Ron Denhaan, Realtor (949) 290-3263. Orange County real estate specialist.
All about lease options All about Lease Options

Is a lease option the right choice for you? Read on to learn about lease-options and the benefits they may offer you as a buyer or seller!
Note: If you are considering a lease-option because you have poor credit, no down payment, etc, please read my BLOG article, here: The trouble with lease-options

A lease option (also known as, lease to own, rent to own, or rent to buy) is a combination of a conventional lease, a purchase agreement, and an option contract to purchase the property at a future date, usually at pre-determined price. At the end of the lease term, the tenant becomes the buyer, and the landlord becomes the seller. Lease-options are typically used by home sellers during periods of declining home prices or slow sales. They are rarely offered during periods of rising home prices or rapid sales, since sellers benefit more from selling immediately.

Benefits - A lease option can have many benefits. In a perfect world, a lease-option benefits both the buyer and the seller. The tenant (buyer) is able to lock down a home and perhaps put their financial house in order before taking on the extra responsibilities of home ownership. The tenant can also give the home a "test drive" before deciding to purchase. The landlord (seller) receives cash-flow from the home during the lease period and a sale at or near market price, at the end of the lease term. However, lease-options can hold certain advantages or disadvantages for each party (as I will discuss below).
Family in front of home Your goal - Always remember that your objective will be to purchase the home at the end of the lease. Most lease-options are used by people who do not qualify for a home purchase due to poor credit, lack of funds, etc. If they do not change their financial habits or manage to save enough money during the term of the lease, they risk losing their option money along with the purchasing credits of their rent payments. If you have financial issues, you should not enter into a lease-option contract unless you can be reasonably certain that you will have enough cash for a down payment and that you will be able to qualify for a loan. To avoid surprises, always consult with a qualified real estate professional and a mortgage loan specialist before entering into a lease-option contract.

Some important tips!

A lease-option is suitable for someone who:

  • Has good credit

  • Has a property they are selling and will have equity for a down payment

  • Has consulted with a lender and is confident that they can qualify for financing at the end of the lease term

  • Has a sufficient amount of cash for the option deposit which is typically 1 to 5% of the purchase price, and understands they may lose it if they do not exercise the option.

A lease-option is unsuitable for someone who:

  • Is not sure if they qualify for a loan (has not consulted with a lender yet)

  • Has poor credit

  • Is uncertain whether or not they will have enough cash for a down payment at the end of the lease term

Lease-option myths

  • The home owner will finance the purchase - This is almost never the case. You will most likely need to obtain your own financing at the end of the lease term. 

  • The lease term can be for three years or more -  Typically, the term is 12 to 18 months, maximum

  • That all of the rent applies to the purchase  - Almost never. Typically only a few hundred dollars per month is offered, and this is usually only if the rent is increased to cover it!

  • A lease-option or rent-to-own is a great way to build "equity", vs. just paying rent -  Unfortunately, per the myth above, paying rent is all that you are doing during the lease term. I have not found a single instance of an option contract in which the seller is crediting all of your rent money toward the purchase. 

  • That it is a great idea for people with bad credit  - This is very miss-leading! It is very difficult to qualify for the lease and for financing for the purchase if you have credit challenges. Unless you plan to purchase the home will all cash, you will need to obtain financing at the end of the lease term, and doing so with poor credit will be very difficult. I always recommend speaking with a lender before considering a lease-option, so that you can check your loan qualifications. 

Additional pointers

  • Lease-option terms are never published in the MLS. There are no fields for lease-options in the MLS because they are done too infrequently. It is strictly a phone call business between agents. 

  • Lease-options are generally done by sellers who cannot sell their home conventionally. In many cases, the true market value of the home is below what the seller owes or below his equity position. Therefore, they turn to a lease-option in hopes of finding a tenant/buyer who will over pay for the home. 

  • Most lease-options are never consummated and many tenants wind up losing their lease-option deposit. This is usually due to a lack of understanding of the risks and processes of an option contract.


 Basics of a Lease-Option

  • The buyer pays the seller option money called "Option Consideration" for the right to later purchase the property. The lease option money may be substantial and it is non-refundable if the buyer does not exercise the option.

  • The buyer and seller may agree to a purchase price now or the buyer may agree to pay market value at the time the option is exercised. It is negotiable. However, most buyers want to lock in the future purchase price upon inception of the lease option.

  • During the term of the lease option, the buyer agrees to lease the property from the seller for a predetermined rental amount.

