avoid handing over appreciation if the pocket runs hot again. Repairs during the term are the other lever. A tenant asking for everything under $500 to be their responsibility sounds generous until the water heater is from 2011 and the HVAC is a 2014 builder unit; $250 is a more defensible threshold for an owner to propose. With an 18 to 24 month term and a tenant needing time to clear collections and season a down payment, the credit and strike pair worth writing leans toward the flat credit with a fixed strike, since it gives both sides a known number, paired with the lower repair threshold to protect against the aging systems.

priya_n21 PB2BPRO 21

Answer

nicole_adeyemi SS3APRO 13

The two numbers here are not equally sensitive. If the tenant exercises, the credits and the strike both come out of the same pocket, so a fixed price of 285k with 10,344 of accrued credit nets 274,656, and 285k with 7,200 of credit nets 277,800. Three thousand of difference. If she never exercises, the credits evaporate and cost nothing, so the whole 25 percent versus flat debate is an argument about a scenario that may not happen. The strike is the number that actually moves the outcome. A fixed price set two years out at roughly current value is fine if appreciation in that market runs around 3 percent a year, and it is a gift to the tenant if it runs closer to 6. Appraisal minus a discount protects the owner and understandably worries the buyer, which is exactly why buyers push for fixed. A middle path is a fixed price with a floor and a modest built in escalator, priced against expected rent growth plus a bit. On repairs, a flat dollar amount per event with no annual cap is not a fixed exposure, it is that amount times however many events occur. Cap it. Owning everything above a small threshold with a stated annual ceiling on the tenant's side avoids a month fourteen argument about whether a failed compressor counts as one event or three.

nicole_adeyemi SS3APRO 13

3 replies

ehernandez74 PC3BPRO 12

Two things worth nailing down before the term sheet goes out. First, keep the option to purchase as its own document, separate from the lease. It gets said often and is still the thing people get wrong. A lease that contains a purchase right, a large rent credit, and a two year term can be looked at as something closer to an installment sale in some states, and if it gets recharacterized the remedy on a default stops being an eviction and turns into something much slower. How that doctrine applies is state law and fact specific, so run any draft past a real estate attorney in the relevant state before a tenant signs. Second, find out who the tenant's lender is. Not a vague timeline, but a named loan officer who has looked at the credit report and written down what has to happen. Two collections and a down payment is a plan if someone qualified says so. Otherwise a 24 month term is being set off a guess. Worth deciding now what happens at month 24 if the tenant is at 620 and needs six more months. Set the extension price while everyone is still on good terms.

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ehernandez74 PC3BPRO 12

Rena Expert

The choice between 25% and a flat credit only matters in the world where she closes. That is the assumption the whole term sheet rests on, and you have no evidence for it yet beyond her own timeline. If she closes, parcel's arithmetic holds and the spread between your two credit structures is about $3,100. If she doesn't, the credits are never paid, and your return for the two years is the rent plus a forfeited option fee. Price the deal so both branches are acceptable, then stop optimizing the credit.

On the strike, appraisal minus a discount transfers price risk to you in a flat market and to her in a rising one. A fixed number with a stated annual step is easier for a tenant-buyer to understand and easier for her future lender to work with, because the contract price is a fixed figure on the date she signs.

Repairs on a 2011 water heater and a 2014 builder HVAC over 24 months: assume you replace at least one of them. A $500 per event threshold on her side with no annual cap gives you very little, since most single events on that equipment land above it anyway. A per event threshold plus an annual ceiling is more predictable for both of you.

Three items to confirm rather than assume. Whether a memorandum of option can be recorded and what that requires differs by state. The tax treatment of a forfeited option fee and forfeited credits is a question for your CPA. Your insurance carrier should be told the tenant holds a purchase option, because some policies treat that differently, and get their answer in writing.

Rena Expert

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