The vast majority of investors will be familiar with the terms, lease and options, but maybe not the term lease option. While they are not necessarily commonplace, they can serve a purpose for both a property owner and a potential investor. So, what exactly is a lease option?
The two separate elements of a lease option:
As the term suggests, a lease option is an arrangement that lets you take control of a property, generate rental income with an option to buy at a later date. It’s important to note the term “option”, which means there is no obligation. In essence, a lease option is two separate legal arrangements under one agreement:-
This is no different to a standard lease. You would pay an agreed figure each month to the property owner in exchange for control. The property would be rented out to tenants, hopefully creating income above the monthly payment to the owner. Profit!
As we touched on above, the option element is exactly that, the option but not the obligation to buy the property at an agreed price within an agreed timescale. For those familiar with stocks and shares, this is very similar to a traded option.
When structuring a lease option, four main terms are always included:-
- Monthly payment
- Future purchase price
- Duration of the arrangement
- Upfront payment
It is probably easier to show an example of a scenario and the structure of a lease option.
Example lease option:-
Third-party: Property owner
Mortgage outstanding: £100,000
Property value: £90,000
Monthly mortgage payments: £300
In the vast majority of circumstances, the party looking to lease out their property with the option to buy is likely to be facing financial issues. Many will be struggling with negative equity, although this is not always the case. Someone looking to lease property may be able to negotiate the following deal:-
Monthly payment: £300
Lease Duration: 5 years
Monthly rental income: £600
Option purchase price: £100,000
Upfront payment: £1
While this is an example of both sides of the arrangement, the general scenario is not uncommon when lease options are discussed. This now prompts the question, what are the benefits for each party?
The property owner will receive £300 a month, covering their mortgage payments and allowing them to avoid default. During or at the end of the five-year arrangement, the lessee can use their option to buy the property. In this scenario, the property owner would receive sufficient funds to pay off their mortgage, addressing the original negative equity situation.
Even after costs, the lessee may make a £200 monthly profit which equates to £2400 a year, or £12,000 over the five-year lease duration. They will retain the option to acquire the property at £100,000. If we assume the property value increased to £110,000 during the lease term, they could activate the purchase option, sell in the market, and make £10,000. They may decide to purchase (using a mortgage) and retain the property in the longer term. This would instantly crystallise £10,000 worth of equity in the property.
Why would a seller agree to a lease option?
In the above example, the upfront payment to secure the £100,000 option price was a mere £1. The property owner may negotiate a higher upfront payment, but as this is non-refundable, it may be difficult. In most cases where lease options are available, they tend to involve property owners who have slipped into negative equity or financial distress.
It may be that they cannot make up any shortfall between the property value and their outstanding mortgage. Therefore, a five-year arrangement with a monthly payment that covers their mortgage obligations will undoubtedly assist. In a worst-case scenario, they receive £18,000 in monthly payments even if the lessee does not take up their option to buy. In a best-case scenario, they still receive £18,000 in monthly payments, sell the property for £100,000 and pay off their mortgage.
Taking legal advice
Both parties must take legal advice to ensure that everything is down in writing and all parties are aware of their options and obligations. There are several issues to take into consideration, such as:-
- The owner fails to use the monthly payment to cover their mortgage, and the property is repossessed
- The owner refuses to honour the option to buy, leading to significant legal costs
- The lessee may be forced to pay for expensive maintenance on the property
There are various ways the property owner and lessee can protect their rights and options, hence the need for legal advice. What seems a relatively straightforward arrangement can sometimes be a little complicated in reality, mainly when not all parties abide by the agreement.
In the majority of cases, a lease option would be the last choice for many property owners but a good arrangement for a potential property investor. The property owner is guaranteed monthly payments while the lessee can rent out the property (for a net profit) while retaining the option to buy outright. It is important to note that the opportunity to buy can be exercised anytime during the arrangement. However, it would be sensible to exercise the option just before expiry from a cash flow perspective.
The above gives a fascinating insight into an alternative area of property investment, of which many people are unaware. Even though these scenarios are not necessarily typical, they can be highly beneficial if you’re prepared to do the research and groundwork.
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