Can Rent-to-Own Models Actually Help Unlock Homeownership Affordability?

While the US’s housing market is starting to normalize after historic appreciation, many purchase-intent consumers still can’t afford homes. Prices remain at record highs, and rising interest rates put affordable lending assistance out of reach. Consequently, more and more people are forced into prolonged renting.

Unfortunately, the US’s rental market is no better than our housing market. For the first time in history, the median nationwide rental price exceeded $2,000, making it progressively challenging to save for down payments.

(source)

Many of the consumers stuck in the rental cycle seemingly should be eligible for homeownership (e.g. stable, consistent, and healthy earnings). They just need down payment assistance. Luckily, a growing number of “rent-to-own’’ proptech startups have emerged to help solve this problem. To name a few: Verbhouse, ZeroDown, Halo, Up&Up, and Divvy.

Put simply, rent-to-own is a mechanism by which prospective homeowners rent a home with the option to buy in a set amount of time. The homeowner generally only has to put down a fraction of the home’s value initially (~2%), vs the traditional 20%. A portion of his or her monthly rent payments are set aside for the down payment in the event he or she opts to purchase. (More on this later).

History of “Rent-to-Own”:

Like most land and property related programs and policies in the US, rent-to-own agreements have discriminatory origins. In the mid 1900s African Americans were excluded from homeownership most notably via redlining, the practice of race-based denial of mortgages within specific neighborhoods. Without lending options, black families turned to predatory “contract buying” programs — effectively agreements to rent homes from landlords and corporate entities with the promise of eventual homeownership, that was almost always denied in one way or another. Importantly, these agreements required down payments that were lost in the process, costing African Americans an estimated $3–4B during the 1950s and 1960s.

Blatantly racist programs like contract buying have been eliminated, for the most part. But, the US is still riddled with systemically engrained housing practices with the same discriminatory undertones (which, you could argue, are equally dangerous because they’re normalized and often hiding in plain sight). For example, racially-motivated lending practices played a major role in the housing crisis of 2008.

“Rent-to-Own” models are, structurally, extremely similar to contract buying, so it bears considering these origins when evaluating companies building in the space.

How do “Rent-to-Own” Models Work:

There are some slight variations in process, but the “rent-to-own” model generally works in the following way.

A prospective homebuyer applies for approval on a platform, sharing some basic information such as income, credit history, and location preference. If “approved”, the homebuyer is granted a purchase price limit, and works with the platform to identify a house within his or her range. The platform purchases the home, generally in all cash, with the homebuyer contributing 1–2% of the down payment. This contribution effectively goes into a savings account that is later applied to the home purchase price.

Post purchase, the homebuyer is locked into a multi-year lease, and a forward purchase agreement on price. The homebuyer can opt to purchase the home at any point before the contract expires, and is generally granted a lower price point for purchasing sooner. Until this point, or the contract expiration, the homebuyer pays monthly rent, ~25% of which is set aside and put towards the price of the home in the event of purchase.

Benefits for Home Buyers:

In theory, there are a few, key benefits for home buyers utilizing the “rent-to-own” model.

First, home buyers don’t have to worry (at least at the point of purchase) about qualifying for a mortgage, or for one with a competitive rate. They also don’t need to have a 20% down payment. For professionals with medium to high, stable income streams that are uninterested in or unwilling to take on additional debt, the rent-to-own model can make a lot of sense. It can also be great for contract workers or independent workers with “lumpy” income patterns where qualifying for a loan can be challenging.

Second, in a competitive housing market, having the support of a platform that can make an all cash offer on your behalf is incredibly valuable. From a sellers perspective, all cash offers often condense the time to close, and mitigate the potential for unseen challenges in the closing process (e.g. the deal falling through). In April 2022, 25% of home offers were all cash, up from 15% the year prior.

Third, rent-to-own models, theoretically, give home buyers the opportunity to test homes, and neighborhoods, before fully committing. While I’d argue that we’re not in a full “urban exodus” situation, people are moving out of cities, often to suburbs they may not have strong ties to or familiarity with. I wouldn’t suggest using rent-to-own without the intention to buy, but if a homeowner did want to back out after a few years, doing so would likely be easier than if he or she had bought a house and needed to re-list.

Cons for Home Buyers:

These are circumstantial, but rent-to-own models also have many potential challenges for home buyers.

First, home purchase prices are pre-set, often multiple years in advance. In the event the platform under prices a home, the homeowner can theoretically come out on top. But, more often than not, prices are set to favor the platform (and sometimes mechanisms are built in to ensure that, in the event the home appreciates less than predicted and the renter opts not to buy, he or she has to assume some of the costs).

Second, homeowners often incur additional costs and responsibilities avoided as a renter. Divvy, one of the leading rent-to-own platforms, for example, states that while it covers “repairs required to ensure the home is safe and hospitable” it is the homeowner’s responsibility to identify said issues, and manage hiring contractors. Divvy also shares that they don’t “cover any cosmetic repairs, including but not limited to painting, carpeting, landscaping, or appliances.” I’ve heard from rent-to-own homeowners that managing repairs can be a headache and timesuck, in addition to costly, especially in the event a platform fights them on expenses.

Third, in many cases, the proportion of rent set aside (generally ~25%) towards the purchase price of the home isn’t invested for the homeowner’s benefit. If the home appreciates greatly in value, the homeowner doesn’t participate in that appreciation, in most cases, if they don’t purchase. (And, in these instances, the he or she likely would have been much better off investing that money elsewhere).

Fourth, the homeowner is generally responsible for excess fees if they don’t go through with, or aren’t approved for, purchase. On some platforms, this is tied to the home value, or other costs, and on other platforms it’s a set fee (often $10,000 or more).

Fifth, at the end of the rental term, the homeowner may still not qualify for a mortgage, and be forced to vacate. Divvy reports that about 40% of homeowners on the platform are eligible to buy at the end of their contract — on other platforms it’s far fewer.

Overall Thoughts:

Conceptually, I love anything that unlocks homeownership for people that are otherwise priced out. But, in many rent-to-own models, it seems there is a fundamental misalignment between platforms and homeowners. Platforms claim to have the homebuyer’s best interest in mind, but the best financial interests of homebuyers often contradicts those of platforms. (e.g. charging more in rent, setting a higher purchase price, or moving consumers into not-ready homes to enable rent payment collection as soon as possible).

For consumers optimizing for speed, and ensuring they can secure a home they want (even if just as a rental) rent-to-own models can make a lot of sense, especially in neighborhoods with limited rentals. I’d assume this use case prevails for parents optimizing for homes in specific school zones, for example. But, I doubt that the 50%+ of rent-to-own tenants that can’t or don’t purchase homes at the end of their contract fall into this bucket.

As always, if you’re building in this space or thinking about home ownership unlocks, I’d love to meet — julia@flybridge.com

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Julia Maltby

Julia Maltby

Early Stage Investor @ Flybridge & X-Factor Ventures | GP @ The MBA Fund | Previously @ Underscore VC, WeWork, and Plum Alley Investments | Wharton MBA