Lease-options: a Different Way to Buy and Sell Property

By: Mark Sumpter

Are you having difficulty selling a property? Would you like to buy a home or an investment property but you don't have enough cash for a down payment?

If you answered yes to either question, a lease with option to purchase (lease-option) can solve your problem. But it's important to understand the pros and cons of lease-options to maximize your benefits.

A lease-option is a combination real estate rental, sales, and finance technique. It is a property lease for a fixed time period, such as 12 or 24 months, with an option for the tenant to buy the property at an agreed option price during the lease term. (Lease options are sometimes also called 'land contracts.')

In general, the lease-option technique is one of the quickest and least expensive methods available to investors for buying and selling real property. The purchaser is not required to conform to the various underwriting guidelines that banks and other lenders require. The seller, unlike an underwriter working for a mortgage company, requires little in the way of documentation. The seller providing the financing doesn't care where the money for a down payment comes from as long as it comes from somewhere. After all, to the seller cash is cash.

Buyers like lease-options because little up-front cash is required. Sellers also like lease-options because they provide necessary cash flow to pay the mortgage and property taxes from a tenant who has a vested interest in treating the property well and who is likely to buy it.

A lease-purchase is different from a lease-option because it obligates the tenant to purchase the property at the end of the lease. With a lease-option the tenant has the right, but not the obligation, to purchase the property.

With both, however, the tenant usually pays an above-market rent and receives a monthly rent credit toward the down payment. And, of course, both a lease-option and a lease-purchase obligate the seller to sell the property at the previously agreed-to terms.

What hurdles will you face? It should come as no surprise that the biggest obstacle to a lease-option transaction is often the real estate agent. The reason is the agent receives only part of their commission up-front at the time parties enter into the lease-option. The commission balance is paid when the option is exercised. Many agents who can't afford to wait for part of their commission don't realize a lease-option is better than no sale at all.

Advantages for Sellers
Unless your property is located where there is very strong demand from buyers, lease-options can be especially advantageous for home sellers.

Primary property seller advantages are:

* Strong Demand from Prospective Buyers: No matter how slow the local market might be, there is almost always good demand from lease-option buyers. Many prospective home buyers can usually afford the monthly payment but they often have insufficient cash for a down payment. The lease-option solves this problem by giving the tenant-buyer a rent credit toward the down payment. In addition, the tenant-buyer usually pays up-front, nonrefundable consideration for the option; typically several thousand dollars.
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* Top Dollar Option Price: Because of strong buyer demand for lease-options, home sellers can often demand and get top dollar for their properties. Usually the option price is set at the market value when signing the lease-option. If the market value of the home goes up during the lease-option term, the buyer benefits. If the property drops in value, then the tenant typically doesn't complete the purchase. (That's an advantage of a lease-option; there's no obligation, just the right.)
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* Higher Quality Tenants: During the lease-option, the tenant-buyer usually takes good care of the property; after all, they're hoping to own it someday. The average lease-option tenant will take much better care of the property than a typical renter will.
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* Above-Market Rent: Another seller advantage is earning above-market rent. Landlords can usually charge tenants 10 to 20 percent above market rent levels.
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* Seller Keeps the Tax Deductions: During the lease-option period, the seller retains all the property income tax deductions. If a tenant complains about not receiving any tax benefits, a reminder about the rent credit toward the down payment usually ends the discussion.

Advantages for Buyers
Lease-option benefits aren't one-sided deals. Advantages for buyers include:

* Small Amount of Up-Front Cash Required: The amount of up-front cash needed to acquire a home or other property on a lease-option is usually small; often just a few thousand dollars for the first month's rent plus non-refundable option consideration. This option money is in lieu of a security deposit.
* Monthly Rent Credit Builds a Down Payment: The unique characteristic of a lease-option is the rent credit toward the buyer's down payment. Typically, the rent credit is 10 to 100 percent of the monthly rent, depending on how motivated the seller is to sell. The higher the rent credit percentage, the greater the probability the tenant will buy.
* 'Try Out' the Property before Buying: Another special lease-option benefit for the tenant is the ability to try out the property before buying. If it turns out to be undesirable, the tenant hasn't tied up a large amount of cash in a home that might be difficult to resell.
* Control Property with Very Little Cash: Buyers enjoy great leverage; they have the ability to control a property and profit from its market value appreciation with very little cash. Lease-option buyers have this unique advantage.
* Longer Terms Mean Greater Profitability: Although most residence lease-options are for short terms, such as one or two years, smart investors seek lease-options with the longest possible term. They assume the property is likely to appreciate in market value over the long term.

As a seller, you should try to collect the maximum amount of option money you can. The more the buyers or tenants have invested in your property, the better they will take care of it. And, if they decide not to exercise their option, you'll keep the option money - so the more you get down, the more you keep.

The amount of the premium will vary depending on where your property is located. In general, an option premium can range from $1,000 to $10,000. Your goal will be to charge what the market will bear in your particular area.

As a buyer, on the other hand, your goal will be to pay as low an option premium as possible. Why should you invest more than you have to? Then, if the property appreciates in value, when you exercise your option your profits will be greater. In effect you can build equity in the house while you're leasing it.

To help you understand the process, here's an example of a lease-option. A buyer has signed a lease-option agreement for a single-family house that gives him the right to purchase it at any time during the next twelve months. (Again, he doesn't have to buy the house; he has the right.) He agrees to purchase the house for $100,000, and he gives you a $2,000 option premium. If you give the buyer $100 in credit towards the purchase of the house from each month's rent payment, at the end of the 12-month option period the buyer would have accrued a total of $1,200 in credit that could be applied toward the purchase price. (If you wanted to be more generous and offer the buyer $200 per month in credits, you could simply increase the price of the house by a corresponding amount.)

If he exercises his option at the end of the 12-month period, then his purchase price for the house is $98,800. If he doesn't exercise the option, you keep the credit towards the purchase and the option premium (if your original lease-option contract is written that way).

A lease-purchase works in a similar way, except the buyer has entered into a contract to purchase the house; he simply hasn't completed that purchase. If the lease-purchase contract is for 12 months, at the end of 12 months he must purchase the home or he is in default. You keep the option premium and any credits he's accrued if he defaults.

The lease-option technique is similar to a purchase option in that it grants the right to investors to purchase property at a predetermined price within a predetermined period of time. The lease-option technique, however, combines the basic lease or rental agreement with an option to purchase contract. Whether you are a buyer or a seller, lease-options provide greater flexibility in structuring transactions while simultaneously reducing your level of risk.

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