Rent-to-Own Revisited By: Stephen J. Nash Nash & Lodge, PLLP nash@nashandlodge.com In our newsletter I previously wrote about various alternative financing options including “Rent-to-Own” agreements*.  In that article I expressed concern as to how they might be used and you could easily find yourself in a situation where both the landlord/seller and tenant/buyer are unhappy and blaming the real estate agent for the rent-to-own that did not work out. Well, the problems are starting to appear. I. Problems With Rent-to-Own Deals The following are examples of some of the problems we have dealt with in the last three months relating to rent-to-own transactions. A. Who me? I'm a Landlord? Sometimes the owner does not understand that they might become a seller in the transaction but for sure they are a landlord and taking all of the risks of being a landlord. If they do not protect themselves like a true landlord would they are bound to run into trouble. B. Show Me the Money This, of course, is the most common default. If the landlord has not prepared for this possibility they immediately have a huge problem – how do they pay the mortgage? The landlord has to realize that they can't just kick the tenant out but must bring an unlawful detainer to evict the tenant which costs time and money. The issues that come up in this situation that relate to the real estate agent are as follows: Was the financial situation of the tenant checked into? Whose responsibility was it to check the tenants background or to discuss the issue? Was there a sufficient security deposit and was the issue of the amount of security discussed? Was the lease properly drafted or does it cause further problems for the landlord? Who drafted or found the lease?   C. Trashing the Home When you rent out your home you are entrusting a very valuable asset with strangers. Unfortunately, the tenant can cause great damage to the property in a short period of time. Maybe because we are in an economic downturn or because many of the tenants have already lost their home to a foreclosure and feel that the world has kicked them in the teeth we are seeing tenants do much more harm to properties than in the past. While the landlord may not be to blame for all of the tenants trouble, tenants sometimes take out their frustrations against the property. D. Not Completed, Not Paid For – what's the Problem? Tenants many times feel like the home is theirs, especially in a rent-to-own situation. This can be good but sometimes can backfire. If the tenant decides to “improve” the property, three problems can result. First, the improvement is completed but not paid for. Second, the improvement is only partially completed. Third, the tenants idea of an improvement and your idea of an improvement are two different things. A landlord has to protect himself/herself from a tenant deciding on what is an improvement to the property (does a turret improve the value of the property or not?), to make sure the tenant has the money and pays for the improvement (i.e., protected against mechanic liens) and make sure that the improvement is actually completed. The bottom-line is that an improvement can cost the landlord money and may actually hurt the value of the property so the landlord must protect their interest in the lease so that the tenant can only do improvements if approved by the landlord in a method controlled by the landlord. E. The Tenant Who Just Won't Leave. Once the tenant is on the property the landlord cannot remove them without following the terms of the lease and in compliance with Minnesota law. Just because a tenant defaults does not allow the landlord to kick the tenant out or exclude the tenant from the property. The law does provide a method to kick a tenant off the property which is referred to as an eviction. This is an expedited court process. Even though it is expedited, it still takes time and money to go through the process and if the tenant knows what they are doing they can cause the landlord to expend more money and extend the amount of time necessary to get them out of the property. This can cause great frustration for the landlord. II. Why Do the Problems of Landlords Become the Problem of the Real Estate Agent? There are three reasons that I believe explain why the owner/landlords are blaming real estate agents for their tenant problems: The real estate agent “sells” the homeowner on the rent-to-own transaction as a way to cure all of the problems facing the seller – get money to pay the costs of holding the property, get a buyer in a buyers market and get the price you want versus what you can get in the marketplace today. The real estate agent provides the lease forms or downplays the importance of having these forms drafted to protect the landlord which comes back to haunt the landlord if the lease does not protect them when trouble arises. The real estate agent acts as a property manager but doesn't do it properly. If the real estate agent markets this as a tool to sell property but does not make clear that the homeowner is going to be a landlord and must protect themselves as if they were in the business of renting property, there is going to be trouble. Being a landlord involves risk and takes time and effort to make sure that you rent to the right person and that they do what they are supposed to during the term of the lease. If the homeowner only focuses on the sale part of the transaction they are setting themselves up for disappointment. A rent-to-own does not ensure a sale.  