I’ve recently consulted with several buyers and sellers in the Kansas City Northland who were considering entering into Lease Option agreements. Depending on your situation, this may, or may not be a possible solution. It’s important to understand the mechanics, benefits and downsides to this type of arrangement before plunging into one. Hopefully this will help.

What is a Lease Option?

A Lease with Option to Purchase is a lease that gives the Lessee (Tenant) the right to purchase the property at an agreed-upon price under certain conditions.

To simplify, think of a Lease Option Agreement as two seperate documents. The Lease (rental agreement), which spells out the terms and conditions under which the Lessee will rent the property from the Lessor.  And the Option, which spells out the agreed upon price that the Lessee may purchase the property and the time period the Lessee has to purchase the property.

      Example: Abel leases property with an option to purchase. He must pay $500 per month rent for 12 months: at any time during the rental period, or after an agreed up period of time, he may buy the property (but is not forced to buy) for $100,000.

Typically, Abel would be required to pay consideration (anything of value given to induce entering into a contract; it may be money, personal services, a product, etc. Typically money in the amount of 3-5% or more of the agreed upon purchase price.) In a properly structured Lease Option Agreement, if Able elects not to exercise his Option OR is unable to exercise his Option, he would forfeit his consideration. This compensates the owner for keeping the property off the market during the term and for locking in the purchase price, regardless of whether home values increase.

Since we have a Lease (rental agreement) we also need to have a security deposit from our tenant. Usually, this is an amount equal to or slightly less than the monthly rental amount. I like to set the security deposit at $25 higher or lower than the rent amount to avoid confusing this with the rent.

When we structure our Leases we don’t mention or refer to the Option agreement. It’s a totally seperate agreement. However, our Option agreement does include language that says if the terms of the Lease are not fullfilled, the Option becomes null and void.

Why Consider A Lease Option?

For sellers: A Lease Option can provide debt relief and allow you to move on with your life. If you’re faced with two mortgage payments, or are unable to sell for some reason, Leasing Optioning your home can be a good alternative. I prefer Lease Options to straight Leases (rental agreements) for several reasons. Your tenant/buyer is acting as a future owner so chances are they will take better care of the property and pay on time. Because more money is put down, there’s more to lose by defaulting. Tenant/Buyers will sometimes even make improvements to the property in anticipation of eventually owning the home.

 When I put a tenant/buyer into a property, I also explain that they are responsible for day to day maintenance items (sinks, toilets, minor repairs, etc.) while I remain responsible for the major systems of the house (roof, furnace, a/c. structural, etc.) With a straight rental, I’m responsible for any day to day maintenance issues.

For buyers: It provides the opportunity to “test drive” a home before buying. The Option Consideration locks in the price during the term and gives the exclusive legal right to purchase the property, but doesn’t require it. If the Option is exercised, all of the money down usually goes towards the purchase. Since the price is locked in, buyers profit from any appreciation during the term. No upfront loan qualification is usually necessary. It allows additional time to save down payment monet, fix credit problems, etc. while actually living in the house. Many buyers have enough income to afford a home but aren’t yet ready to obtain traditional financing. Also, no taxes to pay during the Lease term and a quick move in. Buyers also have the benefit of having their rent work for them by earning rent credits towards the purchase of the home.

For investors, Lease/Options can be profitable and provide a great service for buyers looking for a place to call home. Many investors have built profitable businesses from Lease/Options alone.

Downsides and Risks

Some of the down sides for sellers are the possibility that the tenant will tear up the house and may not eventually qualify to purchase the home. You may have to evict and you may have periods of vacancy and some repair expenses. One note for sellers; if you have an adjustable rate mortgage, be sure to review the terms of your mortgage and understand when the note adjusts, how often it adjusts and how much it adjusts and plan accordingly.

It’s important that buyers carefully review the paperwork before signing. I saw a Lease/Option once that basically said the seller had the right to sell the home to another buyer at any time with just a 30 day notice. The tenant in this example, would have lost the right to buy the home and been forced to move on short notice if the seller decided they wanted to sell to someone else. The tenant was prepared to put down a large amount of consideration and finish the basement. If they had, and the seller sold to someone else, well……….. it could have been ugly. An animated discussion at the least.

Another risk for buyers is the homeowner not making the mortgage payments and the buyer being forced out by foreclosure. I’ve talked to several tenants who were unfortunately put in this position. One solution is to have a third party collect the rent payments and forward the appropriate amount to the lender.

Seek Help if Necessary

While this can be and often is a win/win for sellers and buyers, guidance and due diligence are important. Unless you’ve done this before or know someone who has successfully, it’s important to consult with a professional.  A licensed Accredited Consultant In Real Estate, Attorney, or both will help you navigate and troubleshoot.

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