Q. “I’ve heard the lease option is a great way to both get into real estate and to sell real estate. Why does this work?”
Ans. The ‘lease with option to buy’ has been around for a long time. Years ago, builders stuck in a sluggish market with unsold inventory conceived the notion of adapting the lease/option to their marketing needs. The idea was to offer prospective buyers who lacked the necessary down payment the ‘opportunity’ to convert part of their monthly rent into a down payment.
The agreement stipulated that a (modest) portion of their rent–which was at or likely a bit over market rates–would be booked by the landlord (seller) as an installment on a future down payment on the rented house or condominium. In time, it was said, there would be enough accumulated in this ‘account’ to satisfy a lender’s down payment requirements. It was to be a form of forced savings and a way to recover some of the rent the aspiring homeowner was otherwise obliged to pay.
But there is an obvious problem with the scheme. The portion of the monthly commitment applicable to rent may not be artificially reduced significantly below market rents merely to accelerate the so called ‘equity’ buildup. To do this would be construed as a sham, a phony transaction. To legitimize this concept the monthly rents would either have to be increased to accommodate a more substantial equity accumulation, or the length of time necessary would be long indeed at, say, $50 or $75 per month.
The strategy is nevertheless popular among some sellers schooled in this marketing technique. Buyers of limited means are attracted by the prospect of owning their own homes only to find, after a year or two, very little accumulated in their ‘account.’ Or circumstances will have changed, requiring a move and the likely abandonment of the prospective ‘down payment’ (it always pays to read the document!). In the end, the option is not exercised and the funds forfeited. The bottom line is they were tenants after all.
Going back to the nomenclature itself, the ‘lease option’ clarifies the issue. The contract is first of all a lease, subject to a landlord-tenant legal relationship. The ‘option’ is simply the right, under certain conditions, to purchase the leased property at a predetermined price. The two benefits possible are a) the possibility to accumulate a down payment to contribute to the eventual down payment necessary (relying on the landlord to be an honest banker); and b) fixing or predetermining the future value of the home at some future date, say two or three years in future.
In a sluggish, slowly appreciating market the lease option favors the seller (landlord) in that the property is occupied and earning perhaps a premium rent. And practitioners report few lease options are ever in fact consummated. The net benefit to the landlord is perhaps a more stable tenancy with little risk of having to sell.
Conversely, in a more dynamic, appreciating market where property values are going up, the lease option may in fact favor the tenant buyer. Recognizing monthly ‘contributions’ to future equity might be slight, the astute tenant buyer wagers that by the agreed future option date the property will be worth more than the predicted amount. The option price then represents an opportunity to purchase at a discount with or without the benefit of accumulated installments. A recent book recommends this technique as a no-money-down purchasing strategy.
Landlords, then, use the lease-option to attract a stable tenancy recognizing there is little likelihood of giving up the property. Unsophisticated tenant buyers find false promise in the arrangement. And the occasional speculative buyer finds opportunity in a rising market. The strategy is viable. It’s simply important to know into which of these categories one might fall.