It's possible for sellers to earn a 10 percent return on investment
By Jack Guttentag, Wednesday, November 28, 2012.
A lease-to-own (LTO) transaction is one in which a potential homebuyer occupies the home as a tenant but has an option to purchase it within a specified period at a specified price. In exchange, the potential buyer pays a nonrefundable option fee upfront plus a monthly rent.
In a recent article, I noted the intense interest in LTO deals today by wannabe homebuyers who can't qualify for the mortgage they need to make a purchase now.
Despite the large demand, not many LTO deals are being done. They are very complicated, and most potential buyers and sellers don't know where to go to get help. Further, most sellers view the LTO as a last resort rather than as a potentially profitable investment. In addition, there is no marketplace where potential buyers and sellers can connect.
To deal with these problems, I developed a three-part plan. Part 1 focusing on contractual complexity was to develop with Jack Pritchard a checklist of all the major provisions that might be included in an LTO, explaining the implications of each for both buyer and seller.
The checklist can be used as a negotiating platform for the two parties, who can turn the results over to a local lawyer for conversion into a contract. This list is on my website at Lease-to-Own Home Purchases: Huge Demand But Few Deals.
Part 2 focusing on seller reluctance is an LTO calculator developed with Chuck Freedenberg, and is the subject of this article. The calculator allows potential sellers to view an LTO deal as an investment generating an attractive rate of return, relative to what the seller could obtain by selling at the best price obtainable in the current market.
The investment return is net of the costs of ownership during the option period, including mortgage interest payments, property taxes, homeowners insurance and other expenses of ownership.
Viewing an LTO as a profitable investment should make it a more attractive option to sellers. The potential savings on real estate sales commission, not included in the return on investment, would be icing on the cake.
Here is an example. The seller could get $100,000 if he placed the house on the market today. The balance on his 6 percent mortgage is $60,000, giving him homeowner equity of $40,000 if he sells now. If he does an LTO, the costs of ownership during the option period sum to $610, which includes a $500 mortgage payment, but he is paid an option fee and a monthly rent. In addition, the option price may be higher than the current market price.
The calculator shows the following combinations of option fee, monthly rent and option price that will generate a 10 percent yield over a 12-month option period:
- Option fee of $1,000, monthly rent of $610, option price of $100,660.
- Option fee of $1,000, monthly rent of $501, option price of $102,000.
- Option fee of $654, monthly rent of $610, option price of $101,000.
Of course, the prospective buyer may not find any of these options desirable; among other reasons, she might need a longer option period than 12 months.
A seller and a buyer negotiating a deal can use the calculator together to find the best set of terms that are satisfactory to both.
Negotiations between buyers and sellers at the outset will probably focus on the rate of return, which is based on an estimate of current property value used to calculate it. In setting the current value, we recommend that the two parties agree to accept the judgment of an appraiser.
Part 3 of my plan to develop an LTO market is to provide an online forum where potential buyers and sellers can interact. Sellers would take the initiative in presenting information about the house for sale, and would provide a range of options acceptable to themselves from which potential buyers could make a selection. The table illustrates this approach. Stay tuned.
Option price for different combinations of option fee, option period and monthly rent that yields 10 percent to the seller, with option exercised, on a home salable for $100,000 today
|Option Fee||Option Period in Months|
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.