Lease Option Agreement Explained

They’re difficult to grasp. They’re difficult to successfully pull off. Yet it seems like everybody is talking about them, and some landowners absolutely love them.

Then what’s in the lease options deal? Let’s see if we can answer all of your questions in this explanation post.

WHAT IS A LEASE OPTION?

A lease option is a legal arrangement that allows you to control and produce revenue from a house, with the right (but not the obligation) to purchase it later.

It’s actually two different agreements bundled into one, and when you separate them, it’s easier to understand:

Lease: You agree to a monthly payment to the owner of the property, allowing you to manage the property and to also rent it out for a profit to the tenants.

Option: You agree on a price at which, if you want, you can purchase the property later.

There are four key terms that need to be decided at the core of every lease option agreement:

1. The monthly charge, usually regardless of what the owner wants to finance their mortgage and all other expenses.
2. The buying price at which you have the option to purchase the property in the future
3. The term of the deal, in which you have to return the property if you haven’t used the option to buy. In return for the option, the upfront payment you will owe them (which in law is called a consideration)
4. There has to be at least some upfront charge for the arrangement to be legally binding, but this can be for as little as a quid. So, if you’ve heard people talk about “buying a £1 house”“? They’re speaking about lease options.

WHY WOULD YOU USE A LEASE OPTION?

The question, as a buyer, why wouldn’t you use the lease option?

(OK, actually, there are reasons why you should not – we’ll come to those later.)

When you correctly structure the contract, it wins all the way:

• You spend very little cash: only the consideration rather than a 25 percent deposit, as little as £1
• There’s no need for you to take out a mortgage,
• Every month, you make money, just like you own it.
• You can buy it and then gain “instant equity” if the value of the property goes up above the negotiated purchase price.
• But if it doesn’t, you can just hand back the property, in the meantime, you will have made money from it!

Let’s cement all of this with an example

Let’s say I agree with the following conditions for a lease option:

The property is now worth £90,000, and I have the option of buying it for £100,000.

The option duration is five years long.

To have the option, I pay the owner £ 1

I pay £ 300 a month to the owner, covering their mortgage payment.

I rent the property for £ 600 a month, and my monthly expenses (repairs, etc.) amount to £ 100 on average. So, every month, I make a profit of £200.

Fast-forward 5 years and two or three outcomes are possible:

1. The estate is now worth 90k. I obviously wouldn’t want to buy it for £100,000, so I’m letting the option expire and returning the house. Oh well, I still made £12,000 in rental profit, minus the £1 I charged upfront, for a total £11,999 profit!
2. The estate is worth £110,000 now. I’m taking out a mortgage and purchasing the property for the £ 100,000 we settled on in the usual way. I just purchased a house at a discount of £10,000 and in the meantime, I made £12,000 in rent!

Actually, there’s a third way: I might sell the £ 10,000 option to someone who wants to buy the house. They will pay me £ 10,000 and the property owner £ 100,000, and end up purchasing the property for its present value.

With £22,000 in cash: £12,000 from the rent, and £10,000 from selling the option, I would walk away. Uh, not bad!

In fact, an option allows you to purchase the property during the option period at any time, not just at the very end.

So lease deals sound pretty fantastic, from our point of view: it’s all an upside because there are two ways to benefit from the option, and if things don’t work out, we can just give the property back with no consequences.

Which leads to an apparent question –

WHY WOULD A SELLER EVER AGREE TO A LEASE OPTION?

Yeah, if they have any other choices. They’re not going to.

After all, now they commit to a selling price and lock themselves into a long deal when you are free to back out without any repercussions other than losing the upfront charge.

Would that be reasonable to you?

So, those who do not have any other choice are the only people who will give you a lease option. And that, for the most part, means negative equity owners.

“Negative equity” means they owe more than they will sell the house for on their mortgage. It’s not a big concern as long as they want to keep living there and the bank is OK with the situation. But if they have to move, they’re trapped there.

Say the house is worth £90,000, the balance of the mortgage is £100,000, and the owner has to move for work. By selling under the market value, they can’t get a fast deal, so it wouldn’t be enough to clear their mortgage. If they have £10,000 in cash to pay the bank for the difference, they can’t even sell it at market value.

All they can do is rent the property out, which is a lot of trouble, because if the tenant doesn’t pay for any reason, they may not be able to afford the mortgage payments.

So for the property owner, is a lease option a brilliant option? No: they would much rather get rid of it now, or at least have the assurance of selling it later. But if that’s the only choice they have, maybe they’ll go for it.

HOW CAN YOU FIND LEASE OPTION OPPORTUNITIES?

