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Lease-options offer an alternative

Extended warrantiesWhen Chris Toth and his wife were looking to buy their first home, two-bedroom houses in their hometown of San Mateo, Calif., were going for more than $500,000.

So when their real estate broker suggested making a lease-option offer on a house that was coming on the market, it seemed like a great solution. It turned out to be just that.

The Toths bought their house for $447,500, lived in it for 15 months before committing and locked in the price 15 months before purchase. Had they bought the home immediately without the option, the price would have been higher.

Had the market tanked by 20 percent in the year after the Toths made their deal, as some were speculating, they had the option of backing out. They would have forfeited a $10,000 option consideration payment, but a steep market decline would have cost them a lot more.

The option also gave them time to get to know the house and ensure they wanted it, and allowed them time to save more money for the down payment.

 

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"It was perfect for us," said Toth, an assistant vice president at investor relations firm FD Morganwalke, "because we wouldn't have been able to afford the house without it. We wouldn't have had enough for a down payment."

Lease options are a terrific way to buy a house for those who are unable or unwilling to immediately commit to a purchase. Reasons for this could include bad credit you need time to fix, an uncertain work or relationship situation, lack of a down payment or maybe just wanting to give the house a test drive before signing on the dotted line.

A lease option exists somewhere between buying and renting. While the specifics vary per deal, here are the basics.

In a lease-option deal, the renter leases the house for a predetermined amount of time, often one year but sometimes more. They may pay a consideration fee up-front for the option, plus possibly an elevated monthly rent. If they do pay those extra fees, the option consideration and the amount of rent over market goes into a fund. The buyer has the option, either during the contract period or at the end, to purchase the property for a price that is usually locked in at the time the deal was signed (although it can contain certain provisions, such as allowances for changes in the consumer price index).

If the renter purchases the house, both the consideration and the money paid over and above the market rent goes toward the down payment. In addition, sometimes a percentage of the market rent can be credited toward the down payment. If the renter decides not to buy the house, the money in the fund and the rent credits are forfeited.

Still, the potential loss of that amount is often offset by an increase in home value. For this reason and others, experts say that lease options generally skew heavily in favor of the renter/buyer.

"As long as the renter doesn't pay more than market rent, there's really very little downside to getting an option to purchase," says Todd Thornton, author of "Home Buying Without the BS." "They basically build equity without getting a loan. Plus, it sets a price. California has 9 percent per year appreciation. At the end of a year, the house may be worth substantially more than what the price is. So you could have instant equity."

Since lease options are skewed toward the buyer even if you are paying slightly over market rent, they are easier to find during down real estate markets. The current market is strong, so a good lease option is rare. Still, when you do find one, it's probably out of either a seller's desperation or just desire to get a deal done, perhaps because the owner is moving out of the area. So, it should be possible to get favorable terms.

Finding a lease option deal involves the usual home-finding sources -- agents, brokers and ads. While a broker would prefer an up-front sale, since all the commission gets paid immediately, they also realize that a lease-option sale is better than no sale at all. So, if you want a lease option, talk to brokers and agents just as if you were looking for a regular purchase. In some cases, like for the Toths, a seller might just take an option as preferable to continuing to seek a buyer, especially if the house has been sitting empty for a bit.

And landlords can be more flexible in other ways.

"Some landlords may skip the credit check if they believe they have an opportunity to sell the home at some point in the near future," says Thornton, since the lease option puts cash in their hand now, even if it turns into rental income in the long run.

Also look in the classifieds. Someone looking to get rid of a property may put an ad saying, "$5,000 moves you in." As one example, that could mean that they'll take $5,000 as the first month's rent and the option consideration.

Despite the advantages, there are some potential pitfalls in a lease option. As usual, safety comes from being an informed buyer.

"Sometimes the buyer doesn't understand the deal," says Gerald Marsden, a CPA with Eisner & Lubin. "Sometimes all he's getting is the right of first refusal at a market rate. And sometimes, the price isn't fixed, or it's exorbitant."

There is also a danger in the strength of current ownership, or what the owner does during the lease option period. An owner can take loans out on the property during the lease option period, clouding the potential sale. Or, he might have already done so.

"The tenant needs to know the quality of title that the seller has when they enter into the agreement," says Rick Zelman, a real estate lawyer and senior partner with the Miami firm of Sacher, Zelman, Van Sant.

The first step toward protecting yourself is to have a real estate lawyer inspect the contract. "Problems are usually avoided by having a good lawyer look at it," says Marsden, "and by reading what you're signing and understanding what it means. If you don't understand it, sit down and do scenarios -- what happens if. You'd be amazed how many people make commitments they don't understand."

In addition, Zelman recommends taking out an ad and filing a notice with the county record's office alerting the world to your lease option to protect yourself from an unscrupulous seller.

"You want to put the world on constructive notice in the public record -- that's the legal term," says Zelman. "It's more protective than an airtight contract. When someone purchases property, or wants to have a mortgage, they are legally obligated to search the public records to see if someone else has an interest. If the owner sells to someone else during the lease period, then the new buyer knows there's someone living there who has rights to the property."

But assuming you've taken the steps needed to protect yourself, the lease option can be a great deal. The bottom line on a lease option deal is that the option belongs completely to the buyer -- the seller is locked in, while the buyer is not.

As such, Thornton recommends that lease optionees continue to test the market, even while in the deal.

"Just because a renter has an option to purchase, doesn't mean they shouldn't look around at other homes," says Thornton. "Maybe the purchase price in the lease option was too high, maybe the market values have declined, or maybe they can find a more appropriate home based on their individual situation."

Of course, as Zelman points out, since the buyer is the one with the option, he can always try to renegotiate in the event of a drastic decline in home value.

So for the smart and careful home buyer who might not be able to buy under normal conditions, lease options can create a broad range of opportunity for better value and choice in home buying.

"The word 'option' means renters have a choice," says Thornton. "That's the beauty of lease options. They don't force you to buy, but rather give you the opportunity to buy."

-- Posted: July 1, 2003

 

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