Rent-to-own agreements, or lease purchase options, are alternative names for lease options. It enables you to control property with limited capital required. In the following section, we detail exactly how you can use lease options to aid with your property endeavors. Whether that’s securing your next investment project or securing your dream home with limited money upfront.
- What is a lease option?
- 3 different types of lease options
- Examples of how to use lease options
- Typical terms found in lease purchase options
- Pros and Cons of a Lease Purchase Agreement for Buyers
- What is the first right of refusal option?
- Lease option summary!
WHAT IS A LEASE OPTION?
It enables someone to rent a property for a specified period of time with the promise or option to purchase at the end of the lease term. The owner is contractually obligated to sell the property at the end of the term at a fixed price. Furthermore, depending on the deal structure, the renter has the option or obligation to buy the property at a set date in the future.
3 DIFFERENT TYPES OF LEASE OPTIONS
1) An agreement to buy
This structure locks in the requirement for the tenant to purchase the property. This will be at a given time in the future and at an agreed price, with a penalty if either party backs out.
2) An option to buy
This structure provides flexibility for the tenant to purchase the property within a certain timeframe at a certain price. The owner has committed to sell and cannot pull out. The tenant can opt to walk away at the end of the lease term if they choose to.
3) First right of refusal
The tenant has the right to negotiate the purchase of the property first before it is marketed. This scenario doesn’t have a fixed price or a fixed lease term when the decision must be made. The discussion only starts when the owner decides that they want to sell the property.
What are some examples of lease options?
This strategy can be used for a number of scenarios, including:
If you are unable to get a mortgage on a property.
For example, for a hotel, lenders require a track record and three years of accounts to be able to lend on the property. If you have no experience and no accounts, this method works well. By renting the hotel for 3 years, you gain experience and 3 years’ worth of accounts in order to apply for a mortgage. At which point you can trigger the option to buy, and using some of the profits from the first 3 years to aid the deposit.
Where the deal stacks up, but you don’t have the capital to buy the property at that time.
For example, if you are buying an industrial yard and think there is scope to divide the units and increase the rent achieved for the property. Then leasing the space and adding value will generate a profit margin for the property. This margin will help contribute to the deposit to buy the property when the option agreement is due.
If you’ve found your dream home but are unsure about another aspect, such as price, location, or future plans.
Leasing the property with the option to purchase it in the future provides the best of both worlds. It gives you the ability to control your dream house for the short term, but it also gives you flexibility on whether you want to deploy capital or not to purchase the property for the long term.
TYPICAL TERMS FOR THE DIFFERENT LEASE OPTIONS
An option agreement has two different elements: a leasing section and a purchase section. The letter of intent (LOI) sets out the agreeable terms for both parties to submit to lawyers. The LOI should include the following:
The purchase agreement terms.
Sale date: the day, month, and year when the renter or purchaser will give the seller the agreed sum to buy the property.
Sale price: the amount the renter or purchaser will pay for the property. This might be the property’s current market value plus inflation, appreciation, or another agreeable metric.
Option fee: The sum the renter will pay the owner and when it is due for the exclusive right to buy the property at a given date. Moreover, whether this is a deduction from the purchase price or is non-refundable.
Right to sell the option: whether the renter or purchaser can sell the option right to another party.
Owner default: The consequences if the owner decides not to sell the property.
Buyer default: The consequences if the renter decides not to buy the property.
The lease agreement terms.
This is very similar to a normal lease arrangement, such as the rent, term, and parties, but should also cover the following:
How much of the rent payment are rent credits: what portion of the monthly rent payment, if any, will the owner consider to be part of the renter’s down payment towards owning the property.
Escrow: This stipulates how to manage the security deposit, option payment, and portion of the rent, which are credits towards the down payment during the lease term. In common practice, the parties involved typically set up an escrow account to control the funds until the completion of the purchase.
Right to sublet: whether the renter can sublease all or part of the property.
Modifications: What changes can the renter make to the property?
Lease cancellation: how much the renter will owe the owner, in addition to forfeiting the lease option fee and any additional rent paid, if they break the lease.
Insurance: Who’s responsibility it is to insure certain aspects of the property during the lease term?
Maintenance and repairs: establishing whether the lease is full-repairing, internal-repairing only, or the owner has full liability over repairs until the purchase date. This clause will affect the rent paid.
PROS AND CONS OF A LEASE PURCHASE AGREEMENT FOR BUYERS
The renter will have to accept certain risks in exchange for potential rewards when they enter a lease purchase agreement.
Why investors use lease options: the pros
1) Provides long-term control of the property with limited capital
If they don’t have sufficient funds for a deposit or there are issues with getting a mortgage, you can control the property and secure the purchase price now and build equity over time during the lease period to purchase at a later date.
