What is a Lease Option?
REtipster does not provide legal advice. The information in this article can be impacted by many unique variables. Always consult with a qualified legal professional before taking action.
How a Lease Option Works
A Lease Option Agreement consists of two parts:
- A Lease Agreement
- An Option to Purchase
This kind of rent-to-own arrangement can be set up as two separate agreements or combined into one.
With a Lease Option, the tenant can exercise their option to buy the property at a pre-determined price at or before the expiration of the lease term. However, the tenant is not making a commitment to purchase the property. If at the end of the lease term, the tenant is still not in a position to purchase the property or no longer wishes to buy the home, they can simply walk away from the deal (and in doing so, they will typically forfeit any upfront, nonrefundable option consideration and equity they’ve paid toward the purchase price to date).
Aside from the high-level concept of how a Lease Option works, all of the specific requirements within the agreement(s) can vary depending on what the tenant-buyer and the landlord-seller are willing to accept. Here are some of the common terms found in many Lease Option arrangements.
Term Length: The length of the term in most Lease Option Agreements is typically between one and five years, depending on what the goals of each party are. If the landlord’s intent is to simply get the property sold, it may be in their best interests to make the contract shorter (6 – 12 months), and if the landlord’s intent is to collect more money and cash flow, it may be in their best interests to make the contract longer (3 – 5 years).
Upfront Consideration: In a Lease Option arrangement, there is typically an upfront, nonrefundable option fee or “option consideration” paid by the tenant-buyer, between 2% and 7% of the price of the home or the equivalent of 3 to 6 months of rent payments.
Rent Price: In many lease option arrangements, the rent price will be above-market (typically 25% higher than comparable rentals in the area).
Purchase Credit: Depending on how the agreement is written, the tenant-buyer can potentially have a portion of their upfront option fee and/or rent payments allocated toward the down payment or purchase price if they choose to buy the home.
Holding Costs: In a lease-option agreement, the landlord-seller continues to pay for all holding costs. However, the agreement may be negotiated so that the tenant-buyer pays for repairs, maintenance, and utilities until the title changes hands.
Advantages and Disadvantages for Tenants
Many tenant-buyers enter into a Lease Option for similar reasons.
Here are some of the most common reasons for a tenant to pursue this type of arrangement:
- Advantage #1: If a buyer cannot qualify for financing today due to a poor credit score or insufficient income, but they think they will quality before the rental period is over, a Lease Option will give them the option to purchase the property after they’ve had a chance to improve their credit and income.
- Advantage #2: A Lease Option allows the tenant-buyer to get very familiar with the property and its surrounding neighborhood before they proceed with buying the property. While most homebuyers spend 30 – 60 minutes walking through a property before making an offer to purchase, a Lease Option affords the tenant-buyer the luxury of living in the property for many months (or years) before making this major financial commitment.
- Advantage #3: A Lease Option essentially allows the tenant-buyer to get familiar with the property without owning it. Since the tenant is not the owner on title, they are able to avoid some of the additional burdens and expenses that come along with property ownership (i.e. – hazard insurance and liability insurance, property taxes, etc).
- Advantage #4: Depending on how the Lease Option Agreement is written, some or all of the tenant-buyer’s upfront option fee and/or rent payments may be allocated toward the down payment or eventual purchase price of the property. This effectively allows the tenant to build equity in the property during the term of their lease, as a sort of ‘forced savings’ mechanism.
There are also some disadvantages for a tenant-buyer in a Lease Option arrangement:
- Disadvantage #1: In many Lease Option Agreements, the tenant is required to pay money upfront for the right to purchase the property and an above-market rent amount each month during the term of the lease. Unless they can negotiate otherwise, they’ll have to put more money on the line than they would in a normal rental agreement (i.e. – one that does not give them the option to purchase). If the tenant chooses not to purchase the property in the end, they’ll often end up losing more money than if they had simply signed a normal rental agreement without the option to purchase.
