Renting-to-own housing is hardly a silver bullet in stressed real estate markets
This choice is likely to limit options for struggling households than growing them, Murtaza Haider and Stephen Moranis say.
When it comes to affordable housing, there are no silver bullets. Still, election campaigns deliver catchy slogans for stubborn housing problems, which at times defy economic fundamentals and common sense. The rent-to-own housing option, which surfaced as an electoral promise in Toronto, is one such idea — is likely to limit housing and career choices of struggling households than expanding them.
Many supporters of rent-toown (RTO) housing naively believe that it offers an affordable and viable alternative to mortgage finance for home ownership. The proponents argue that households who could not save for a down payment or are deemed uncreditworthy by mainstream lenders could rely on RTO for home ownership. The reality is far more complex, and, in many circumstances, RTO programs can hurt the long-term financial prospects of struggling households. Before one signs off on an RTO housing contract, some basic facts must be understood.
An RTO contract enables a household to rent a dwelling that the household may buy in the future at a predetermined price. The RTO thus enables households to select a neighbourhood and dwelling of their choice. In instances where the household may not have enough for a down payment to secure a mortgage, the RTO might put such households on the path to home ownership.
At a predetermined date in the future, the transfer takes place from the landlord to the renter. The prearranged price offers protection to renters against unexpected housing price inflation. What could possibly be wrong with such a benevolent arrangement? The answer is a lot. The devil, as always, is in the detail. To begin with, a typical RTO client is one with a down payment that is not adequate to qualify for a mortgage from mainstream lenders, who charge lower interest rates than the lenders who lend to highly leveraged borrowers. As the loanto-value increases, so does the charged interest rate.
Given the way RTO contracts are structured, they may hurt the financial interest of a struggling household. For starters, a renter household cannot avoid a down payment, which is called the option money and is likely to be less than 20 per cent but is still required. The one-time, often non-refundable, payment at the initiation of an RTO contract buys renters the option to purchase the dwelling in the future. The predetermined future purchase price serves as a hedge against rapidly increasing housing prices. Yet, if housing prices were to decline in the future, the renter must pay the higher agreed upon price. Equally important is the realization that the rent in RTO contracts is usually higher than the rent for a comparable property because part of the rent is credited towards the purchase price. So, from a cash flow perspective, an RTO contract carries a higher burden than a comparable rental unit.
While an RTO dwelling is not technically owned by the renter, it is still the renter’s responsibility to maintain the property. Thus, if the furnace blows out during the renting phase, the renter might be on the hook for it, depending on the terms of the agreement.
When the renting period ends, the renter has the option to purchase the dwelling. During the renting period, part of the rent accrues towards the purchase price, which is akin to building equity. However, the renter must borrow the balance from a lender. At this point, depending upon changes to interest rates, a mortgage could be cheaper or more expensive than when the RTO contract was signed. RTO contracts are predicated on the assumption that the renters’ finances in the future will improve in terms of creditworthiness. Should that fail to happen, the renter will have to walk away, leaving the equity built over the years behind. Furthermore, such contracts restrict one to the same location, making it expensive to relocate to more lucrative job markets in other cities.
Sanjiv Jaggia and Pratish Patel in the Journal of Derivatives analyzed RTO contracts in the U.S. after the Great Recession when many homes faced foreclosure. Their analysis concluded that RTO contracts were no silver bullet.
They found that lenders could benefit from entering into an RTO contract when a borrower was about to default on a mortgage. If the borrower faced severe financial constraints, the option to buy the dwelling in the future was essentially “worthless.”
RTO contracts have existed with limited success in certain niche markets. But without subsidies, market-based RTO solutions to promote housing affordability are unlikely to succeed.
A preferred option to improve housing affordability is to increase the supply of new housing by aggressively releasing land suitable for development and streamlining the development approval processes.