What is lease option?
Lease option is simply a lease with an option to purchase at a later date. It is also called "rent to own". This means that if you can't purchase your dream house, with lease option, you can pay monthly rent, live in your dream house and purchase it later. Some of your rent payment goes towards the purchase of the house. You are not obligated to purchase the house; you just have the option to buy it at an agreed-upon price.
What are the benefits for the seller and the buyer?
Lease option can be a great real estate investment strategy, because it is simple and benefits both the buyer and the seller. It can be a true win/win situation. The seller benefits by receiving the full sales price, positive monthly cashflow, a non-refundable down payment and most importantly, the seller retains the title of the property. The buyer benefits from price protection, no bank qualification, profit from appreciation and of course has the possibility of owning the house in the near future, because some of the rent is put towards purchasing the house.
How can a real estate investor help me?
There are many different sources of finding lease option deals and many ways of getting the lease option deals done. One of many ways is through a real estate investor. If you choose to work with a real estate investor, it is important that you trust this person and have an open communication with them.
Real estate investors are different than real estate agents. They make money through negotiating and arranging good real estate deals. Real estate agents make money from commission, that is, when they arrange the sale of the real estate from the owner to you.
Real estate investors should never pressure you in signing any contracts. They are there to educate you and help you to sell or buy your property.
How do real estate investors make money?
If you choose to work with a real estate investor, it is also important to understand how real estate investors make money in lease option deals. Basically, there are three ways an investor can profit: from the down payment, from positive monthly cash flow and from the sales price. Here is a simple example to illustrate.
Bill is a real estate investor, and he knows that his friend Sally wants to sell her house. Bill explains to Sally how a lease option works, and Sally agrees to lease option her house. Bill presents a contract to Sally that has the following terms:
- Sales Price $100,000
- Down Payment $2,000
- Monthly Payment $700
- Monthly Credits $200
- Term 3 years.
Sally agrees with the above terms and signs the contract. Then Bill looks for potential buyers. He finds Danny, who wants to buy Sally's house. After showing Danny the house, Bill presents a contract to Danny with the following terms:
- Sales Price $110,000
- Down Payment $3,000
- Monthly Payment $900
- Monthly Credits $200
- Term 3 years.
This means that a portion of Danny's monthly payment ($200) will be credited towards the future purchase of the house. If you look at this example, Bill makes a profit from arranging this deal between Sally and Danny.
Bill negotiated that Danny would pay Bill $110,000 for a house that Bill can buy for $100,000. Thus, if Danny exercises the option and buys the house, Bill will have a $10,000 profit.
Bill's cash flow is also helped by this transaction, because up front, Danny will pay Bill $3,000 as a non-refundable down payment. Bill only paid Sally $2,000, so again, Bill makes a profit, this time of $1,000.
Finally, Bill also has a monthly profit of $200 for as long as Danny makes his payments, since Danny is paying Bill $900, but Bill is only paying Sally $700.
Danny's initial $3,000 doesn't get him any right to live in the house and is completely forfeited if he doesn't purchase the house within the three years. So, as a tenant, or lessee, Danny is paying $3,000 before he moves in.
Some of the benefits and risks of lease option
Lease options, if done correctly, can be a reasonable real estate investment strategy. The seller (Sally) benefits from receiving the full price on the sale of his/her property. They also retain their title while they are earning higher than market rents. On the other hand, the buyer (Danny) also benefits by purchasing the house without bank qualification, and a portion of his/her rent every month is going towards owning the house. The investor (Bill) also benefits by generating money without tying up his own cash or credit. In addition, if the property is listed with a real estate agent, that agent benefits by being paid a commission, provided the listing agreement covers the lease option situation.
To fully evaluate whether a lease option is a good choice for the purchaser, it's necessary to compare the situation with a base case. For most people, the usual option is to get a mortgage from a bank and make monthly mortgage payments of combined principal and interest until the house is paid for.
In the given example, if Danny waits the full three years before exercising his option, he will have credits of 36 months X $200 per month = $7,200 + the $3,000 down payment = $10,200. He still has to pay $99,800 to own the house.
Danny should compare this to the situation of making a $3,000 down payment now and borrowing $107,000 from the bank now to buy the house for $110,000 today. However, if Danny's credit score is low and he can't get approved for a traditional bank loan, lease option gives Danny a chance live in his dream house with an option to buy the house in the near future until he gets his credit score up and gets approved for the loan.
How much money will he owe in three years time under each scenario? The result is going to depend upon the interest rate the bank charges, and that is what Danny needs to know in order to compare the lease option to the conventional mortgage.
Sally can do a similar analysis, if she has a buyer who will purchase the house today. She can compare how much cash she will have in three years' time by selling the house now and investing the funds, versus granting the lease option, collecting rent, and possibly selling the house, but only if the buyer exercises the option. However, she has to make a guess, and take a risk, because there is no guarantee the buyer will actually exercise the option. If the market value of the house goes down, the buyer may not purchase it, and she may end up regretting not selling the house now.
The lease option structure is an alternative to the more common type of residential real estate transaction. It has its pros and cons, and each participant should be fully aware of the economics and the legalities before agreeing to it.
Disclaimer: This article is for information and is not a substitute for specific individual professional advice.
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