You’re searching for someone in negative equity who wants to move because, as we’ve just seen, to find a property owner who might be interested in a lease option:

• They’re getting divorced
• They need to relocate
• Their family has grown
• They’ve lost their job and can’t pay the mortgage
• Or any other reason you can think of

So, to start with, you need to concentrate your quest on places where negative equity properties are likely to occur. This was most of the nation five years ago, but as rates have bounced back from the last recession, fewer and fewer places have large numbers of negative equity properties. Today, the North East and some parts of the North West are possibly the places where it is most likely that individuals who bought around 2005-2006 would still be underwater.

Then you need to locate individuals who need to move home, but you can’t just carry on as they are. We won’t go into too much detail about the various ways to do this, but common ones are:

• Writing to everyone in an environment where you realise that there is a lot of negative equity, hoping that some owners can meet the correct criteria.
• Running online ads (on Google or Facebook) targeting individuals who are actively looking for a solution or have someone’s demographics that are likely to be a match.
• Looking for assets that are more than worth advertising for sale, where you will find out that they have purchased the property for an equally large price in the past.

It’s not simple: you are not in favour of the needle/haystack ratio. Then a lease option is going to be a whole new idea that you need to clarify once you have found them. And they’re not going to fall in love with the idea, because (even though it’s the only choice they’ve got) it’s not their dream solution.

But as we’ve seen, lease options are fantastic from your point of view as an investor, so you might decide that the juice you can get our is worth far more than the squeeze.

ARE THERE ANY DOWNSIDES TO LEASE OPTIONS?

Put it this way: given the option, it’s always easier to own a property outright. No property strategy is flawless, and there is no difference in lease options.

Remember: a lease option was never the first choice for the owner, and if they were placed in this situation in the first place, their finances would probably be very shaky. For as long as the agreement continues, you depend on their support, which exposes you to risks like:

The owner did not pay the mortgage (although you paid enough to cover it every month), and the lender repossessed the property.

The owner refused to allow you to exercise the option, forcing you to take costly (which would probably not be worth it) legal action.

In order to keep the property profitable, having to do costly maintenance work, wiping out your earnings, and still not being able to purchase at the end.

There are also concerns with the landlord agreeing to the deal, providing the right insurance, and avoiding breaking the contract if the property is a flat, all of which a specialist would need to advise you on.

HOW DO YOU PUT TOGETHER A LEASE OPTION AGREEMENT?

Two separate arrangements are simply a lease option agreement:

The option agreement: specifying, among other things, the term of the agreement, the initial payment due and the purchase price

The lease (or management agreement): specifying how much you’re going to pay per month, the terms you need to abide by, and so on.

You might also want an extra document, such as a title restriction, which will provide you with a degree of protection against the owner selling the property to someone else.

In comparison to rent-to-rent, where you will possibly get by with only a well-drawn contract and no more advice, it is imperative that both parties have legal counsel for lease options.

You would want a solicitor to ensure that it is handled properly and that the agreement is legally binding, and you will also want the owner to have a solicitor so that they will not argue later that they have been coerced or that they have not understood what they agreed to. Because it is impossible that the owner will be able to afford it, you will definitely end up paying for both sets of legal fees.

The key points are when negotiating the terms of the agreements themselves:

The option period: The longer, the better, from your point of view, to give time for capital growth to work its magic.

Options price: the lower, the better, so the faster you are, the sooner your “in the money.”

The advance payment (consideration): the lower, the better, again, so you can walk away with limited losses.

The monthly payment: which is likely to be whatever the owner wants to cover their expenses and leave them in a neutral place

You certainly won’t get it exactly as you want, but you should be able to come up with something that reduces your downside and gives you a fair chance of a good upside with any combination of these four variables.

Personally, since I have no leverage over capital growth (or the actions of the owner), I would want the monthly income alone to make it worth my while over the options span, so I just don’t know whether or not I would want to purchase the property at the end. (I’m essentially treating it in this way as a rent-to-rent contract with the added benefit of being able to buy if I want to.)

WHY ISN’T EVERYONE USING LEASE OPTIONS?

Often because it is easier said than done, and it’s not even that easy to say, because getting your head around is a complicated idea!

It is difficult to find possibilities, particularly now that there is far less negative equity around than there was. Convincing the owners is also not a walk in the park. And I’d file it under “not for beginners,” because if you don’t keep your eye on the lawyers and handle the relationship with the owner well, there’s a ton that can go wrong.

But it is well worth learning about lease options, because:

You may be looking for something else (such as a rent-to-rent or below market value deal), and you may come across the perfect lease opportunity.

There will be times in the property cycle where it will be much easier than it is now to make them work.

The idea may just be ideal for what you want to do in real estate, and you’re willing to make it work.

And you do, now!

We hope you found this post on lease option agreements useful and we hope it explained everything you needed to know. If we’ve missed anything or you’d like us to write about a certain topic or subject then don’t hesitate to get in touch or check out our property forum where you can connect with other like-minded people who are talking about similar topics.