What Exactly is a Lease to Own Agreement?
A lease to own agreement is the same as a rent to own agreement. They are just two different names for the same thing. Both agreements are hybrid contracts under which a buyer or tenant agrees to purchase a property at some point in the future, but with the right to live on and rent the property for either a specified period of time or until the buyer is able to buy the property.
Usually, an initial security deposit is collected up front, along with the monthly rental payments. The cost of the security deposit and the rental payments are typically considered part of the agreed purchase price of the property. However, the way the money is applied towards the purchase price will usually differ from a standard purchase agreement. For instance, maybe the seller applies a certain percentage of payments to interest on the purchase price. With the rest of the payments, perhaps the seller applies 80 percent towards the actual price of the property (the principal) and 20 percent towards interest.
Take this example: You need a home and you’re unable to qualify for a mortgage right now. You find a home listed for $200,000. The seller only wants to rent to you but after two years of making timely monthly rental payments, you’ll have the option to buy the home at a price of $225,000 .
You agree to pay $1,500 per month for the first two years. At that point, you may buy the home for cash or with owner-financing with monthly installment payments or a balloons loan. Assuming you get 100 percent financing, your monthly mortgage payment would be approximately $1,645. That’s not that far from what you’re already paying.
Under the terms of the lease to own agreement, you’re essentially renting the home with the option to buy it later. The home is still titled in the name of the seller (the landlord), but with the right of you (the tenant) to buy it at a later point in time. That means you assume the risk that the property may lose value over the term. However, you also have the benefit of being able to enjoy the home without having to make a down payment, since you aren’t actually buying the property until later.
This example shows how a rent to own agreement will probably mirror a standard purchase contract. The seller is still responsible for maintaining the property and covering all maintenance and repair expenses. The seller also continues to pay taxes and insurance on the property until closing. The only difference is that the buyer, the tenant, gets to live in the property, even if the tenant does not end up purchasing the property.
The Perks of Lease to Own for Tenants
Tenant Advantages of a Lease to Own Agreement
An advantage for tenants is the opportunity for home ownership and some equity in a property that was previously unaffordable. The tenant is currently paying a certain amount of rent. That amount can be paid towards the future purchase of the property instead of the tenant continuing to pay rent to a landlord. Money a landlord would take as a net with no returns to the tenant. Ownership is a way for the tenant to have an option to pay for the purchase price as foreseen in the Option and Purchase Price set out in the document.
Life happens. Life events may have put the tenant in a situation where they do not have the funds to put a down payment on a house. Or the tenant has a job that requires them to relocate at the end of each rental period making it prohibitive to purchase. A lease to own agreement will afford a tenant an opportunity to apply money from their rent towards a future purchase as long as they exercise their option to buy.
This arrangement provides flexibility to the parties if the tenant must move from the residence before the expiration of the tenancy. The parties can easily amend the agreement to move the pay-off date forward or the parties can agree to another term. The tenant can move on and continue life somewhere else or the tenant can choose to stay and renew the lease. Flexibility is the mantra of the lease to own agreement.
Why it’s Good for Property Owners
Lease to own agreements are also beneficial to the owner. Under this type of agreement, the seller usually remains responsible for property taxes, insurance, HOA dues, and maintenance. While most lease to own agreements require the responsibilities of maintenance to be the same as a rental property, a buyer may be able to negotiate that they will be responsible for any repairs over $500 or that the seller will be responsible for the first $3,000 in repairs. This is not uncommon and often provides the buyer more understanding of how the finances will work under the lease to own agreement and makes them more amenable to making the payments.
The owner will also get a small amount upfront as earnest money, and depending on how the agreement is structured, may receive a portion of the monthly payments as rent. If an interest rate is used, they will also see a monthly interest payment until the sale closes. An interest rate will often be used to ensure that the buyer is making the payments in a timely manner and is financially responsible. Since most lease to own agreements are between three and five years, the owner should walk away with a hefty profit after the end of the term. This is especially true if the seller did not offer owner financing, as the monthly payments will usually be larger with the interest rate and can provide the seller with double the payments as compared to some mortgage terms.
Legal Mandates in Texas
In Texas, lease to own or rent to own agreements are governed by both state law and the terms of the individual agreement. The Texas Business and Commerce Code Subchapter D of Chapter 93, commonly referred to as the Texas Rent-to-Own Act, provides guidelines and requirements for agreements that meet the definition set out in the statute.
To be covered under Texas law the agreement must meet the basic elements, which are the total of all payments be weekly, less frequent than weekly or monthly, and that the agreement be between a customer and a home service contract provider or a rent-to-own provider. The home service contract is described in Chapter 1304 of the Texas Occupations Code and is generally an agreement for specified repairs on or for a specified period of time, not including service or maintenance agreements or warranties that cover repairs or maintenance after expiration.
A rent-to-own provider is one who is primarily engaged in the business of selling or arranging for the sale of goods, leases goods used for nonbusiness purposes, partially pays for the goods and then resells them to the customer under the agreement.