The buyer has the right but not the obligation to purchase the property so a seller cannot force the buyer to buy until the option is exercised.   Often when the focus is on the sale, the terms of the sale are either unrealistic or vague. We see purchase terms that are significantly higher than the fair market value. If the purchase price is higher than the fair market value today, the seller is gambling that the property values are going to rise to the price set forth in the rent-to-own documents. If this doesn't happen why would the tenant exercise the option? Even if they did, the property will not appraise.   If the terms of the purchase are not spelled out in the rent-to-own lease, you are just opening yourselves up to future arguments. What is the point of granting an option to purchase if the deal has to be negotiated a year down the road anyway?   Many, if not most, of the leases we are seeing are poorly drafted. Sometimes they are being downloaded from the internet, are the product of software that someone purchased or is just copied from a lease that somebody else used. If the lease used was drafted for California it is not going to deal with uniquely Minnesota issues of laws. Leases can be drafted to favor the landlord, tenant or attempt to be neutral. As a landlord, they need a lease slanted in their favor. Just because a lease is on the internet does not make it well drafted. Just like a purchase agreement, the lease must be clear, understandable, and deal with the issues that may face the landlord. If the lease is unclear, does not make sense or doesn't deal with the situation facing the landlord, the landlords problem is amplified. Since your normal homeowner knows nothing about being a landlord we are seeing more and more real estate agents acting as property managers. Sometimes they are charging the homeowner for this service, in other cases they don't even realizes that they are acting as a property manager. In either case, the real estate agent who acts as a property manager must do so in a competent manner and must make sure that they comply with Minnesota licensing laws. There should also be a written agreement stating what duties the real estate agent is undertaking. If not, the homeowner will later argue that the real estate agent should have performed all of the duties of a property manager. If you are going to act as a property manager, you must educate yourself as to how to properly do so. Are you screening the tenants? How are you screening them? Are you handling the money? Holding the security deposit? Collecting the rent? Who is checking on the property to make sure that it is being taken care of? Who deals with repairs? Who deals with the tenant if the tenant defaults? IV. Where Blame is Pointed at the Real Estate Agent If the tenant defaults or if the tenant simply does not exercise the option or the sale can't be completed, the following are issues that can and do arise. Many of these issues only arise in a rent-to-own scenario. A. Security, What Security? Many of the rent-to-own leases simply do not require enough security deposit to be paid given the risks taken by the landlord. I'm often told that they didn't get more security deposit because the tenant/buyer didn't have the money yet this is the same tenant that the homeowner is relying on to purchase the property? In the end, if the agent does not discuss the importance of the security deposit and the risks that the homeowner is going to undertake that will quickly eat up their money if a problem occurs, the blame will be directed at the real estate agent. The security deposit is the money that is going to compensate the landlord if the tenant causes a problem. If the security deposit is equal to one month's rent, the landlord doesn't really have much security since the landlord will always lose a minimum of one months rent if there is a problem plus incur the cost of evicting the tenant. In most cases, the landlord will lose more than one month's rent and will also incur costs repairing and/or cleaning and re-leasing the property. B. I Paid Too Much Rent...I Didn't Get Paid Enough Rent! Many rent-to-own leases have provisions giving the tenant credits towards the purchase. Problems can arise when the terms are poorly drafted or when the tenant believes that the purchase is a done deal. If the purchase doesn't occur the tenant often believes that they paid extra money renting the property that they have now lost. In other words the money that was to be credited towards a sale was money paid over and above the rent. It is even worse if the tenant could not purchase because the property does not appraise. Ironically, in the same transaction the landlord also looks at it like they have lost money. The rent barely or did not cover their costs, the tenant didn't pay the last money's rent, failed to leave so the landlord had to spend the money to bring an unlawful detainer and lost yet another