The Lease Option for Sellers
What is a Lease Options?
Before I begin talking about the advantages and disadvantages of doing a lease option for sellers I should explain, briefly, what a lease option actually is.
When an owner decides to do a lease option he is actually making the decision to sell a home to a person on a delayed sale. What he is doing is selling the home to someone who will occupy the home before actually buying the home. The person who wants to buy is like test driving the home before actually committing to the purchase.
A lease option is also known as a rent to own or, in some cases, lease to buy. This is not to be confused with a lease purchase.
A lease option has many pros and even some cons to it. When you decide to sell a home on a lease option you are committing to a sale that you must be okay with … in the future. It is a contractual agreement by all parties.
In a lease option, there are a few things you must be aware.
The first term to be established is the purchase price. This is the price you are selling the home. It must be a locked in price.
I have done many deals before I became an agent where this value was a vague value. Either being set at the market price at the time of the purchase or some hybrid of set price and market price.
With any contract, there can not be any ambiguity. Both parties must have exact terms in order for a contract to be enforceable. I am not an attorney nor have I even played one on TV. Consult with your attorney on what I have said. If she tells you otherwise then ignore what I just said.
Regardless, if there is a set price then what price should you agree to? The easy answer is the price that both buyer and seller say “yes” to.
Some sellers look at adding some appreciation to it if the values in the local market are on the rise. The average appreciation rate pre-recession can be estimated to be 3 – 5%.
I feel in recent years, post-recession, that the values have risen about the same starting at the lows since the recession.
The second thing that needs to be agreed upon is the length of the contract.
Most lease options that I have experienced are for 2 or 3 years. I have seen shorter time frames but this is what I see as an industry standard.
The reason you don’t see too many over 3 years is due to the unpredictability of market fluctuations over that period of time. A market can take a huge nosedive of soar in that period of time. Durations longer can hurt either party very significantly.
If you are going for a long period of time it is best to have a two-year contract with a right to renew at that time and have it open for renegotiations of all terms depending on what is going on at that time.
You will probably not want to go less than two years because of the following reasons:
- Most people need two year job history in order to get a loan. If they just moved to town or started a new job then this is a loan restriction.
- When someone has filed bankruptcy they will also need two years before they can purchase a home.
- When someone has collections or divorce it usually takes a year or two to get stable again.
My best advice is to do a two-year contract with rights to renew or extend with new terms being set at or near the time of renewal.
The next thing a tenant/buyer and owner has to agree upon is what is known as the option payment. This is the amount of money the tenant/buyer pays the landlord/seller to have the right to buy the home.
The buyer wants this to be as low as possible. The owner wants as much as possible. What is the best amount?
First of all that is always something that will fit for both parties. The buyer has to be serious when this amount is put down. The seller wants to be sure that this person is going to buy before he or she takes the home off of the market for the two or so years as described above.
In my years of experience if the buyer and seller are working directly with each other then between 3 and 5% is a good number. If a REALTOR® is involved then that could increase the number in order to compensate them.
When the number gets too high then I would suggest going the route of seller financing.
This amount should also be given back to the buyer when they buy, but only if they buy. This is much like an option strike price in the stock market.
If the buyer does exercise and buys they will have this toward their down payment and closing costs. Most loans for FHA start at 3.5% or conventional at 5%. With the inclusion of the rental credit, described below, the buyer could be getting into the home with little to no additional money out of pocket.
Rental Rates and Rent Credit
Most lease options are based on the local rental rates plus a couple of hundred dollars. This extra amount is called a yield spread or a rent credit.
The rental credit is an extra amount of money that will be given back to the tenant/buyer when they decide to purchase the home. Count it as an extra incentive.
The tenant/buyer gets extra money every month that will be used toward their down payment or closing costs.
In most cases when a tenant decides to exercise their option and purchase they are most likely trying to qualify for an FHA loan with 3.5% down payment. Or a conventional loan around 5% down payment.
As mentioned above with the option payment and rental credits combined the buyer could be purchasing the home with little out of the pocket expense.
You may now ask what is the upside to doing a lease option.
For an owner, this is a great investment technique. You will get a higher Return on Investment (ROI) than on a normal rental.
Let us look at this from a strict cash flow perspective.
When an owner rents a home he will get something like the following. Let’s look at two different scenarios (one rental, one lease option). We are going to assume the following is true.
- Today’s home value: $200,000
- Market rental rates: $1200
- Assumed appreciation in the market: 5% per year
Renting Home to a Renter
Most landlords charge a security deposit in about the same as a month’s rent.
Thus, a tenant moving into a home is paying $1200 security deposit and another $1200 for the first month’s rent.
Thus, they are paying $2,400 for keys and are now on a one year lease.
Renting Home to a Lease Option Tenant/Buyer
As described above and using the above estimates you and the tenant/buyer agree to the following. We will assume no REALTOR is involved as this will be discussed in another Article.
- A purchase price of $220,000. This is from $10,000 per year of assumed appreciation.
- Option payment of $11,000 (5% of the set price — $220,000 * .05)
- Monthly payment of $1,400 per month to include a $200 credit being applied toward the purchase of the home if they exercised their option.
This makes their total move-in cost of $11,000 + $1,400 = 12,400.
If they bought the home then you got the $1,200 market rent just as you would have if you just rented the place.
Plus, when they exercise you got $20,000 more.
What If They Don’t Exercise?
Don’t do a lease option with the hopes that they will fail. That is just bad karma.
But, over 80% of the people who do a lease option actually do not buy. That is just the truth.
Thus, if they don’t buy and let’s say they are in the home only 20 of the 24 months to keep the math simple.
Your return would be …
$11,000 + 20 * $1,400 = $11,000 + $20,800 = $31,800.
If they rented from you and assuming they left the home in good condition thus you are giving back their full security deposit you would get …
20 * $1,400 = $20,800.
Thus, you can see the lease option would be the best way. Even if they did buy you still got the $20,800 in rents for those 20 months. Plus the $20,000 in appreciation.
Other Advantages to Owner
There are still other advantages to doing a lease option versus a rental.
The main one is “attitude”. You may ask how does attitude affect these types of deal.
I am glad you asked. Let us look at these two different scenarios from an attitude perspective.
Renter 1 is a normal renter and is only paying a security deposit versus Renter 2 who has an interest in buying the home in the near future.
Who do you think would take better care of the home. The person renting or the person trying to buy the home and has given a sizeable amount of money to move into the home? Given all other things being equal who would you rather rent to?
Advantages to Tenant/Buyer
This is a long question that can be better addressed by reading the article The Lease Option: The Buyer’s Perspective.
Disadvantages to Owner
There is only one big disadvantage. This is mainly future greed.
And this is seen if the market were to take off much higher than originally anticipated. What if the above home actually went to $260,000 in value? This means the owner lost out on about $40,000 in profits.
I would say do not look at it that way. Nobody can predict the future. Anything can happen at any time. The home could have shot up to $260,00 or plummeted to $150,000. You can never know and that is the truth in any forms of investing.
The way to look at it is if you are going to do a lease option then you must be okay with whatever happens in the future. If it went up high then great for the tenant/buyer. They received some equity when they bought. You, the owner, still got your profit.
If it went up and they didn’t buy then you got additional profit and a great tenant.
If the market went down then you had an insurance policy on the fall and you can renegotiate with the tenant or hold true to the original contract.
A lease option is a great way of renting out your home. It is a great tool with a great way to make a high ROI on your investment while still helping someone buy a home. What better karma is that.
You need to know your numbers and be in the game not only to make a profit but also to help a tenant buy their next home.