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A lease option (is different than a lease purchase, a lease purchase binds both parties to the sale[citation needed], where in a lease option the buyer has the option but the seller doesn't) is the abbreviated form of the appropriate term “Lease With the Option to Purchase”. It is a type of contract used in both residential and commercial real estate.
Commercial real estate can get pretty complex so we are going to stick with residential.
The contract is typically between two parties: the tenant (also called the lessee), and the landlord (lessor), who owns or has the right to lease or dispose of the property.
As the name lease with an option to purchase says there are two events and one is not mandatory. In order to have a valid option the tenant/buyer must provide valuable consideration for the option. In other words buy the right to purchase at a later date at an agreed amount of money.
The lease option only binds the seller to sell, it does not bind the buyer to buy. That is why consideration is important. Valuable consideration is approximately 1-3% but there is no rule.
The basic elements are
1. Buyer purchases the option, the parties agree to what the cost of the option is.
2. The parties agree to a purchase price. It can be decided that the price will be the appraised value at the time the option is exercised.
3. The length in residential real estate is typically 1-3 years and may start to get longer because of the current credit conditions (spring 2010)
4. How much the monthly lease payment is, whether any of the lease payment is to be credited towards the purchase price reducing the purchase amount.
5. Whether the tenant/buyer will occupy the property or whether the tenant/buyer has the right to sub lease or the right to sell the option.
6. An investor may acquire a distressed property with a lease option and make improvements to the property. Then the investor can sell the option to a buyer that is willing to pay the new market value for a profit. It is a common financing technique with investors.
6.a An example of this. Seller has a property that needs considerable amount of work. Retail buyers typically cannot get financing or have too much to choose from to bother with physically distressed properties. Investor enters into a lease option agreement for let’s say $100,000, rehabs the property with about $20,000 and now the market value is approximately $135,000 the investor can sell the right to purchase for $35,000 and the new buyer would close with the original seller for $100,000
6.b Another example of this would be a buyer buys the same property and uses their own money to rehab and may use their rehab money towards the down payment. This allows the buyer to NOT have to come with a large down payment and rehab money.
Everything functions like a lease except there is a schedule when the buyer can decide to purchase the property.
The terms of the lease have to be negotiated also. The responsibilities of maintenance, utilities, taxes, pets, how many occupants, what type of insurance...
During the term of the lease option, the tenant makes lease payments to the landlord for the use of the property with the terms mutually agreed. At the end of the contract, the tenant has the option to purchase the property outright; the tenant would typically obtain the money to do this using a mortgage.
Excess credit may also be applied towards the eventual purchase of the property, or towards the down payment for a mortgage (CAUTION, the buyer and seller can agree to whatever they want, but when the buyer goes to get permanent financing the bank has guidelines to what can be applied towards the down payment or the purchase. Typically a banks only allow an amount that is above and beyond market rent to be considered for a down payment) In that case, the lease option works as an automatic savings plan for the tenant. This down payment is applied as part of the "option consideration fee"; in the arena of lease option purchasing this is a fee charged for the right to purchase the property.
Reasons for using a lease option
1. Buyer is relocating and may need to sell a property in another area before the buyer can qualify to purchase the new home.
2. Buyer may have had some credit issues that have since been resolved and can afford the payment but needs to time to get permanent financing.
3. Buyer may have started a new business and otherwise qualifies and can afford the payments.
The lease option may carry less risk for the landlord than a mortgage would for the lender. In the event of non-payment, it may be possible to remove the tenants through eviction, which is likely to be cheaper than foreclosure on a mortgaged property. The lease option may also require less money up front, while a mortgage might require a substantial down payment from the tenant.
If the tenant does not exercise the option to purchase the property by the end of the lease, then any up front option money along with any monies that the tenant paid in addition to the market rental rate for this option may be retained by the owner depending on the agreement. This might occur if the tenant no longer wishes to purchase the property, or if the tenant wishes to purchase the property but is unable to obtain the financing required to do so.
Advantages to the seller. Allow the seller to sell a property that they may not have otherwise been able to sell. Most cases a seller can net more money when offering terms to a buyer.
There is an expression, “Price or Terms, Pick One” Usually you get one over the other. So for a seller to get a better price they can offer terms that favor the buyer and the opposite is true. For the buyer to get a favorable price the terms usually have to favor the seller.
Default if the buyer defaults and the contracts are drafted properly then there is an automatic tenant landlord relationship. All valuable considerations are typically surrendered and then it would be an eviction.
Some forms of lease option have been criticized as predatory, if a lease option is sold to a tenant who cannot realistically expect to ever exercise the option. These types are usually but not always advertised as “rent to own”. Owner Carry, Seller Financing, Owner will Carry, Owner Carryback are all terms that can be used for Lease Option purchases.
See also
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