For any agreement subject to the Texas Rent-to-Own Act, the Texas Business and Commerce Code Sections 93.302-303 establish requirements for disclosures from the provider to the customer, including a written statement with separate itemization of all agreements currently made or entered into such as: 1) description of the goods being rented; 2) list of all terms, conditions and charges; 3) total number of payments, including the due dates; 4) total amount of rental payments, including how any payments paid in advance can be refunded generally; 5) a description of the purchase option, how it is calculated, and the amount already paid to date; 6) a statement explaining the customer’s rights to redeem the goods, what those rights are, how they can be exercised, and how to locate the goods if not currently in the customer’s possession; 7) additional items depending on whether the goods are home goods, motor vehicles or manufactured housing, and other items as set out in the statute.
The agreement must also include a place for the signature of the customer, an additional space for a third party to sign, if applicable, and a statement of whether a security interest in the goods is created under the agreement and detailing how the interest is created. Section 93.305 of the Texas Business and Commerce Code sets out requirements for security interests.
If there is an existing security interest in the goods that will be subject to the lease to own agreement, the provider must state the senior state interest and how much is owed on it as of the date of the agreement. Section 93.307 of the Texas Business and Commerce Code sets out requirements for senior state interests in the goods.
Section 93.309 of the Texas Business and Commerce Code states the agreement may not sell an annuity or life insurance policy with a fair market value of more than $25, does not include postdated checks, does not extend credit for any purpose other than goods that are rented, contains a description of the goods being rented, and does not contain a confession of judgment of any type.
The provider may not require the customer to purchase any insurance from them or show satisfactory proof of insurance for any additional cost, unless required by the lessor for loss or damage to the goods, fire, theft, vandalism, personal liability or death. The Texas Business and Commerce Code 93.311 sets out requirements for insurance.
The customer has a right to prepay the balance owed under the agreement at any time from the time the agreement is signed; however, the provider must set out in the disclosure statement how the prepayment is to be calculated. The provider may only charge a reasonable prepayment penalty, if any. Section 93.312 of the Texas Business and Commerce Code sets out requirements for prepayment of the agreement.
The customer has a right to a refund of any charges paid for a good that is returned to the provider or excluded from the agreement. Section 93.313 of the Texas Business and Commerce Code sets out requirements for refunds.
Under Section 93.319 of the Texas Business and Commerce Code, a provider may repossess goods using self-help enforcement methods after giving notice to the customer based on the statements made in the disclosure statement. If no such statement is made, the provider must give the customer notice of intent to repossess goods sixty days before doing so as stated in the statute.
Essential Clauses to Incorporate
As with any contract, there are certain terms that must be included, as well as terms that make it easier to enforce the agreement in the future. When negotiating a lease to own agreement, it is imperative that you include the following terms in it:
Option Fee: Similar to an option fee in real estate, an option fee is essentially a deposit on the purchase of the property. This is considered "consideration," or money offered in exchange for something else. In some cases, this is returnable to the tenant at the end of the lease, like a security deposit, and can be used towards the purchase price of the home.
Purchase Price: The tenant and landlord will negotiate a purchase price, just as in a regular sale. This will usually be at market value when the lease begins, but you can also set an eventual sale price at the beginning of the lease.
Rent Credits: Rent credits are a portion of the rent for the month that are applied to the eventual purchase of the home. The rent will be paid like normal, but a stated percentage of it will be set aside to go towards the purchase. For example, $200 of the $1,500 monthly rent payment will go towards the ultimate purchase of the house, thus allowing the buyer to "buy" the house over time.
Repairs and Maintenance: Most of the time, the agreement will state that the landlord is responsible for all repairs and maintenance, as the tenant is not the owner of the property at this point. However, some landlords may be willing to negotiate if a tenant requires repairs to be done over time.
Addressing Risks and How to Handle Them
As with every contract, there are inherent risks involved with purchasing a home through a lease to own agreement. From the purchaser/home buyer’s perspective, they risk losing not only any up-front money (such as earnest money, option money, down payment) but also the monthly rent credits if they are unable to make the payments or keep the property in good repair. Because these agreements are not yet officially governed by Texas law and the general principle of common law controls regarding contracts, the timing of a move out and what constitutes good care of the property is unclear. Without a clear time for move out or standard of good care of the property, disputes can easily arise between the seller and purchaser.
For sellers/home owners, although the lease to own agreement is still private property the seller must comply with all laws and standards for renting a property in Texas. This includes, but is not limited to, complying with local law regarding mold and cleaning up any mold problems and complying with applicable health and safety codes. Additionally, the seller should also not misrepresent or hide any problems that exist with the property from the prospective purchaser. However , unlike an actual sale of the property where there are certain required disclosures, there are very few required disclosures for rental properties that the seller must give the purchaser.
For both parties, if the home buyer does not have a sufficient amount of liquid assets available to cover the greater of 20% of the purchase price (plus transaction costs, including intermediary fees) or 5% of the price of the property, they should at least get preapproved for a mortgage loan so they know that they will be able to pay for the house at the end of the option period.
