When the home building market was roaring, T.W. Lewis homes was building a house a week in each community at an even-flow pace. As the market slowed he didn't stop.

"When there was a leak in the boat we were still even-flowing and we ended up with more specs than we wanted, and then as the market continued to deteriorate we knew we were going to have to do something creative to offload some of this inventory," says owner and CEO Tom Lewis.

That's when Lewis, who used to work for Trammel Crow, a leading builder, developer, and leaser of rental housing, came upon the idea of leasing out his excess inventory. T.W. Lewis' homes are high-end and Lewis realized there were few high-end homes to lease in the area.

"The big thought here was that there was not really a market to sell these houses at those prices, but that there was a market to lease them," he says.

The idea isn't unique to Lewis. Builders across the country, large and small and those selling entry-level homes as well as high-end, have taken to the idea of lease-to-purchase as a way to manage spec inventory.

Lewis started implementing his plan a year and a half ago in stages. He took 25 of his spec homes in the $500,000 to $800,000 price range off the market, added swimming pools, upgraded landscaping and appliances, and put them out to lease for $2,300 to $3,200 a month. They leased out quickly, many to renters who had lost their homes to foreclosure yet still had enough income to rent a high-end home. So Lewis proceeded to lease out three more 25-house phases of rental homes from his spec inventory sprinkled throughout his communities, creating a rental inventory of 100 homes.

Lewis started a separate company to buy the homes from his building company at about 65% of full retail value, financing half of the cost himself from profits he had squirreled away over the last 10 to 15 years of home building and borrowing the rest from lenders.

"As an investor I feel like I am buying at the bottom," Lewis says. "In some respects, essentially, I am buying my own stock. The total portfolio value is probably $50 to $60 million. It pretty much breaks even after debt service and provides a bit of cash flow."

But that doesn't take into consideration how it has helped his home building company by cutting the costs of holding the inventory.

"When you have 100 specs out there and they are each costing you $1,500 a month in interest and another $500 in other costs, you do the math and you see you can rent those for $2,800 a month and you are turning a $2,000 a month negative into a positive," he says. "It's good business."

Plus, the money he pumped into the homes by building pools and adding extra landscaping, refrigerators, ceiling fans, and window coverings required to lease a house pumped money into the building company. And the rental portfolio has allowed him to keep some staff who probably would have lost their jobs otherwise as the builder's construction volume fell from 350 houses in 2006 to 170 last year and an expected 90 in '09.

"We have our construction technician mowing the grass, construction manager taking care of the pools, customer care doing service inspections," Lewis says. Sales agents are paid a $4,000 commission for homes they lease.

"We have half our whole company engaged in these 100 houses in some way," he says. "We are keeping our company together, helping us maintain our core people."

While Lewis' renters are signing lease-purchase agreements, Lewis doesn't expect most of them to buy the houses. In many of the agreements there is a clause allowing the renters-turned-buyers to credit 25% of their rental payments made on time to the purchase price as an incentive. Typically the leases are for a two-year term, but some are for as long as five years. The purchase price is set approximately 10% higher than the market rate at the time of occupancy, with the purchase price rising every year thereafter at 5% during the terms of the lease.

"The reality is, though, I think there is a fairly small percentage who purchase," he says. "I hope they all purchase, but I'm not counting on it. If they don't decide to purchase, then at some point in the next three to seven years I'll wait until the market is strong and start peeling them off."

Meridian Homes of Atlanta had a problem similar to Lewis'. It had people who needed homes and spec homes that needed people. The problem was the people couldn't get loans to buy them, so the homes sat empty, their costs eating away at Meridian's bottom line.

Like many other builders burdened with excess spec inventory, Meridian has found a solution to part of the problem through a lease-to-purchase program for buyers who have cash coming in but some blemishes on their credit that keep them from getting a loan in the tighter lending environment.

"What we found with the credit market tightening up is that there are some creditworthy people who have some reason why they can't get a loan, and many of them have cash to put down on a home," says Joel Gregory, Meridian's vice president of sales and marketing.

Potential lease-to-own buyers are heavily vetted, their credit checked, and a deposit of between $1,000 and $15,000, depending on the cost of the house and a risk-assessment, is required.

"That immediately takes some people out of the market," says Gregory. During the lease period, which Meridian doesn't want to exceed 12 months, the tenant/buyer works to fix credit issues.

So far the program, which began last June, has been successful, Gregory says. Meridian has leased to sell about 15 home, and about five have closed. Two other buyers left amicably. One found another house at an incredibly low price and the other couple lost both their jobs.
The program works especially well for Meridian because its products, priced from the 160s to the low 200s, are targeted to first-time home buyers who are interested in getting into a home and don't have one to sell. The company is on course to close about 230 homes this year, down from 425 in 2007.

"Has it helped us?" asks Gregory. "It hasn't meant survival or not, but it doesn't hurt because if you take that many houses that you don't have to pay overhead on and then you convert it to sales, it helps."

Not all builders are able to lease out their spec homes. If there's a bank loan on the house, there's a chance the bank will balk at the arrangement. But that's not an impediment for Elliott Homes in Arizona.

"We are a cash builder, so we have built up a little nest egg over the years," says Derek Anglin, Elliott Homes' sales broker. "When we buy land, we pay cash. And when we build homes, we pay cash, which allows us to be a little bit more creative."

Last year Elliott Homes' Phoenix division started offering a lease-to-own program that allows potential buyers to accumulate the down payment through lease payments made over the year.

The company sets the rent at what the mortgage payment would be plus enough extra to allow the renter/buyer to save up the 3 ½% required for a down payment for an FHA loan. When it comes time to get a loan, the buyer will be able to show a 12-month history of making payments greater than the mortgage bill will be.

If the renter doesn't buy at the end of the year, all the lease payments, including the extra that was to go to the down payment, are forfeited as rent.

"We look at it as stealing buyers six months before they are on the market," says Anglin. "This is just one more marketing tool to offset costs, unload specs, and lock in buyers."

In March Elliott had 10 families in lease-to-purchase homes.

"With them having skin in the game related to the option money, we don't anticipate a whole lot of drop off," Anglin says. And, if they do, the company will have at least been able to offset its expenses on the home while it was leased out.

Teresa Burney is senior editor at BIG BUILDER magazine.