Written by JD Esajian
Key TakeawaysLease options are investing tools that advanced real estate investors can use to sell properties in their portfolios. Renters can use a lease option to temporarily rent a property before deciding whether to buy it. In other words, a lease option is a unique tool that provides both property owners and renters some flexibility. To use lease options successfully, you must understand how they work and what their limitations are. Keep reading to find out how lease options work, their requirements, and whether or not they may be a good fit for you.
A lease option, also called a lease with the option to purchase, is a type of lease contract that lets a renter purchase their rented property either during or at the end of their lease period. Furthermore, a lease option prevents an owner from putting the property up for sale or selling it to another person during the lease’s term. After the lease’s term expires, the renter must either forfeit the option to purchase the property or exercise the option and purchase the property.
In a nutshell, a lease option lets a potential property buyer flexibly rent a property from an investor/owner without having to buy it at the end of the lease period. Unlike the terms of a regular lease-purchase agreement, a lease option allows the renter to forfeit the option to purchase the property if they want to move on. A property’s price is typically agreed upon upfront by the renter/prospective buyer and property owner at the start of the lease option arrangement. Prices are also usually at the current market value for the home or property. This can be beneficial for the prospective buyer, as it means they may purchase the home for less than the current market rate by the end of their lease term. However, to exercise the lease option, renters are often charged fees by the owners, such as up to 1% of the home’s total sale price.
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On their face, lease options are trade-offs for property owners or investors. They may end up being required to sell the property to the renter at a lower price than they’d be able to secure if they sold the property to another buyer when the lease term ends. In exchange, tenants must pay more rent than they would normally. Additionally, lease options have several requirements for a tenant to qualify. A lease optioned property owner will charge a premium in addition to regular monthly rent. This can either be a percentage added to the normal rent price or another type of fee. However, this premium, called the rent credit, usually becomes part of the down payment for the property if the tenant exercises the option to buy the home from the property owner.
Some banks may not let the above premium or rent credit be used for the down payment if the tenant purchases the lease optioned home. This normally occurs if the rent was charged at the at-market rate. Buyers should therefore check with multiple banks when leasing a home with the intent to enter a lease option agreement. Lease option terms are typically between one and three years, although they can be whatever timeframe the property owner and renter agree upon. The lease option contract must state the property’s eventual prospective purchase price. This purchase price will stay the same regardless of how at-market rates may rise or fall in the interim.
Naturally, lease options are excellent deals for tenants who don’t mind paying a little extra rent in exchange for the option to purchase the home at the end of their lease agreement. The lease option also gives them flexibility in that they aren’t forced to purchase the home at the end of the lease term – they can walk away if they find another option or life circumstances force them to reconsider. Furthermore, renters may enter a lease option arrangement if they don’t have enough money to make a down payment at the moment. By renting, they can save enough money to make the down payment while benefiting from the premium credit (which will hypothetically lower the down payment required to purchase the property).
Renters benefit even more because they can buy the property in the future at earlier market prices. They will not have to worry about the market rate increasing in the future. Owners may also decide to enter into a lease option for separate reasons. For example, a property owner could have difficulty selling a house outright but could easily secure renters. In this way, they can still get income from the house and still have the possibility of a full sale later down the road. Additionally, property owners get to charge rent at a premium (or rent at a price above the current market rate) to their tenants. This results in more short-term profits. If the renter doesn’t buy the house, they get to keep the premium funds since they aren’t put toward the down payment for the house. Entering a lease option agreement could also be strategic on the property owner’s part. For example, if there are tax problems involved with selling the property at the moment, they can wait for the tax issues to clear up and potentially sell the property later.
Be sure to consider renter’s insurance and homeowner’s insurance. Renter’s insurance should be held by the renter and protects any loss of value for personal belongings and furnishings. The homeowner should have their own separate insurance policy to protect the home value in case anything adverse happens during the lease term, such as a fire or water damage.
Also make sure to include an appraisal contingency in your lease option agreement. The appraisal is used to calculate the exact amount owed to the property owner at the end of the lease term before the sale goes through. By enforcing an appraisal, an updated home value and price will be established, just in case the home value increased or decreased during the time of the lease.
Suppose that there’s a landlord with a home valued at $400,000. It already has a tenant looking to buy a home in the future. Since both parties find the current real estate market grim, the landlord offers the tenant a lease option.
In this case, the buyer-tenant pays an extra 3% of the total house price as a fee for the lease option. They also pay a premium on their monthly rent. They then have the option to buy the house they currently live in two years in the future at current market prices. The premium credit rent goes toward the eventual down payment.
There are several ways in which you can use a lease option to creatively invest in real estate.
You could offer a straight lease option. In this scenario, you will become the owner or lessor of a property. You’ll find a tenant-buyer, enter the lease option agreement with them, then either sell the property eventually or cycle through more tenant-buyers until you find one who eventually makes the sale. You can also be a lessee, in which case you will still act as the investor. In this scenario, you’ll sign the lease option agreement with the property owner intending to sublet the property to another person.
The property owner, meanwhile, charges you the lowest rent possible. You and the property owner can split the difference in cash you get from your subletting tenant. More advanced investors can potentially try a “lease option sandwich” strategy, in which the investor acts as a lessee and finds the property where they can secure a lease option from an owner. Then the investor finds an excellent tenant looking for a rent-to-own arrangement. The investor signs the potential tenant with a lease option for the same property, keeping the difference in cash.
As you can see, lease options are a viable means of getting into the real estate investing market and good options to pay for a home if you don’t currently have enough cash for a down payment. Consider the above strategies carefully and always remember that a lease option can also be risky – if you’re the lessor, you’re on the hook for selling your property to your tenant if they exercise the option to buy it at the end of their lease’s term!
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