A Valuation Framework for Rent-to-Own Housing Contracts

Abstract

The housing market crash in 2007 followed by a banking crisis and deep recession led to many underwater mortgages and a large shadow inventory of unsold properties. An innovative mechanism that may be playing a role in lowering inventories is the emergence of rent-to-own (RTO) housing contracts. RTO is potentially an attractive alternative to traditional financing for would-be buyers who cannot qualify for a mortgage due to an inadequate credit score, insufficient savings etc. These transactions, however, carry risks for both renters and owners. In this paper, we explore the contours of an RTO arrangement and suggest a binomial tree option valuation framework. In particular, we solve for the zero-profit purchase price at national and metro levels. We evaluate cases where the buyer can and cannot prematurely terminate the contract. We also consider scenarios in which both seller and buyer have deadweight costs that affect the contract outcome in a Nash bargaining framework. To the best of our knowledge, our model is the first analytical attempt to focus on the RTO housing contract.