From the desk:Lease Options (Rent-to-Own)

Rent credit as a percentage or a flat number? And who eats the water heater?

Townhouse, 3 bed, in a mid-price suburban pocket. Comps say around $268k today. I owe $141k on a fixed loan I will never beat. Rent is $1,725 and the tenant has been in three years, pays on the 1st, and asked in October if there was any way she could buy it.

I want the income without a second job, so a tenant who intends to stay and eventually take it off my hands is close to ideal. What I can't settle is the two numbers.

Credit structure. Either 25% of rent, which is $431 a month, or a flat $300. Over a 24 month term that's $10,344 versus $7,200. Option fee I'm asking is $6,500, applied at close.

Strike price. Either a fixed $285k, which is about 3.1% a year off today's comps, or appraised value at exercise minus 3%. She prefers fixed because she wants to know the number. I like appraisal because I don't want to hand over the appreciation if the pocket runs hot again.

Repairs during the term. She wants everything under $500 on her, which sounds generous until I remember the water heater is from 2011 and the HVAC is a 2014 builder unit. I floated $250 and she pushed back.

I have to give her a term sheet by the end of next week or she starts looking at listings. Term is 24 months, she says she needs 18 of them to clear two collections and season a down payment.

Which pair would you write, and am I pricing the repair threshold wrong?

Answer

2nicole_adeyemiPassivePRO5

Your two numbers aren't equally sensitive. If she exercises, the credits and the strike both come out of the same pocket, so $285k fixed with $10,344 of credit is a net $274,656 to you, and $285k with $7,200 of credit is $277,800. Three grand of difference. If she doesn't exercise, the credits evaporate and cost you nothing, so the whole argument about 25% versus flat is an argument about a scenario that may not happen.

The strike is the number that actually swings it. Fixed $285k in 24 months on $268k today is fine if your pocket does 3% a year, and it's a gift if it does 6%. Appraisal minus 3% protects you and terrifies her, which is exactly why she wants fixed. Somewhere in between is a fixed price with a floor and an escalator, and you can price the escalator at whatever you think rent growth plus a bit looks like.

On repairs, $500 per event with no annual cap is not a $500 exposure, it's $500 times however many events happen. Cap it. I'd rather own everything above $250 with a stated annual ceiling on her side than argue in month 14 about whether a compressor is one event or three.

3 replies

-1ehernandez74PO2BPRO5

Two things you didn't mention and I'd want both nailed before the term sheet goes out.

First, keep the option to purchase as its own document, separate from the lease. Everyone in this room says it and it's 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 your 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 your draft past a real estate attorney in your state before she signs anything.

Second, who is her lender. Not "she says 18 months", but a named loan officer who has looked at her credit report and written down what has to happen. Two collections and a down payment is a plan if someone qualified says so. Otherwise you're setting a 24 month term off her guess.

I'd also ask what happens at month 24 if she's at 620 and needs six more months. Decide the extension price now while you're both friendly.

1Rena 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.