A lease option is widely considered by today’s real estate investor community to be a tool; one that simply increases a person’s ability to acquire a property. This alternative form of financing makes it easier for more people to buy homes that they would have otherwise had to pass on.
Wondering if this powerful financing strategy is one that might benefit you and your business? Keep reading to learn more about lease option contracts.
A lease option is an agreement made between a tenant and their respective landlord which gives renters the option to purchase the property at some point, either during or at the end of the lease. As their names suggest, however, lease options do not guarantee the renter will purchase the property; they simply give them the option to at the end of the predetermined term. Prior to the lease expiring, the renter must choose to exercise the lease option or forfeit the right to purchase the property.
[ Want to own rental real estate? Attend a FREE real estate class to learn how to invest in rental properties, as well as strategies to maximize your cash flow and achieve financial freedom. ]
On the surface, a lease option agreement is a simple transaction between buyers and sellers. In fact, a lease option contract isn’t all that different from a regular lease. However, there are several elements in a lease option that aren’t in a traditional sale, these include:
The Buyer Exercises The Lease Option: Buyers will typically have to purchase the right from the seller to exercise the lease option. The price is usually somewhere in the neighborhood of 5% of the value of the home, and not considered a deposit. Purchasing the option will allow the buyer to exercise their right to buy the property.
Set The Duration Of The Lease Option: The duration of the lease option is decided upon by both parties, and is often anywhere from one to five years long.
Both Parties Agree On A Purchase Price: Both parties will need to come to an agreement on the purchase price. Instead of placing a value on the home at the time the option is purchased, however, the purchase price is usually contingent on the duration of the lease option. More specifically, the purchase price is often the appraised value of the home at the time the option is carried out.
Monthly Lease Payments: The monthly lease payments, also agreed on by both parties, is typically equal to or slightly above the fair market rent of the property. Some lease options will credit some of the monty rent towards the eventual purchase, so it’s quite common for the monthly rental obligations to exceed the fair market rent.
Determine The Occupants Of The Property: Terms must include who will reside in the property. While the renter is usually going to be the tenant, there’s always the chance the renter is an investor who will sublease the home. Therefore, it’s important to determine (beforehand) who will live in the home as the option is being carried out.
Investor Intervention: It’s entirely possible for real estate investors to acquire a distressed property with a lease option. The investor may then sell the lease option to a subsequent end-buyer that is willing to pay the latest appraised value on the home.
Let’s say a renter decides that they finally want to buy their first home, but are having a hard time coming up with a significant down payment. Exercising a lease option may be just the opportunity they need. A lease option will allow the renter to take steps towards homeownership without having to put down a significant amount of money up front.
Instead of the 20% down payment that has become synonymous with traditional mortgages (without private mortgage insurance), renters using a lease option are typically only required to put down about 5% of the home’s value at the time the option is exercised. On a $200,000 house, for example, the renter/buyer will only be expected to come up with about $10,000, which counts towards the purchase price of the home. Meanwhile, a traditional lease option will require renters to pay monthly rent obligations that exceed fair market rent prices. That way, the renter may cover the current owners mortgage and accumulate rent credits, which may be credited to the eventual purchase.
For example, if the owner’s current mortgage is $1,600 a month, they may ask the renter to pay upwards of $1,900 a month. That way, the renter will be covering the mortgage while contributing $300 to their purchase credit. Once the lease option term is complete, the rent credits will be applied to the purchase of the home.
There are a number of reasons both buyers and sellers may want to consider using a lease option. However, most buyers and sellers agree to sign a lease option contract for one reason more than just about any other: the absence of the “middleman” (traditional banks). In exercising a lease option agreement, the buyer and the seller agree on terms they deem appropriate. It is worth noting, however, that a real estate lease option also coincides with several benefits for buyers and sellers, not the least of which may be found below.
Lease option terms are mutually agreed upon by both buyers and sellers, which bodes incredibly well for each side of the transaction. However, buyers may find the scales tipping slightly in their favor when lease option terms are agreed upon. Lease options are typically exercised when buyers can’t afford to come up with a large enough down payment. In fact, most homeowners are willing to consider a lease option to simply help their renters.
That said, there are several other benefits, the most noteworthy being the approval criteria. Unlike strict bank requirements, lease options don’t require the borrower to have an immaculate credit history. Lease options make it easier for borrowers with less-than-perfect credit to buy a home.
Investors, on the other hand, appreciate lease options for an entirely different reason: owner financing contributes to the myriad of financing options already made available to today’s buyers. With an additional means of acquisition, buyers increase their odds of securing funding.
