Lease Options

Definition and Overview

Lease options, also known as rent-to-own agreements, are a form of creative financing in real estate. This arrangement gives a tenant the option to purchase the property at a predetermined price within a specified timeframe. During the lease period, a portion of the rent may be credited towards the eventual purchase, providing the tenant with an opportunity to build up equity while testing out the property before committing to ownership.

When to Use This Strategy

A lease option is a flexible method that is easy for both the buyer and seller to exit. It is commonly used in situations where a buyer wants to purchase a property but is unable to qualify for traditional financing. This strategy allows the buyer time to save more money or improve their credit score.

Step-by-Step Implementation Process

1. Agreement: A contract is established between the owner and the buyer, allowing the buyer to lease the property for a specified time with the option to purchase it at a pre-agreed price.
2. Option Fee: To show good faith, the buyer may put down a "non-refundable option fee," typically 3 to 10 percent of the purchase price. This fee can be applied to the eventual purchase.

Benefits and Advantages

• Flexibility: It is the most flexible method and is easy for both the buyer and seller to exit.
• Buyer's Option: The buyer has the option to buy but is not obligated to do so.

Risks and Warnings

• Seller's Obligation: The seller is bound to sell the property if the buyer decides to exercise the option.

Alternative Definition

A lease option gives the renter a choice to purchase the rented property during or at the end of the rental period at a specified price. A "rent-to-own" agreement is a type of lease option where renters will rent for 3-7 years and have the option to buy the house, which allows them to build their credit.

Calculations/Formulas

While specific formulas for lease options can vary, the following general real estate investing rules can be applied to assess the viability of the deal:

• The 2% Rule: This rule helps to quickly screen potential rental properties. It states that the monthly rent should be at least 2% of the purchase price. For example, if a property is purchased for $100,000, the monthly rent should be at least $2,000.

• The 50% Rule: This rule helps to estimate the profitability of a rental property. It suggests that, on average, 50% of the income a property generates will be spent on operating expenses (excluding the mortgage payment). These expenses include taxes, insurance, utilities, repairs, and vacancy.

• The 70% Rule: This rule is often used by house flippers and wholesalers to determine the maximum allowable offer (MAO) for a property. It states that an investor should pay no more than 70% of the after-repair value (ARV) of a property, minus the cost of repairs.

Common Mistakes to Avoid

• Not Having a Written Agreement: A verbal agreement is not legally binding. It is essential to have a comprehensive written lease option agreement that is signed by both parties.
• Failing to Conduct Due Diligence: The buyer should always conduct a thorough inspection of the property and have a title search performed to ensure there are no liens or other encumbrances.
• Not a Realistic Purchase Price: The purchase price should be fair and realistic for both the buyer and the seller. An inflated purchase price will make it difficult for the buyer to obtain financing when the lease term expires.
• Ignoring the Seller's Motivation: Understanding why the seller is offering a lease option can help the buyer negotiate a more favorable agreement.

Real-world Application Scenarios

• A first-time homebuyer with a low credit score: A young couple wants to buy a home but doesn't have a high enough credit score to qualify for a traditional mortgage. They find a seller who is willing to offer a lease option. This gives them a few years to improve their credit while living in the home they want to buy.
• An investor who wants to test the market: A real estate investor wants to buy a property in a new market but isn't sure if it will be a good investment. They use a lease option to test the rental market and see if the property will be profitable before committing to the purchase.
• A seller who wants to attract more buyers: A homeowner is having trouble selling their property in a slow market. They offer a lease option to attract a wider pool of buyers, including those who may not qualify for a traditional mortgage.