Rent-to-own - where's the equity?

The weakness in the mortgage-credit market has led many would-be sellers to enter into what are known as “rent to own” or “lease-purchase option” agreements. Under such an arrangement, the buyer-seller relationship is restructured as a landlord-tenant relationship with an option for the tenant to buy the property for a fixed price. The tenant typically agrees to pay a deposit and a monthly rental which is greater than the pure rental value of the property. In exchange for this, the tenant is given an option to purchase the property and have a portion of his payments credited to the price.

Although many tout this as a win-win situation for sellers losing patience with a slow market and for buyers with temporary credit issues, a seller/landlord can end up with an expensive and protracted problem if the purchase option is not exercised and the buyer/tenant nevertheless chooses to remain in possession without making any further payments.

The legal issue is whether the tenant/buyer has acquired equity in the property. As is often the case with contractual relationships, lease-purchase option agreements work fine if the terms and conditions are met and either the buyer/tenant moves out at the end of his term or exercises his option to purchase the property and closes.

If the occupant of the property instead decides to stop making payments and remain in possession until forced out, the inequity begins to become evident. The buyer/tenant may now argue that things are not as they appear. Looking for any plausible argument, he may assert that the lease is really deferred purchase money financing and that the portion of the rent credited to the purchase price is really mortgage amortization. Adding insult to injury, the buyer/tenant may claim that the security deposit is really the down-payment. The buyer/tenant is clinging to the legal argument that he has acquired equity in the property by virtue of the fact that some of his payments have reduced the balance due under the purchase option.

Under these circumstances, the owner now finds that he has shot himself in the foot twice. He may not avail himself of the streamlined FED residential eviction process applicable to a pure lease and, without a deed of trust, he may not have access to the expeditious public trustee foreclosure process. Much to his surprise, the seller/landlord is cast as a lender with an equitable mortgage securing his right to payment. The only way for him to regain possession of his property is through a full-blown legal foreclosure.

Any seller contemplating such an arrangement should consult an attorney for assistance in negotiating the terms and drafting the documentation in a manner which minimizes the risk of this inequitable result.