Lease Options: The Downside

In 2008, Margi Lee, 50, of Boone, N.C., fell in love with a 150-year-old farmhouse. In order to give her time to make repairs required by mortgage lenders, she signed a one-year lease/option with the investors who owned the property. But a year later, with the upgrades completed, the lending environment had soured and rules had tightened. The mortgage lenders that had assured her they'd provide financing after the improvements backed down. Having sunk thousands of dollars into a house she doesn't own, she's still trying to wrangle financing, while trying to renegotiate with the property's owners.

Lee's experience illustrates the problem with lease/option agreements: both buyer and seller are gambling on an unknown future. And, if that gamble doesn't pay off, it's usually the renter who suffers. The property owner still has the property, after all. The renter may walk away with less cash than he had before.

This is the third installment in our series on rent-to-own real estate. If you missed them, read part one, which explains these deals in detail, and part two, which discusses the potential benefits for buyer and seller. 

In rent-to-buy real estate deals, the renter usually pays some upfront money to secure an option to buy the property at a set price before a deadline, usually one or two years. He may also pay more than the going rate in rent, with some or all of the surplus going accruing toward a down payment or closing costs. If he decides not to buy, he loses all that.

But he can also lose all that equity if, like Lee, he wants to buy but cannot get financing.

That's not the only pitfall. In that one- or two-year lease/option period, his personal financial situation may change for the worse. Even more likely in today's market is that the home's valuation may be very different from the agreed-upon purchase price. In the worst markets, a house may have lost 50 percent of its value in two years.

Says Kris Krohn, founder and president of Orem, Utah-based real estate investment firm REIC, "Unfortunately, lease options are dangerous for most potential homebuyers. Misguided investors collect large, non-refundable option considerations and stipulate a short time period for the leasees to purchase the home. Then, when the tenant is unable to obtain traditional financing, the investor boots them out of the home and does it all over again with someone else."

In fact, he says, many investors hope that their tenants won't be able to buy, allowing them to pocket the non-refundable down payment.

Coldwater Banker realtor Lisa Sevajian of Haverhill, Mass., points out that sellers take a risk, as well.

"They're removing their home from the market in the hopes that the rent-to-owner may be able to get qualified, may want to continue with the purchase and may be willing to pay the same price," she says. Moreover, although the person living in the house is supposed to be responsible for normal wear and tear, she's found that many want to negotiate needed repairs when it comes time to buy.

Krohn, who has developed a system he calls "compassionate financing," structures his rent-to-own deals to avoid the problem of fluctuating real estate prices.

"I've always thought setting the price in the future to be one of the silliest notions," he says. To mitigate this, he first of all buys only heavily discounted real estate, to ensure he can make a profit even if prices don't rise. Then, he sets minimum and maximum selling prices for the contract. When the renter is ready to buy, he has the house appraised.

In the final installment in this series, we'll offer more tips for sellers and buyers, as well as resources in this emerging sector.