At Grabham and Associates, we pride ourselves on being relevant and well informed regarding the current state of the housing market in Arizona.  And it is a goal of ours that our clients are equally as savvy, in order to make the best decisions in relation to their respective situations.  A few days ago, we were asked to negotiate an agreement between two of our clients with regards to a lease to own contract on a rental property.  And as we've been preparing for our clients, we started the morning yesterday opening the paper to a very pertinent article regarding lease to own options in Arizona. The article was published this week in the Business section of the Arizona Republic, on July 29th, written by J. Craig Anderson.  The article brings up a lot of good points, so we thought we'd chime in on the conversation as well, in an effort to provide all of our clients with information that will better equip them when making decisions. We've included the article below for you to peruse, and then follow our subsequent comments.

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With thousands of single-family rentals spilling onto the metro Phoenix housing market each month, a growing number of investment owners and brokers now market their properties as rent-to-own deals. Local experts say rent-to-own agreements, also called lease options, are a way for prospective buyers with cash shortages or credit problems to build up a down payment while repairing their credit.

With a glut of investor-owned homes available for rent, offering lease options is another way to stand out in the crowd while appealing to credit-impaired residents who may have gone through a recent foreclosure, short sale or bankruptcy. Advocates say an increase in lease options could help ease the looming problem of investment homes flooding the market when today's investors decide to sell.

But others argue that lease-option agreements rarely result in sales because buyers back out or fail to qualify when the lease expires. Those renters generally lose their down payments and end up back at Square 1, critics say. "My guess is that less than 10 percent ever exercise that option," said Kammrath & Associates owner Bob Kammrath, a Phoenix real-estate analyst who follows the rental market.

"It's a good way to do a test-drive on a house," said Jason Grandon, who operates Scottsdale-based InstantRenters.com with his sister, Stacey Grandon.  Jason said lease options have found a relatively new audience at the high end of the market, with wealthy buyers staking their claim on recently foreclosed-on luxury homes at a time when jumbo mortgage loans are expensive and nearly impossible to get.

Even prospective buyers who intend to pay cash are leasing to own, Stacey said, because luxury-home prices are on the decline and desperate sellers are willing to negotiate attractive terms. Kammrath said he sees the logic in using a lease option to wait out "the worst environment for jumbo lending in the last 20 years," but he said there is no guarantee the situation will improve in a year or two.

Phoenix real-estate broker and agent Bill Brandt agreed, adding that lease options generally work better in theory than in practice. "The big thing is the price," said Brandt of AZ Paradise Realty. "When are we going to determine the price, and who's going to determine it?" Most lease-option deals involve a two-year lease that can be extended to three or four years if a buyer's credit isn't expected to be good enough to obtain a mortgage after only two years, Stacey Grandon said.  Brandt said the current real-estate market could be particularly treacherous for lease-purchase buyers who agree months ahead of time on a sale price. "If the house doesn't appraise for the agreed-upon amount, then the buyer won't be able to get a loan and they won't be able to buy it," he said.

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Obviously, Bill Brandt hit the nail on the head, that the most important thing to consider, on both sides of this deal, is when is the price set, and who sets it.  Everything else is in the equation is based upon the purchase price that the renter and owner agree upon; i.e. the rental price, lease term, etc.  As the owner, if the price is set today, what happens if the home appreciates significantly during the lease term?  If the price is set at the end of the term, what happens if the appreciation prices the renter out of the purchase?  Either one of these situations can be worked out, but the devil is in the details of the agreement.  So what's the benefit to the owner to do a lease to own option with a tenant?

Right now, the home rental market in Phoenix is inundated with investors trying to fill empty homes with prospective tenants, and there doesn't appear to be enough tenants to go around because houses are so affordable, even though lending is tighter.  And those that are looking to rent, are being very selective with where they live.  But a growing number of investors are looking at setting themselves apart by offering a lease to own option to their tenants.  So by offering the option, the investor is increasing the likelihood that they will get a tenant in their property.  And depending on the particulars of the agreement, the lease to own option could have other benefits as well for the investor.

If the purchase price were set at the beginning of the lease term, than it would be ideal for the investor to receive a premium inside of the rent payment to account for any anticipated appreciation between the time of setting the price and the actual purchase.  But this scenario is unlikely as the renter theoretically is already paying an above market rent rate with a percentage of that payment going towards their down payment.  However, another option to consider, if setting the price early, would be to have the renter pay a rent premium and have none of it go towards a down payment, with their benefit being a below market purchase price, assuming the home appreciates during the lease term.

If the purchase price were set at the end of the term, then there's really no benefit to the renter to enter into a lease to own agreement, unless a significant portion of their rent payment is going towards a down payment; and that is assuming that the lease is a market rate lease.  And that is also assuming that the house is one that the renter really wants to live in.  Because after all, this agreement is basically saying that the renter is so sure that they want this house, that they want to take it off of the market until they can afford it, for fear of it not being available when they can.  But what happens if the renter chooses not to purchase the home at the end of the term?  What happens to the money that they were paying towards the down payment?  Does the investor get to keep that money?  If so, how much? If not, why?

If the renter decides not to purchase the home, then there is a good chance that the only benefit to the investor was the fact that they had a paying tenant for a period of time, which is certainly something to be appreciated.  But if that was the only benefit to the investor, what's the point of doing these deals in the first place?  The incentive for the investor has to lie within the rent premium as well as being the beneficiary to the escrow account holding the down payment funds in case any issues arise.

Unless these lease to own deals are structured with acute attention to detail, they may be more trouble than they're worth.  And with the uncertainty and volatility of the housing market, there is an elevated element of risk for the investor.  Because let's not forget, the overwhelming majority of prospective tenants who are doing these deals are people who don't have the ability to qualify for a mortgage on their own!  So what are the odds that they will be able to qualify for a mortgage in a year or two? Who knows, which is why the investor needs to be protected financially.  A lease to own option can very quickly turn into a one sided deal if it isn't structured right, or many of the details are "assumed" by either party. 

Now, there are plenty exceptions, and these deals have worked out great for some.  The point is to make sure that the due diligence is done before entering into these deals, and it probably wouldn't hurt to have a real estate attorney finalize the agreement to make sure nothing is missed.

Last night, our day concluded with a meeting of our two clients, to go through many of the aforementioned details.  Now the deal isn't done yet, but it has been a tremendous benefit to both sides to take our time and go through every painful detail to ensure that this is a win-win for all involved.