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 called the lessee or tenant-buyer), and the landlord (lessor), who owns or has the right to lease or 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. In contrast, a lease-purchase is a bilateral, or two-way, agreement.
The basic elements of a lease-option are:
1. 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 usually is 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.
2. The parties agree to a purchase price. It can be decided that the price will be the appraised value at the time the option is exercised. Generally, however, the purchase price is agreed upon at the inception of the option.
3. The length in residential real estate is typically 1–3 years. However, it is often unwise for the tenant-buyer to agree to a short period of time (often 2 years or less). 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.
4. How much the monthly lease payment is, whether any of the lease payment is to be credited towards the purchase price reducing the purchase amount. Often, the monthly lease payment is equal to or slightly above the fair market rent of the property. And while it's fully negotiable, a credit in the range of 15%-25% is often offered. So, for example, if fair market rent for that unit would be $1,000, the seller might charge $1,100 with $200 of that being credited toward the purchase price.
5. 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.
6. An investor may acquire a distressed property with a lease option and make improvements to the property. Then the investor can sell the option to a buyer that is willing to pay the new market value for a profit. It is a common financing technique with investors. However, it is riskier than other methods the investor could use for controlling the property. The risks include the seller's inability to transfer clear title when the investor seeks to exercise the option. In that case, the investor will have made improvements (sometimes substantial) to a property he/she doesn't own and may not be able to acquire. If the investor is considering anything more than cosmetic enhancements, he/she might consider another method of control such as a land trust or acquiring the property using what's called a "subject to" (or Sub 2) transaction.
6.a An example: Seller has a property that needs considerable amount of work. Retail buyers typically cannot get financing or have too much to choose from to bother with physically distressed properties. Investor enters into a lease option agreement for let’s say $100,000, rehabs the property with about $20,000 and now the market value is approximately $135,000 the investor can sell the right to purchase for $35,000 and the new buyer would close with the original seller for $100,000
6.b Another example: A buyer buys the same property and uses his/her own money to rehab and may use rehab money towards the down payment. This allows the buyer to NOT have to come with a large down payment and rehab money.
Everything functions like a lease except there is a schedule when the buyer can decide to purchase the property.
The terms of the lease have to be negotiated also. These include items typically found in leases: maintenance, utilities, taxes, pets, how many occupants, insurance, ability to make modifications to the property, and so on. One note: Maintenance terms in a lease-option often differ from those in a standard lease. In a typical lease, often the owner is responsible for all repairs, except—sometimes—for a $50-$100 per incident deductible. Basically, the owner is responsible for virtually all repairs. In a lease-option, often a greater burden for repairs is shifted to the tenant-buyer.
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.
Excess credit may also be applied towards the eventual purchase of the property, or towards the down payment for a mortgage (CAUTION, the buyer and seller can agree to whatever they want, but when the buyer goes to get permanent financing the bank has guidelines to what can be applied towards the down payment or the purchase. Typically banks only allow an amount that is above and beyond market rent to be considered for a down payment.) In that case, the lease-option works as an automatic savings plan for the tenant. This down payment is applied as part of the "option consideration fee"; in the arena of lease option purchasing this is a fee charged for the right to purchase the property.
Reasons for using a lease option
Buyers
- 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 downpayment.
- Buyer is relocating and is unfamiliar with the new area. He/she wants to "get a feel" for the area—safety, school quality, convenience, etc.
- Buyer is seeking a VA loan and the property does not meet VA appraisal guidelines. Buyer agrees to make the needed repairs during the lease term to allow the property to meet these specifications.
In the event of non-payment, it may be possible for the seller to 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.
Seller
A lease-option allows the seller to sell a property that they may not have otherwise been able to sell. In many cases a seller can net more money when offering terms to a buyer. Sellers can often avoid paying a Realtor fee by using a lease-option agreement (as they have already found the buyer themselves).
There is an expression, “Price or terms, pick one;” sellers may be able to sell for a better price (or sell the property period) by offering attractive terms to the buyer(s). For the buyer to get a favorable price the terms usually have to favor the seller.
If the buyer defaults and the contracts are drafted properly then there is an automatic tenant landlord relationship. All valuable considerations are typically surrendered and then it would be an eviction.