months rent. In addition, the landlord only did the rental deal in order to get a buyer which they now lost. Both the tenant and the landlord look at the real estate agent as the only person who came out in this deal which only first their anger. C. This Was Doomed From the Start When the deal blows up both parties will look at the deal and in many cases will see that the deal never really had a chance to succeed. If either or both parties entered into the transaction based upon the sale/purchase but find out that it really never could have happened, they are not going to be happy. If the purchase price is based on what the seller wants, not on what it is really worth, the deal is never going to happen unless the market increases to meet that price. Is that realistic? Does the seller or buyer understand that risk? If not, they are going to be unhappy. Can the buyer qualify? If they are looking for a rent-to-own deal it is often because the buyer cannot qualify for a loan to purchase. If they can't qualify today, how are they going to qualify in a year from now, especially when the lending standards are getting tougher not easier? If they lost a home on a foreclosure it is not going away in a year. If they have bad credit can they repair it enough to qualify in that period of time? If they had late payments before what has changed so that they will make payments on time? What if they lose their jobs? From the sellers perspective a through background check is needed to find out if the buyer really can qualify for a loan to complete a purchase. From the buyers perspective a realistic look at their situation is needed so that they don't chase something that is not going to happen. D. I Didn't Know It would Take 10 Years to Repair Their Credit or That They Trashed Their Last House! Who is responsible for checking out the tenant? If the purpose is to allow them to rent while they position themselves to purchase the property shouldn't somebody make sure that the tenant can actually purchase the property? Just because they say they can does not make it so. Just because their loan officer says they can, does not mean that they really can. Just because they hired a company to repair their credit does not mean that their credit can repaired to the point that they can actually purchase the property. If the real estate agent undertakes this responsibility they must do so with diligence and document their file as to what they did and found. If the real estate agent is not undertaking this responsibility they must make this clear to the homeowner and make clear the risks that they are taking if this is not diligently done by someone. When the deal blows up and it turns out that the tenant would never be in position to buy the property, the homeowner is going to be mad and is going to look to see who can be blamed. If the tenant damages the property and it turns out they did the same thing in the last home they we in, the homeowner is going to be furious and is going to look to blame someone other than themselves. E. Can't Sell to a Qualified Buyer Because a Buyer Who Will Never Qualify Has an Option to Buy A rent-to-buy involves the homeowner giving the tenant the option to purchase the buyer. A standard rent-to-buy does not allow the homeowner to sell the property to someone else until the option right expires or the tenant voluntarily releases that right. While the tenant can prevent the landlord from selling the property, the landlord cannot force the tenant to buy. If the tenant kills a sale yet the landlord knows that the tenant will never buy, the landlord is not going to be very happy. The landlord will be even more upset if they find out that they should have known when they entered into the lease that the buyer would never be able to buy. The final insult would be if the seller never received compensation for tying up the property with the option. IV. Conclusion Rent-to-own deals can work-out and there are times where they are appropriate. There are other times when the rent-to-own transaction is simply not appropriate. When the seller/landlord grants an option to purchase they are tying up the property and should receive proper compensation for the risk they are taking. If they are not receiving additional compensation or they do not want to tie themselves to someone who may or may not be able to purchase the property, they can always simply rent the property without an option and, if and when the tenant can and is willing to purchase the property, they can negotiate an appropriate purchase agreement at that point in time.   NOTICE The foregoing is not intended to constitute legal advice for any specific circumstance, but is intended to reflect broadly applicable principles, under Minnesota law, relevant to a typical situation. Each set of facts and each contract are, or can be unique; the unique facts and specific language of the contract may require a different legal analysis and may result in a different outcome. Before proceeding in reliance upon this or any other general description of law, consult with an attorney competent in the field of practice relevant to your situation. Copyright 2008 Nash & Lodge, PLLP

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