Lease-options offer an alternative
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
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.
"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
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
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