Lease Options have been around for a long time. The basic reason for it is a buyer, although interested in buying a particular home, can’t qualify…just yet. Sometimes the obstacle is a short term problem, and sometimes it is a long term problem. A short term problem could be a credit issue that the buyer is working on and has a solution they are working for and will be achieved in a short period of time. A long term problem could be a bankruptcy, foreclosure, job issue, income issue, etc… These could be short term issues, but mostly are long term issues. These issues need a systematic approach to solving them…a plan, and the buyer must stick to it. I say this because 80% of the buyers using lease options to buy, or so I’ve been told, never exercise their option. In other words, they never buy. If you want to buy the house, and you have one of these issues stopping you, you must have a plan and stick to it.
As far as how Lease Options work, they are a combination of rental agreement and long term purchase. The Rental Agreement is the same as any rental agreement. You put up a Security Deposit, pay rent on time every month, based on the rental agreement you and the landlord signed. The length of the lease can be anywhere from monthly to multiple years.
The Option Agreement is a separate agreement and should never be on the same paperwork as the lease. The reasons are too many to list here. If this is the way as a seller you are interested in moving your homes, you should consult with a L/O expert…I can refer you to one if needed. I have specially designed paperwork for buying and selling on L/O that I stick to at all times. The Option Agreementcan be set up for both short term issues and long term issues. You can set up a 6 month option, or a much longer one…such as 5 years (or whatever both parties agree on). Keep in mind though, as the option period is longer, you should put scheduled increases in the purchase price to reflect inflation and appreciation. When I do it, I use an agreed upon yearly increase as the minimum purchase price. The actual sales price for future years would be either the minimum agreed price or the appraised price…whichever is greater.
The tenant/buyer would put up what amounts to a down payment up front, but it is called an Option Considerationand is usually equal to at least 5% of the purchase price. Now, this is where it can get tricky. If the option term is short, like 12 months, this is a simple calculation. However, if you are looking at a longer option term, like 5 years, what do you use to calculate the Option Consideration? If the sales price per year is increasing each year, the 5% of purchase price at the time of signing will be no where near 5% of the actual purchase price in year five. I’ve seen instances where the percentage of purchase price in year 5 was less than 2% of that price.
Now there are two ways of looking at this. First, if the tenant/buyer were to put up more than 5% up front they would need to come up with more out of pocket funds at the start, but they would have a much larger percentage to use at closing…in other words, less to fund. Second, if the tenant/buyer doesn’t execute the option, that’s more money to lose. Pick your poison.
The Option Consideration can be increased monthly by allowing part of the rent payment to be credited to the Option Consideration. This can be based on a percentage of the actual rent credited to the Option, an increase in rent based on the Option Consideration per month added to the rent, or a combination of the two…an increase in the rent, but the OC would also take part of the original rent amount. The best way to do it is based on the goals and situation of the parties involved.
A great way to use L/O selling as an investor is buy setting up a long term lease period, then after a 6-12 month seasoning period for the renter/buyer, you sell the package to another investor just like you would sell the paper on a loan. You should get a profit upon sale, and the buying investor gets the cash flow, the deductions, and a locked in sale price/profit at the end. Works well for all concerned…and this transaction has no effect on the original lease or option signed by the tenant buyer. The only thing that changes is who the checks are made out to.
As I stated earlier, about 80% of the tenant/buyers actually exercise their option. This means all the option consideration money they put up at the start, and the monthly credits from the rent, are lost for good. This is good for the owner/investor, but not so good for the tenant/buyer. So if this is the way you want to buy a house you must set up a plan to be qualified before the option period is over…and stick to it.