An old concept has been getting a new look as home sellers have battled a weak market and would-be home buyers have found it difficult to qualify for a mortgage. The “lease option” or “lease with an option to purchase” has been making something of a comeback.
In short, it's a real estate transaction that is a hybrid between a sale and a lease. As with just about any type of option, the buyer pays something up front for the right to exercise the option – in this case to purchase a home that they are renting.
The option payment can be as little as $100 or as much as three to five percent of the agreed upon purchase price. It's money the seller gets to keep, whether the buyer exercises the option to purchase or not.
A way to sell a slow-mover
Very often a seller will agree to a lease option if they believe the property will be difficult to sell. A couple of years ago, when sales were very sluggish, a lot of homes were in that category. Today, with the market improving, homes are selling faster.
That means that if an owner is willing to consider a lease option, there may be something about the property that puts it at a competitive disadvantage to faster-selling homes. It might be a less-desirable location and have a less-than-ideal floor plan. That's something to consider if you are thinking about a lease option.
While the seller gets to keep the up-front option payment, the buyer gets to apply some of his or her rent toward equity, a huge advantage. You are going to pay rent anyway, right? This way some of it goes toward the down payment.
The National Association of Realtors (NAR) notes that the lease option is also a way for a consumer with damaged credit to get into homeownership. Getting a mortgage today is tough enough without having bad credit.
By agreeing to accept the down payment in monthly increments, the seller is actually letting you stay there for reduced rent. However, those payments turn out to be all rent if the buyer decides to walk away at the end of the lease. Even so, these types of arrangements tend to favor the buyer more than the seller, depending on how the contract is written.
In a lease option, whether the buyer follows through on the purchase is totally up to the buyer. If they change their mind, or circumstances change, they can pack up and move when the lease is up. They lose their up-front option payment, however.
If they decide they want to buy the house, they have already locked in the price. At a time when property values are rising, that can be a significant advantage, especially if the lease term stretches over a longer period.
A lease purchase is a different type of arrangement and a buyer needs to be aware one big difference: a lease purchase binds both parties to follow through on the sale agreement. Buyers should avoid these contracts unless they are very sure they want to purchase the property.
A lease option contract, meanwhile, should state what the buyer has to pay for the option, the purchase price, the length of the term, how much the monthly payment will be and how much of it will be credited toward equity for the optional purchase.
Here's an example: the seller may determine that the home's market rental value is around $1,000 a month. For the rent option agreement, she may set the rent a little higher, at $1,100 and apply $200 of that amount toward the purchase. If the buyer follows through on the purchase, they've built up some equity while paying below-market rent over the term of the contract.
Tool for investors
Investors have been a big driver in the real estate market recovery and some of them have used the rent option tool to their advantage. If the property is in need of repair or renovation before it can be approved for a mortgage, an investor may rent the property and make improvements during the lease period. At the end of the term the investor obtains a loan, buys the property and flips it.
While most of the advantages appear to be with the buyer, there are a few for the seller. If the house has been sitting on the market for a while, or you need to generate income from it quickly, a lease option can provide immediate cash flow.
With mortgage standards as tight as they are, you have a large group of people who may see the lease option as their best chance at home ownership. They may be better tenants than you would get ordinarily because they quickly start thinking of the home as their own and take care of it.
Finally, if the buyers turn out not to be buyers but renters, you get to keep the money they paid for the option to buy and the rent premium.
What to do
If you think a lease option might be the right way for you to proceed, either as a buyer or a seller, you should study the question thoroughly. A good place to start is withNAR's Field Guide to Lease Option.