Rent-to-Own Housing Contracts Under Financial Constraints

Abstract

Due to tougher lending standards, Rent-to-Own (RTO) contracts are getting popular. In a RTO contract, a tenant signs a lease with the option to buy a house at a predetermined purchase price. That is, the tenant receives a call option. RTO contracts allow potential financially constrained homebuyers to lock in a price while they use the time to build up savings and creditworthiness. Even ex-chairman Bernanke has endorsed RTO contracts as a tool to stem foreclosures. Despite recent interest, the economic implications remain murky. Contract terms are further complicated since the tenant may stay financially constrained, and not qualify for a mortgage, in the future. In this paper, we analyze the economics of a RTO contract under financial constraints in competitive equilibrium. We show that the equilibrium purchase price is extremely sensitive to the tenant's financial constraints. This information is useful in negotiating contract terms for an interesting new development in the real estate industry.

Keywords: Housing lease Option, Mortgage Requirement, Homeownership, Rent to Own, Credit tightening, Esscher Transform