Some forms of lease-option agreements have been criticized as predatory. For example, sometimes lease-options are offered to tenants who cannot realistically expect to ever exercise the option to purchase. Sometimes the lease-option period is for such a brief amount of time (6 months, for example) that the tenant-buyer has little chance to repair his/her credit, save money for a down payment, or address whatever other problems exist.
In finance, a derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and is often simply called the "underlying". Derivatives can be used for a number of purposes, including insuring against price movements (hedging), increasing exposure to price movements for speculation, or getting access to otherwise hard-to-trade assets or markets. Some of the more common derivatives include forwards, futures, options, swaps, and variations of these such as synthetic collateralized debt obligations and credit default swaps. Most derivatives are traded over-the-counter (off-exchange) or on an exchange such as the Chicago Mercantile Exchange, while most insurance contracts have developed into a separate industry. In the United States, after the financial crisis of 2007–2009, there has been increased pressure to move derivatives to trade on exchanges.
This aims to be a complete list of the articles on real estate.
A real estate broker or realtor is a person who represents sellers or buyers of real estate or real property. While a broker may work independently, an agent usually works under a licensed broker to represent clients. Brokers and agents are licensed by the state to negotiate sales agreements and manage the documentation required for closing real estate transactions. Buyers and sellers are generally advised to consult a licensed real estate professional for a written definition of an individual state's laws of agency. Many states require written disclosures to be signed by all parties outlining the duties and obligations.
A hire purchase (HP), also known as an installment plan or the never-never, is an arrangement whereby a customer agrees to a contract to acquire an asset by paying an initial installment and repays the balance of the price of the asset plus interest over a period of time. Other analogous practices are described as closed-end leasing or rent to own.
A real estate contract is a contract between parties for the purchase and sale, exchange, or other conveyance of real estate. The sale of land is governed by the laws and practices of the jurisdiction in which the land is located. Real estate called leasehold estate is actually a rental of real property such as an apartment, and leases cover such rentals since they typically do not result in recordable deeds. Freehold conveyances of real estate are covered by real estate contracts, including conveying fee simple title, life estates, remainder estates, and freehold easements. Real estate contracts are typically bilateral contracts and should have the legal requirements specified by contract law in general and should also be in writing to be enforceable.
A Lease-Purchase Contract, also known as a Lease Purchase Agreement, is the heart of rent-to-own properties. It combines elements of a traditional rental agreement with an exclusive right of first refusal option for later purchase on the home. It is a shortened name for Lease with Option to Purchase Contract.
As a legal term, ground rent specifically refers to regular payments made by a holder of a leasehold property to the freeholder or a superior leaseholder, as required under a lease. In this sense, a ground rent is created when a freehold piece of land is sold on a long lease or leases. The ground rent provides an income for the landowner. In economics, ground rent is a form of economic rent meaning all value accruing to titleholders as a result of the exclusive ownership of title privilege to location.
Equity sharing is another name for shared ownership or co-ownership. It takes one property, more than one owner, and blends them to maximize profit and tax deductions. Typically, the parties find a home and buy it together as co-owners, but sometimes they join to co-own a property one of them already owns. At the end of an agreed term, they buy one another out or sell the property and split the equity. In England, equity sharing and shared ownership are not the same thing.
Flipping is a term used to describe purchasing a revenue-generating asset and quickly reselling it for profit.
Commercial property, also called commercial real estate, investment property or income property, is real estate intended to generate a profit, either from capital gains or rental income. Commercial property includes office buildings, medical centers, hotels, malls, retail stores, multifamily housing buildings, farm land, warehouses, and garages. In many states, residential property containing more than a certain number of units qualifies as commercial property for borrowing and tax purposes.
Rent-to-own, also known as rental purchase or rent-to-buy, is a type of legally documented transaction under which tangible property, such as furniture, consumer electronics, motor vehicles, home appliances, real property, and engagement rings, is leased in exchange for a weekly or monthly payment, with the option to purchase at some point during the agreement.