- Disadvantage #2: If the value of the property goes down after the tenant signs the initial Lease Option Agreement, they will be stuck with an above-market purchase price, unless the original contract gives them to right to revise the purchase price based on an updated appraisal.
While there is certainly a time and place for a tenant/buyer to seriously consider a Lease Option, it also puts certain limitations and restrictions in place for both parties.
Advantages and Disadvantages for Landlords
Here are some of the most common reasons why a landlord might pursue a Lease Option:
- Advantage #1: In many Lease Options, the landlord is able to collect an above-market rent amount for the duration of the lease term. While a portion of this monthly rent amount may also be applied to the eventual purchase price, it can increase the landlord’s cash flow until the property is sold to the tenant-buyer.
- Advantage #2: Most tenants in a Lease Option situation tend to take better care of the property during their occupancy because they have the mentality of an owner, rather than a tenant. This bodes well for the landlord, and there is a lower likelihood that the tenant will inflict the same level of wear and tear on the property.
- Advantage #3: While the standards for rent-to-own contracts can vary by state, in many cases, the contract may be negotiated so that the tenant-buyer is responsible for paying the cost of utilities, maintenance, and upkeep, which further improves the landlord-seller’s cash flow and greatly reduces the property management burden.
- Advantage #4: If the tenant does not follow through with purchasing the property, the landlord is able to keep the upfront option consideration and rent payments they collected from the tenant during the term of the lease.
Of course, there are some drawbacks for the landlord-seller as well:
- Disadvantage #1: If the value of the property rises substantially during the term of the lease, the landlord-seller is still obligated to sell the property at the pre-determined price in accordance with the original Lease Option Agreement.
- Disadvantage #2: If another buyer comes along during the lease term and offers to buy the property sooner and/or at a higher price, the landlord-seller is obligated to comply with the original Lease Option Agreement.
- Disadvantage #3: Since the tenant has the option, but not the obligation to purchase the property, the landlord has to accept the uncertainty of whether they will still be the owner of the property at the end of the lease term.
Overall, a Lease Option offers less security and certainty for the landlord-seller than a Lease Purchase (which does require the tenant to purchase the property at the end of the lease term), but even so, it’s not always the right fit for every person and situation.
Problems with Lease Option Agreements
If someone is planning to participate in a Lease Option arrangement (either as a tenant-buyer or a landlord-seller), there are a few things to be aware of:
Unscrupulous Landlords: There have been documented cases of landlords who have taken advantage of their tenant-buyers because of the fact that they can charge above-market rent and keep the upfront option consideration. Some landlords might look for any feasible reason to evict their tenant-buyer or otherwise convince them not to purchase the property at the end of the lease term. Why? Because if they can regain control of their property, they can find another tenant-buyer who will also pay above-market rent and an upfront consideration. With this in mind, it’s important for any potential tenant-buyer to be aware of their rights and perform in accordance with the Lease Option Agreement to avoid any potential loss.
Low Success Rate: Statistically, there are many rent-to-own agreements that don’t result in the tenant buying the property. If a tenant-buyer pursues a Lease Option because of their low credit score or insufficient income, there’s a good chance their situation won’t actually improve to the point of getting mortgage approval during the one to five-year term of their lease (even if they think it will).
In other cases, there can be changes in the tenant’s employment or other common reasons for a tenant to move. For many potential reasons, it’s not uncommon for tenant-buyers to walk away from the property before purchasing it.
Is a Lease Option Right for You?
Lease Options can be a good creative financing solution for some buyers and sellers, but this type of agreement introduces certain complexities that aren’t present in a standalone purchase agreement or a standalone lease agreement.
It’s also helpful to realize, rent-to-own agreements can have significant variations. Most aspects of a Lease Option are negotiable, so if you’re considering this type of arrangement as either a landlord-seller or a tenant-buyer, seek legal counsel, make sure the contracts are written in a way that makes sense for you and get educated about any potential consequences of your failure to perform.
Reviewed by Claude Diamond, J.D.