This article is GRS staff writer Adam Baker. In addition to his work at Get Rich Slowly, Baker blogs over at Man Vs. Debt, where he publicly tracks his spending on a daily basis.
Everywhere I turn, people are speculating on whether housing prices have bottomed. While I personally feel things are looking better, I’m never a fan of trying to time markets. Attempting this often encourages people to make large financial decisions before they are fully prepared or informed. Buying homes in haste is one of the factors that got us into our current financial crisis.
Luckily, there may be a silver bullet for those of you who aren’t willing to rush to buy but are still considering a home purchase within the next couple of years. Your solution may take the form of a lease option.
What the heck is a lease option?
The first thing you need to know about lease options is that everything is negotiable. This can quickly turn a set of simple principles into an extremely complex transaction.
Having said that, here are some common features to help you grasp the concept of a lease-option:
- A prospective buyer pays an option fee, which buys the future right to purchase a property within a specified time-frame.
- Unlike a traditional deposit, the option fee is usually not refundable.
- The fee paid for the option (or option fee) can vary widely, but is typically larger than a traditional deposit, and often ranges between 1-3% of the future purchase price.
- The future purchase price is either fixed up front, or a way to determine future market value is established. For example, at the eventual time of purchase, both parties may agree to average two independent appraisals.
- Many contracts will have a length of between one to three years, although this too is flexible.
- Throughout the contract, the buyer leases the property at a pre-set rental rate.
- Some agreements credit a specific portion of the monthly rental rate against the eventual purchase price. This can add legal complications and potentially present problems with mortgage lenders (who all have different guidelines and allowances for this).
Remember the first thing you need to know: everything is negotiable. These are just a few general guidelines to introduce the concept.
The majority of lease options fail miserably
The average lease option and/or rent-to-buy arrangement is destined to fail. There are several reasons for this:
- Desperate landlords — Many times, lease options are used as a last-ditch effort to sell an overpriced property. Owners are either unwilling or unable to move off a certain price, and therefore turn to any technique that has a chance of bringing the desired sale price.
- Desperate tenants — The majority of tenants shopping for lease options can’t qualify for a traditional mortgage. Many of these candidates have full intentions of being able to eventually purchase the home, but few end up taking the necessary steps to clean up their finances to qualify for a loan.
- Poorly written contracts — All too often, these deals are made between two parties without consulting professional real estate or legal advice. Real-estate agents with no experience in lease options can often complicate the situation by providing bad advice. Malicious investors and property owners make things even worse by using shady agreements to extract large deposits and inflated rent payments, while never intending to actually sell the property.
Situations where lease options succeed
Is there any good news in all of this? Fortunately, yes. I’ve been involved in many successful lease-option transactions, where both parties walked away with smiles on their faces. Here are some situations in which lease options can shine:
- A genuine landlord who can’t sell quickly in the current market and understands the value of strong tenants.
- Homeowners who have recently relocated, can no longer support two full mortgage payments, and are willing to lease to tenants with an incentive to maintain the property.
- Tenants who have already turned their financial lives around and need a little more time to qualify for the best mortgage rates.
- Tenants who could qualify for the loan and afford the purchase, but have specific situations where purchasing immediately is not desired.
- There are a several situations where property owners may have legitimate reasons to desire a delayed purchase due to tax implications.
In our current economy, the value of a strong tenant has skyrocketed. Many landlords and property owners will be extremely flexible with tenants who can accurately demonstrate their strengths. This can include extending low-cost options for those tenants who may want to purchase the property in the next couple of years.
By locking in the future purchase price of a lease-option in today’s market, you’ll have the ability to capitalize on any rebound in housing prices without having to risk buying in haste. If housing prices remain consistent or dip further, you are under no obligation to follow through with the purchase. In most cases you’ll only be out the up-front fee that you paid for the option.
Like many of the topics covered in personal finance, a lease-option is just another tool for you to consider. When used poorly or with malicious intent, they are disasters waiting to happen. However, when used in an appropriate circumstance with the guidance of competent professionals, they can be a powerful addition to your arsenal.