A land contract — often described by other terminology listed below — is a contract between the buyer and seller of real property in which the seller provides the buyer financing in the purchase, and the buyer repays the resulting loan in installments. Under a land contract, the seller retains the legal title to the property, while permitting the buyer to take possession of it for most purposes other than legal ownership. The sale price is typically paid in periodic installments, often with a balloon payment at the end to make the timelength of payments shorter than in the corresponding fully amortized loan. When the full purchase price has been paid including any interest, the seller is obligated to convey legal title to the property. An initial down payment from the buyer to the seller is usually also required.
Real estate investing involves the purchase, management and sale or rental of real estate for profit. Improvement of realty property as part of a real estate investment strategy is generally considered to be a sub-specialty of real estate investing called real estate development. Someone who actively or passively invests in real estate is called a real estate entrepreneur or a real estate investor.
Leaseback, short for "sale-and-leaseback", is a financial transaction in which one sells an asset and leases it back for the long term; therefore, one continues to be able to use the asset but no longer owns it. The transaction is generally done for fixed assets, notably real estate, as well as for durable and capital goods such as airplanes and trains. The concept can also be applied by national governments to territorial assets; prior to the Falklands War, the government of the United Kingdom proposed a leaseback arrangement whereby the Falklands Islands would be transferred to Argentina, with a 99-year leaseback period, and a similar arrangement, also for 99 years, had been in place prior to the handover of Hong Kong to mainland China. Leaseback arrangements are usually employed because they confer financing, accounting or taxation benefits.
A mortgage loan or simply mortgage is a loan used either by purchasers of real property to raise funds to buy real estate, or by existing property owners to raise funds for any purpose while putting a lien on the property being mortgaged. The loan is "secured" on the borrower's property through a process known as mortgage origination. This means that a legal mechanism is put into place which allows the lender to take possession and sell the secured property to pay off the loan in the event the borrower defaults on the loan or otherwise fails to abide by its terms. The word mortgage is derived from a Law French term used in Britain in the Middle Ages meaning "death pledge" and refers to the pledge ending (dying) when either the obligation is fulfilled or the property is taken through foreclosure. A mortgage can also be described as "a borrower giving consideration in the form of a collateral for a benefit (loan)".
In real estate, creative financing is non-traditional or uncommon means of buying land or property. The goal of creative financing is generally to purchase, or finance a property, with the buyer/investor using as little of his own money as possible, otherwise known as leveraging. Using these techniques an investor may be able to purchase multiple properties using little, or none, of his "own money".
In the field of commercial real estate, especially in the United States, a net lease requires the tenant to pay, in addition to rent, some or all of the property expenses that normally would be paid by the property owner. These include expenses such as property taxes, insurance, maintenance, repair, and operations, utilities, and other items. These expenses are often categorized into the "three nets": property taxes, insurance, and maintenance. In US parlance, a lease where all three of these expenses are paid by the tenant is known as a triple net lease, NNN Lease, or triple-N for short and sometimes written NNN.
Vehicle leasing or car leasing is the leasing of a motor vehicle for a fixed period of time at an agreed amount of money for the lease. It is commonly offered by dealers as an alternative to vehicle purchase but is widely used by businesses as a method of acquiring vehicles for business, without the usually needed cash outlay. The key difference in a lease is that after the primary term the vehicle has to either be returned to the leasing company or purchased for the residual value.
Seller financing is a loan provided by the seller of a property or business to the purchaser. When used in the context of residential real estate, it is also called "bond-for-title" or "owner financing." Usually, the purchaser will make some sort of down payment to the seller, and then make installment payments over a specified time, at an agreed-upon interest rate, until the loan is fully repaid. In layman's terms, this is when the seller in a transaction offers the buyer a loan rather than the buyer obtaining one from a bank. To a seller, this is an investment in which the return is guaranteed only by the buyer's credit-worthiness or ability and motivation to pay the mortgage. For a buyer it is often beneficial, because he/she may not be able to obtain a loan from a bank. In general, the loan is secured by the property being sold. In the event that the buyer defaults, the property is repossessed or foreclosed on exactly as it would be by a bank.
A retail lease is a legal document outlining the terms under which one party agrees to rent property from another party. A lease guarantees the lessee use of an asset and guarantees the lessor regular payments from the lessee for a specified number of months or years. Both the lessee and the lessor must uphold the terms of the contract for the lease to remain valid.