  • The term of the lease option agreement is negotiable, but the common length is generally from one year to three years.

  • The option consideration money generally applies toward the toward the purchase of the home.

  • A small portion of the monthly rental payment also applies toward the purchase price.

  • Option money is rarely refundable.

  • Nobody else can buy the property during the lease option period.

  • The buyer generally cannot assign the lease option without seller approval.

  • If the buyer does not exercise the lease option and purchase the property at the end of the lease option, the option expires.

  • The buyer is not obligated to buy the property at the end of the lease term.


 Advantages and disadvantages of Lease-Options

Home for lease Ideally, a lease-option will be a "win-win", benefiting both the buyer and the seller. However, there can be certain advantages or disadvantages to each party, depending on variables such as future real estate market conditions, the tenant's financial situation, etc. Here is a recap of the possible advantages or disadvantages for the buyer and seller:

 Advantages for the Tenant (Buyer)

  • It allows you to lock in a home of your choice for future purchase

  • No one else may purchase the home while you hold an option contract

  • It buys you time to get your financial house in order (save for a down payment, repair credit, etc)

  • You may gain additional equity if the market value of the home increases during the lease period

  • You have the option to back out if you find a better home, or if you cannot qualify for the purchase

  • It's a form of savings - Some of your rent payments may be applied toward the purchase of the home

 Disadvantages for the Tenant (Buyer)

  • You will lose your option money, plus the credit value of your rent payments if you decide not to exercise the option

  • You may not qualify for a loan if you have not improved your financial situation during the lease period

  • The value of the home could decrease during the lease period, causing your purchase price to exceed the fair market value

  • You are locked into one home - You lose the flexibility to shop for and negotiate on other homes

 Advantages for a Landlord (Seller)

  • The market value of the property may decrease during the lease period, rendering your option price more valuable than current market value

  • You get to keep the option money if the buyer decides not to buy the home

  • You get income during the lease and a sale at the end of the lease term

  • It allows you to lock a purchase contract at a fixed price during a slow market

 Disadvantages for a Landlord (Seller)

  • The market value of the home may increase during the lease period, rendering your option price less valuable than if you sold at current market

  • The buyer might not exercise the purchase option, forcing you to re-list the home for sale or lease

  • You cannot entertain other purchase offers while a tenant holds a lease-option on the property


 Lease-option FAQ

What is the difference between a lease-option and a lease-purchase?

A lease-option contract offers you the choice of buying the home at the end of the lease, while a lease-purchase agreement obligates you to buy the home. The risks also differ. Should you fail to exercise a lease-option, you will lose only your option money, but under a lease-purchase you would be in a breach of contract since you are obligated to complete the purchase. Lease-options can be beneficial to both buyers and sellers and are popular in times of falling home prices or slow sales. Lease-purchases are clearly a benefit to sellers but are far riskier for buyers, therefore they are rarely done.

Return to questions

Am I better off with a lease-option or just a straight lease?

It really depends. In a lease-option, you'll need to ensure that you are financially prepared for the purchase at the end of the lease term. If in doubt, go with the straight lease to avoid losing your option money. Also, be sure that this is home you want to buy. If you are new to the area or not sure about the home, you might want to keep your options open and shop for other homes while you're in a lease. On the other hand, if you love the home and feel you will have the financial wherewithal to purchase it, a lease-option is a great way to go, since part of your rent goes toward the purchase and no one else may buy the home while you hold the contract.  Home for lease

Return to questions

Since a lease-option involves certain risks, wouldn't it be wiser to start with a straight lease and negotiate the home purchase afterward?

Possibly, but there are certain risks to this approach also.

  1. There is no guarantee that you will able to purchase the home at the end of the lease. The homeowner may decide to sell to you, but he is also free to market the property to anyone and to sell to the highest bidder, or, he may choose not to sell at all. Under the terms of a lease-option, you hold the exclusive right to purchase the property if you qualify.

  2. The homeowner is under no obligation to apply any part of your rent toward the purchase of the home, as he would be under a lease-option agreement.

  3. If the home appreciates during the term of the lease, you could wind up paying a higher price for the home than you would have, had the price been "locked" under a lease-option agreement.

Return to questions

I would like to go with a lease-option. How can I tell if I'm financially prepared?

Consult with a lender or mortgage loan specialist. They will run your credit report, review your income, savings, and assets, and discuss available loan programs with you.  If you are qualified, your loan specialist may provide you with a pre-approval letter, which you can present as part of the lease-option application package. On the other hand, there may be areas that require improvement such as credit scores, reserves, etc. In this case, you may want to work on getting your finances in order before taking on the greater risk of a lease-option. 