2) Flexibility and time
It provides tenants with the flexibility to rent a property while having the exclusive right to purchase it at a specified date. This allows them time to improve their financial situation by either saving or increasing the return on investment of the asset. It also gives you the flexibility to “try before you buy.” You can test the location and the returns before you deploy capital. By having a lease purchase option, if your goals for the property don’t work, you can choose not to exercise the option and walk away at the end of the lease term.
3) Rent Credit
In some lease purchase agreements, a portion of the monthly rent may be credited to paying down the future purchase price. This provides investors with the opportunity to pay down the purchase price with cash flow from the property. In some circumstances, it might mean no additional capital is required when the option to buy happens, as the down payment covers the deposit from a traditional mortgage.
4) Locking in the purchase price
Lease purchase options allow tenants to lock in a purchase price at the beginning of the lease term. This can be advantageous as you know the target figure you need to raise in a given timeframe. Furthermore, it gives the potential to buy the property at a lower price than the future market value.
Cons of a Lease options for buyers
1) Loss of money if you default
If you forfeit due to insufficient funds to complete the deal or if the property does suit your requirements. Then the option fee and additional rent payments (if any) to the seller will be lost. Moreover, you may also have penalty charges and need to secure a new lease.
2) Loss of the property if the seller defaults
There are multiple reasons why a seller might not uphold the agreement. If the seller fails to pay their mortgage on the property or other life disruptions occur, like divorce or serious illness, further discussions will be required with banks or family members to ensure the deal is maintained and not lost.
3) The seller is getting greedy
If the home’s value increases significantly over the lease period, the seller might have a strong financial incentive to break the agreement. The contract needs a significant penalty to deter the owner, although if they do exercise the right to forfeit, your damages need to be covered.
PROS AND CONS OF LEASE OPTIONS FOR SELLERS
The property owner will also have to accept certain risks in exchange for the potential reward of selling their home.
Pros of lease options for sellers
1) Sell a tricky property
The preferred path for most owners would be to sell the property right away. If a regular sale is slow, a lease purchase agreement is a good second option.
2) You make a return if the sale falls through
The option fee, possibly excess rent, and the regular rental income from the property are better than having it vacant. These three aspects, combined, provide an above market return for the lease period.
3) Responsible tenant
Someone with a commitment to buy the property will likely take care of it as if it were their own. By having reduced maintenance issues, it provides higher net returns during the tenancy term.
Cons of a Lease options for Sellers
1) Home’s value fluctuations
Locking in a sale price leaves you open to fluctuations in the market. If the market appreciates, you will be down, although if the market drops, you will be up.
2) The tenant could be a nightmare
If the buyer doesn’t take care of the property or fails to pay rent, the owner will need to evict them and revoke the agreement, which can be an expensive, lengthy, and difficult process.
3) The buyer could back out
If property prices drop, there is no guarantee the buyer will qualify for a mortgage at the agreed purchase price. The purchaser would need a higher deposit or would need to back out of the sale. The contract needs a significant penalty to deter the buyer, if they do exercise the right to forfeit, your damages need to be covered.
WHAT IS A FIRST RIGHT OF REFUSAL OPTION?
This option is not as detailed or has as many obligations from the outset. It’s a clause in the lease contract that enables the tenant to negotiate the purchase of the property before it is marketed. The key difference between this clause and lease purchase options or agreements is that it doesn’t have a fixed price pre-agreed nor a fixed lease term for when the decision must be made.
It’s a negotiation at the time when the landlord wishes to sell. The clause can be as simple or as onerous as required. For example, it can include the right to instruct third-party valuers to to establish the market value if both parties can’t agree on the value. At which point, if this value is still not agreeable to the tenant, then the landlord can openly market the property.
This option has less stringent requirements for both parties, although the tenant has no exercisable option to buy the property if the landlord doesn’t wish to.
LEASE OPTIONs SUMMARY
Lease options are a creative way to purchase property. It has the ability to create a win win situation for both the seller and buyer. It generates flexibility in terms for the buyer, creates enhanced rental returns for the lease period, and guarantees a price vendors can plan for in the future.
A big part of this approach is about solving the seller’s problems. It will only work if the seller is open to the method. The best place to start is by discussing it with the seller or the leasing agent, depending on how it is marketed. These talks with the agents will give you a sense of why they’re leasing or looking to sell. Plus, agents tend to be chatty, so you might understand the seller’s pain points. Therefore, figuring out if they’d be open to considering a lease option or not.
It’s important to note that lease options involve specific legal and financial considerations. Investors should consult with a legal team to ensure it is properly documented and compliant with the law. Furthermore, you must completely understand what you are signing up for with a lease option agreement.
