Finance or Rent-to-Own?

It’s All About Down Payment – Quite simply, if there is a down payment of 5% to 40% of the purchase price, then this is considered a “purchase contract” with owner financing. Conversely, if there is no down payment, it’s a “rent-to-own agreement” with portions of each rental payment applied to the purchase price. The amount of rent applied to the purchase is clearly stated in the rent-to-own agreement.

In some cases, renting-to-own involves two stages: stage one is where rental payments accumulate to an amount sufficient for a down payment and stage two begins when the rent-to-own agreement is replaced with a purchase contract. This new owner-financing agreement may re-define the financial terms mutually agreed upon by buyer and seller. The alternative is to maintain the rent-to-own agreement in place the entire time until the purchase price is paid off in full.

To Finance or Not to Finance… Which is Better

The decision to finance or not to finance depends on your perspective. For example, if you have no cash, your options are limited. If you have cash, consider what else you could do with that money! From a classical perspective: if your cash is generating higher returns than the subject property — keep the money where it is and finance the new investment. Conversely, if the subject property can generate higher returns than your current cash positions, consider using cash to invest in the new property. The table below shows a comparison between seller-financing and renting-to-own and can be useful regardless of current cash positions.
In the above comparison, we used a property value of $200,000; a 7% interest rate; and a term of 10 years. We also used a 20% down payment for the Owner-Finance column and 0% down for Renting-to-Own. The first thing to note is that rent-to-own payments of $2,322 are $464 a month higher than owner-finance payments of $1,858 a month. This was because there was no down payment made. So which is better? Again, it depends on individual preferences. For example: is it better to come up with $40,000 now for the down payment… or pay an extra $464 a month later and come up with no down payment?

“Applied Rent” – In the above example, applied rent represents monthly amounts applied to the purchase price. This equates to “principal reduction” amounts in the Owner-Finance column. As a side note: the applied rental payments are higher than the principal reduction amounts simply because there was no down payment in the Rent-to-Own column. Looking at this in a different way: it will take several years to accumulate $40,000 by making extra payments of $464 per month — because there was no down payment made. So again, which is better: pay it now or pay it later? Other things to consider:

  • Is the Purchase Price at “Market Value” or at a “Discounted Price”?
  • Is the “Future Value” projected to rise or will Values Remain the Same during the rent-to-own period?
  • What are Costs of Borrowing Money from local banks?
  • What “Rate of Return” is the seller willing to accept?

Market Value vs. Discounted Price – If the Sale Price is at “Market Value” there may not be pressure to make a hasty decision to buy with financing or rent-to-own. So, just take your time and analyze all the cash flows to see what makes the most sense. If the property has been discounted heavily, however, a quick decision may be required to take advantage of the discounted price. If this is the case, you may have to choose whatever it takes to beat out potential competition.

Higher Future Value vs. No Increase in Value – Regardless of whether the purchase price is at market value or a discounted price, projected value should be analyzed over the financing or rent-to-own period. Although net rental income is important in determining rate of return on an investment, don’t forget that an increase in property value will increase the overall rate of return at the end of the holding period. So, if this is the case, you may want to consider making a down payment on the purchase price because cash up front is more appealing to the seller than no money down. As a side note, both the purchase contract and the rent-to-own agreement give the buyer/renter the “option” to purchase the property at a certain price. In some cases, however, the “option” is not given until a certain amount of down payment has been accumulated. So, if the purchase price is discounted and/or the projected future value of the property is projected to be higher, the renter/buyer should consider getting to the down payment minimum as soon as possible so that the option to purchase is secure.

Cost of Borrowing Money – At this time in the Dominican Republic, the cost of borrowing money ranges between 12% and 14%. So in our opinion, seeking seller financing or renting-to-own is a more prudent strategy. The question then becomes what is the cost of seller financing?

Owner Desired Rate of Return – In most cases, a seller would prefer that a buyer get a loan from a local bank so that he or she gets paid in full at time of closing. However, if interest rates at local banks are out of reach for the average buyer, a seller has three options: waiting for an all-cash buyer, considering owner-financing, or renting-to-own. It makes sense that a seller would like to charge interest rates similar to local banks so as to encourage them to finance through the local bank. However, that is not always the case because owner financing may be the better option if high interest rates are not an option.

So what if you have cash, can you still “Rent-to-Own”? – Why Not! It’s your decision… assuming the property is available on a rent-to-own basis. If you have cash, the decision should also be based on a comparison of rates of return on investments. As stated above: which investment has the potential for higher rates of return: the new property under consideration — or your current investments? For example, let’s say your current cash positions generate a 1% rate of return and the subject property is projecting a 5% rate of return. If this is the case, consider putting cash into the real estate investment. However, if a current investments are generating a 10% rate of return you have more things to consider.

What About the Owner-Seller?

Don’t forget… there are two sides of each agreement to consider! So what about the owner-seller? What is best for him or her? As stated above, most owners who are ready to sell most likely want their money in hand as quickly as possible. However, the same question may be asked: “What else will they do with the money?”. At times, there are bills to be paid or other investments to be made. But what if there is nothing pressing or no other viable investments immediately available? Is “owner-financing” or “renting-to-own” a reasonable option? It of course depends on the interest rate applied. In the above example, a 7% rate of return is a safe and secure option when compared to other alternatives. In this scenario, the owner-seller would receive $2,322 a month for 10 years which could represent a lifestyle change.  Alternatively, the owner-seller could use the monthly income to participate in a monthly investment plan and receive the benefits of dollar cost averaging in an index or mutual fund. So, it’s up to a professional real estate advisor to match owner-sellers with renter-buyers. The task may be daunting at times, but as long as the fundamental principles are sound for all parties, the whole process is not only possible… it is also gratifying.

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