Return to questions

Which contracts are required for a lease-option?

A lease-option requires three contract forms: a lease contract, a residential purchase contract, and an option contract, which defines all of the option terms. Be sure to go over the details of each contract carefully with your real estate professional, and do not be afraid to ask questions! A lease-option is a big commitment, so make sure it is the right choice for you!. 

Return to questions

What are the various option terms?

  • The purchase price - Fixed price or market price at the time of purchase

  • The amount of option consideration money 

  • The amount of monthly rent during the lease period

  • The amount of rent credited toward the home purchase

  • The length of the lease period

  • Closing costs

  • Termite and physical inspections

  • Appraisal considerations (what will happen if the property fails to appraise for full purchase price)

  • Future appreciation or depreciation

  • Other terms requested by buyer or seller

Return to questions

What is the typical amount of "option consideration" money?

It can be as low as 1% to as much as 5% or more, of the purchase price of the home. For example, on a purchase price of $650,000, the lowest it would usually be is $6,500, but it could be set at $10,000, $15,000, or much more. The cost is set by the seller but it is negotiable.

Return to questions

Are the option terms negotiable?

Yes, all of the terms are negotiable between the buyer and seller. However, both parties should ensure that they are represented by knowledgeable agents who will look out for their best interests when drafting the agreement.

Return to questions

What if the value of the home decreases considerably by the time the lease is up?

Move on! You might forfeit your option money but a steep market decline will cost you a lot more. If your purchase price is unrealistic, take the loss and buy a different home at fair market value.

Return to questions

What if the home has appreciated substantially during the lease term. Can the landlord back out of the deal?

Just bought a home! As long as you signed a residential purchase agreement, it's your gain if the current market value exceeds the purchase price. The landlord could risk a breach of contract lawsuit by failing to honor the agreement - All the more reason to be sure to use a qualified real estate professional to assist you. Don't go it alone!

Return to questions

Are there other variations of a lease-option?

A lease-purchase is similar to a lease-option, with the exception of the option itself. The buyer leases the home for a specified period of time and then is obligated to purchase the home at the pre-determined price.

A lease with first right of purchase is a more informal arrangement in which the tenant has the first right to purchase the home at the end of the lease contract, but at fair market value. There is no option consideration money and no locked-in purchase price. The buyer and seller negotiate the purchase price just before the lease term expires and if they come to agreement, they go into escrow. If not, the seller is free to re-market the property.

Return to questions

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I hope this article has answered some of your questions about lease-options. Do you have a question that was not addressed here? Please feel free to contact me! I will be happy to assist you with a lease option or lease to own property in Orange County, CA, as well as a sale, purchase, lease, or rental. I will also put you in touch with a loan specialist who can help you qualify for the purchase. I am a real estate specialist in South Orange County, California, including Aliso Viejo, Coto de Caza, Dana Point, Dove Canyon, Rancho Santa Margarita, Mission Viejo, Ladera Ranch, Las Flores, Rancho Cielo, Walden, Wagon Wheel, Laguna Niguel, Robinson Ranch, Foothill Ranch, Portola Hills, San Juan Capistrano, San Clemente, or the Santiago Canyon areas (Modjeska, Silverado and Trabuco Canyons).

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Ron Denhaan - Realtor 

Realty One Group

(949) 290-3263

Ron@rondrealestate.com

DRE Lic # 01728866

Ron Denhaan, Realtor, (949) 290-3263
 

Copyright 2007.  CDC Technology, Inc.   - All rights reserved

No part of this article may be copied without the express permission of the author, Ron Denhaan, Realtor, Realty One Group

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The information herein was written by Ron Denhaan, Realtor, Realty One Group and represents the opinions of the author. It does not necessarily reflect the views of other real estate agents, associations, or of Realty One Group. While all of the information is believed to be true, we do not warrant the accuracy of the information. We cannot and do not warrant that the information in this article is absolutely current, although every effort is made to ensure that it is kept as current as possible. This article pertains only to common real estate practices in the State of California, USA. No part of the article should be construed as representing actual legal advice - Always consult appropriate professionals, such as qualified attorneys, financial advisers, and real estate brokers.. A lease-option may not be right for everyone. People who cannot meet the financial requirements to complete the home purchase should not enter into a lease-option contract

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