In order to minimize risk for all parties, commercial real estate lawyers advise the following provisions to be written into any lease to own or "seller finance" agreement:
Additionally, to avoid litigation over whether a party has complied with their weekly, monthly, annual, etc., obligation to make repairs to the house, the contract should specifically state that any party that wishes to enforce the contract must go to mediation and/or arbitration in accordance with the American Arbitration Association Commercial Rules, or similar rules, to resolve the problem. This will help alleviate any desire to file suit against the other party, which is often times a costly proposition.
Creating a Lease to Own Agreement
The purpose of drafting a lease to own agreement is to have a clear understanding between the tenant and landlord of the maintenance and repair responsibilities of each party. The agreement can help prevent misunderstandings that can lead to serious problems down the road. For the accepted price, lease term, security deposit, tax responsibilities, etc., the agreement should reference the standard Texas Residential Lease Agreement so that all the usual provisions for residential leases can be clearer. The lease to own agreement will have the additional terms unique to lease to own arrangements.
At a minimum, the lease to own agreement should include the following provisions: The agreement should also address what happens should a breach occur. If the breach of the lease is by the landlord, the rules for landlord remedies will apply as set forth in the Texas Property Code. No special extra rules are contemplated in lease to own agreements for a landlord to follow. If the breach of the agreement is by the tenant, the landlord can proceed with eviction and remedies against the tenant under the Texas Property Code. There is not much latitude for creativity for custom provisions to benefit a landlord. The goal of the lease to own agreement is to assure the tenant of the right to exercise the purchase option if the terms and conditions are followed by the tenant. A more creative lease to own agreement would be for the Landlord to have the first right to purchase the property from the tenant if the tenant is evicted or surrenders possession of the property.
Common Mistakes to Stay Away From
The first common error in a lease to own is to not have a written agreement. In some states (but not all) having a lease, and even a lease that converts to a lease/purchase agreement upon the occurrence of the conditions set forth in the contract, is void or unenforceable if the agreement is not in writing. Texas is not one of those states, but if you have a verbal lease, you may be forced into a very unfavorable position if you later decide to exercise an option to purchase.
Another common error is to fail to set forth the terms of the eventual sale when giving a tenant the option to buy. A second related issue is failing to state the price. This failure to state price issue seems like a minor issue, but it is not. For example, if the price is left blank, it might be said to be an unqualified option, i.e., the price is subject to negotiation and the eventual sale is best characterized as a lease. In such a situation, a claimant seeking specific performance to buy the house would bear the burden of establishing the price. The process of determining the price later would be very undesirable for many reasons including because a court may order a realtor to put the house on the market and then order that the sale be subject to high transaction costs which would be payable by the landlord.
A frequent error is to fail to provide in the lease agreement for implied warranties. There are implied warranties of habitability and of good and workmanlike construction. If the lease gives the tenant a right to buy at a later time, such a right has been held in Texas not to terminate the implied warranties of habitability and good and workmanlike construction. As a practical matter, this means that if a tenant fails to pay under the lease while purchasing, that tenant can go to court and say "the roof leaked and there were holes in the walls and floors and so the house is uninhabitable" and that the rent is not due. A current trend in appellate courts is allowing the tenant to say the house was not habitable on day one of the lease, rather than on the day of moving into the house. The landlord will have the initial burden of proving that the house was initially habitable. If the landlord fails to meet the burden, the tenant will have the burden of proving the amount of repair costs and the amount of damages.
Success Stories and Case Studies
The state of Texas has witnessed a variety of successful lease to own deals over the years. From retired war veterans to newlyweds, the strategy has been employed by people from almost every background. One couple entered into their lease to own agreement without giving it too much thought. They found a home that they were familiar with in their neighborhood that was owned by an investor. After a little back and forth, they finally managed to strike a deal. After two short years, they purchased their new home with the purchase option savings they had saved during the term of the lease to own agreement. Many new graduates have use lease to own agreements to start their careers. One individual moved from a northern state down to Texas and was in between jobs when he asked his family friend for advice. He was faced with three potential choices, he could 1) move into the apartment his uncle previously owned, 2) lease a single family home in his neighborhood, or 3) relocate to a completely different city with a job in hand. He decided to look for a lease to own agreement. He negotiated a plan where he would purchase the home a year later provided he was gainfully employed. He negotiated upfront to obtain a request of rental, repair/maintenance information, and updated photographs of the property once a quarter . That way he had recent information to compare his results from the leasing period to other market options, and if he desired the right to walk away without penalty and lose his option consideration amounts. Another great example is the Sanchez family. The Sanchez family lease to own agreement was for two years. Mrs. Sanchez worked overtime making her pay slightly above the average for a similar type of job. She also babysat for a relative on weekends. The family had another child during the lease term. They had two incomes and two small children to support, but they didn’t have credit established in their name as a family. The landlord of their lease to own agreement worked with them and included an additional one percent reduction on the purchase option price for each month they paid their rent on time. The savings were put away to help build credit and the savings plus an additional 10 percent mortgage validation were used to apply for financing from a credit union once their lease to own period expired. While there may be numerous success stories of lease to own agreements in the State of Texas, there have also been a mix of failures. We will discuss them in the next section.