Sellers benefit from lease options when potential buyers find themselves with more ways to buy a deal. More importantly, however, buyers enjoy the flexibility that is awarded to each party. The mere option of owner financing awards buyers one more way to facilitate a transaction, which bodes incredibly well for sellers. A seller’s priority is, after all, to sell a home, and owner financed mortgages give them one more way to do so. As a result, owner financed mortgages have served as a vehicle to attract more buyers.
A real estate lease option isn’t all that different from a traditional lease, up until the option is actually purchased. For the majority of the time, the tenant/buyer is simply making payments to the current owner. However, things tend to get a bit confusing as the term comes to an end. As a result, here’s an example of what a lease option looks like from beginning to end:
Find A Homeowner Willing To Exercise A Lease Option: In order to set up a lease option, hopeful buyers must first identify viable candidates. Fortunately, there are many homeowners that will advertise their willingness to allow renters to enter into a lease option agreement. However, some homeowners may need to be convinced that a lease option is a good idea. As a result, seeking buyers may want to look for homes that have been on the market for a while (more than six months), as their owners may be more likely to consider going the “rent-to-own” route.
Research The Home & Its Seller: With a subject property in mind, investors must then proceed to research the home and its seller. Start by uncovering why the owner is willing to exercise a lease option. Whether they recently bought another property and need to rent their current property out or they are in financial trouble, find out why they are selling. It’s important to know their financial position, as distressed homeowners pose a serious threat to renters. Anyone looking to exercise a lease option will want to enter into an agreement with someone that’s not at risk of losing their home. Pay special considerations to red flags and ask for a credit check and tax records. At this time, buyers will want to run a title report, have the home appraised and inspected.
Negotiate Lease Option Contract & Terms: Once investors are confident in both the property and the current owner, they’ll need to begin to negotiate contract terms. Negotiations need to touch on the purchase price, which is usually set at the fair market value of the home when the lease option term ends. In addition to the purchase price, buyers will also need to purchase the option, which is usually about five percent of the home’s value. The contract will also set the duration of the leasing term, which typically lasts two to five years, at the end of which the buyer will be given the choice to exercise the option. At this time, both parties will also decide on monthly payments that will take place over the duration of the lease. Once everything is in writing, it’s a good idea to have a qualified lawyer review everything.
Execute The Contract At The End Of The Term: If the buyer wants to exercise their option to buy the home at the end of the agreed-upon term, they will need to purchase the option (which is usually five percent of the home’s current market value). With the contract purchased, the rent credits will be applied to the purchase, and the buyer will most likely need to secure a loan for the remaining balance.
Lease option terms are almost entirely negotiable, which makes it nearly impossible to pinpoint universal standards. However, there are some terms that are more common than others:
Variable Down Payments: Sellers tend to ask for down payments that will compensate for the risk they are taking on. That may mean a larger down payment under the certain circumstances, or they may be ok with a down payment as low as five percent. Either way, the down payment must be agreed upon by both parties for the lease option to be exercised.
”Shorter” Loan Amortization Periods: While traditional banks tend to offer loans as long as 30 years, lease options are much shorter, often around the three to five year range, wrapped up earlier with a balloon payment if the terms deem as much.
Balloon Payment: Most sellers will require a balloon payment before the loan is paid off completely. When the payment is made over the course of the loan will differ, but it’s quite common for lenders to request at least one sizable payment.
Higher Than Fair Market Rent: Renters will be expected to pay more than the fair market rent of the property. Doing so will give renters credits that they can later apply to the purchase of the home when the lease option terms are up.
Promissory Notes: Most lenders (homeowners) will require their borrowers to sign promissory notes. As their names suggest, promissory notes represent a borrower’s intent to pay back the loan, and disclose any penalties that may be incurred if the terms are not fulfilled. Due to the sensitive nature of promissory notes, sellers will typically enlist the services of legal professionals to secure their loan.
While not as popular as other forms of creative financing, the lease option has helped many prospective buyers become homeowners when every other option is exhausted. As a result, lease option contracts have developed a reputation for serving as an alternative source of financing. Nonetheless, these agreements between buyers and sellers have become a powerful tool. Those who know how to execute them will likely find it easier to acquire properties. At the very least, the more means one has to acquire a home, the better off they are.
Lease option real estate deals can easily help both sides involved in a deal.
Renters who lease with option to buy real estate may in a unique position to take advantage of a great deal.
Lease option home listings exist, as long as prospective buyers know what signs to look for.