A Rent to Buy / Rent to Own / Lease Option (more formally Lease with an Option to Purchase) is a type of contract used in both residential and commercial real estate. In a lease-option, a property owner and tenant agree that, at the end of a specified rental period for a given property, the renter has the option of purchasing the property.
In a lease-option the buyer has the option to buy but the seller does not option to not sell.
The basic elements of a lease-option
Reasons for using a lease option
What happens if you don’t pay
Buyer Be Aware
Very Important Points
1. Residential example
The example below describes a typical lease-option for residential properties; commercial lease-options are typically more complicated.
The contract is typically between two parties: the tenant (also commonly called the lessee or tenant-buyer), and the landlord (lessor), who owns the property or has the right to lease and dispose of the property.
In order to have a valid option the tenant-buyer must in most cases provide “valuable consideration” (a fee) for the option. Generally, sellers will ask for as much as possible–often around 3%-5% of the purchase price. The tenant-buyer usually will want to provide as little as possible–even a token amount of $100 represents “consideration.” The option gives the tenant the right (but not the obligation) to purchase the property at a later date. The lease option only binds the seller to sell, it does not bind the buyer to buy. That makes it a “unilateral” or one-way agreement.
2. The Paperwork
the paperwork comprises of two important but separate documents.
The first document as suggested by the name is a lease. The lease will be in a standard format for your state. The purpose of the lease is to give the tenant buyer the right to occupy the property.
The second document as suggested by the name is the Option. The option agreement specifies the purchase price, the payments required, any amounts that will be credited towards the purchase price should the tenant buyer exercise the option, the lease of time that the tenant purchaser has to purchase the property as well as other information concerning how payments are made, what happens if people don’t pay, how to exercise your option to purchase a property, etc.
Therefore in simple terms, the lease gives you the right to live in the property,
and the option gives you the right to purchase a property.
3. The basic elements of a lease-option are:
Buyer purchases the option. The parties agree to what the cost of the option is. As noted above, it can range from a token amount to 5% (or more) of the value of the property. The option fee is usually non-refundable. That is, if the tenant-buyer fails to exercise the option, the money remains with the seller. It is not refunded. The reason: The option fee is not a deposit. The option fee has been used to purchase something of value: the Option.The parties agree to a purchase price. The purchase price should always be agreed upon at the inception of the option. It is generally based on what the upper end of what they are property is currently worth in the open market.The length of the lease option to be a very short period of time but is typically five years or more. It is definitely unwise for the tenant-buyer to agree to a short period of time (less than five years). The tenant-buyer often is expecting that the property will appreciate in value, particularly if the agreed-upon purchase price is equal to or higher than the fair market value at the time of the inception of the option. Perhaps even more important, often the tenant-buyer has credit or other financial issues preventing him/her from immediately purchasing. The option period is used to strengthen the tenant-buyer’s credit, amass rent credits, and position him/herself to purchase. That often can take several years.As most of us realise it costs more to purchase a property that it does to rent a property. Therefore if you are looking at entering into a lease option agreement you will be paying a higher weekly payment then you would if you were just renting the property. Since there are two distinct pieces of paper work involved in a lease option there is also two separate payments that make up your weekly payment. The first is the payment mentioned in the lease. This amount will be generally be market rent for the property. The second payment will be an ongoing option fee. The ongoing option fee will be mentioned in the option document. Combined these two will make up your minimum weekly payment.
For example: The lease may contain a rental amount of $350 a week. The option agreement may contain an ongoing option fee of $250 a week. This means that your total weekly payment will be the combination of both payments (that is $350 plus $250) $600 per week.Whether the tenant-buyer will occupy the property or whether the tenant/buyer has the right to sub lease or the right to sell the option. In most cases, the tenant-buyer occupies the property. Sellers will generally seek to make that one of the terms of the agreement.
During the term of the lease option, the tenant makes lease payments to the landlord for the use of the property with the terms mutually agreed. At the end of the contract, the tenant has the option to purchase the property outright. The tenant does so by going out and getting a mortgage.
4. Reasons for using a Lease Option:
The main reason people look the buyer property on a lease option is that they do not have sufficient deposit to enable them to get a bank loan to purchase a property. Other reasons can include:
- Buyer is relocating and may need to sell a property in another area before the buyer can qualify to purchase the new home.
- Buyer may have had some credit issues that can be resolved during the option period.
- Buyer may have started a new business and otherwise qualifies and can afford the payments.
- Buyer may not have enough funds for a deposit and stamp duty.
5. What happens if you don’t pay
In the event of non-payment, the seller will remove the tenants through eviction, which is likely to be cheaper than foreclosure on a mortgaged property. The lease-option may also require less money up front, while a mortgage might require a substantial down payment from the tenant.
If the tenant does not exercise the option to purchase the property by the end of the lease, then generally any up front option money along with any monies that the tenant paid in addition to the market rental rate for this option may be retained by the owner depending on the agreement. This might occur if the tenant no longer wishes to purchase the property or if the tenant wishes to purchase the property but is unable to obtain the financing required to do so.
6. Buyer Be Aware
Some forms of lease-option agreements have been criticized as predatory. It is up to you, the purchaser, to sit down and do a proper budget prior to entering into any agreement that ensure that you can afford to purchase the property using a lease option. Further you should seek independent financial advice from a mortgage broker to ascertain your ability to get bank finance prior to the option agreement expiring.
7. Very Important Points
Your Payments – If you are looking to purchase a property using a lease option or instalment contract you need to insist that the payments that you make are collected by a management company (such as www.paid.net.au) that pays the underlying bank loan, the rates and insurance on the property prior to the vendor receiving any funds.
Time Frames –If you’re looking to purchase a property using a lease option the Vendor Finance Association recommends that the lease option agreement runs for a minimum of five years with an extension period of at least two years. This allows you the purchaser up to 7 years to achieve your bank finance to purchase the property outright.
Seek Legal Advice – This should be easier than actually is. There is a difference between sound legal advice and a personal opinion. When you get a copy of the lease option contract from your vendor it is advised that you read the document cover to cover, ask your vendor what each of the sections mean that if there is anything that you do not understand in the contract ask your vendor to explain to you.
Then take the lease option contract to a solicitor that deals in property contracts (this is not a conveyancer) and who has an understanding of what a lease option actually is. You may need to ask around to find the solicitor that deals in commercial property as many solicitors simply do not have an understanding of how lease options work with residential property.
When you do seek your legal advice, stress to the solicitor that you are seeking advice on your rights and responsibilities under the lease option as well as requesting an understanding of the pitfalls of purchasing using a lease option. Personal opinion is not what you’re asking for and if they do not understand what a lease option is find another solicitor that does.