Use a Lease Option to Lock in Low Home Prices

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.

Disclaimer: The laws governing lease-option transactions vary greatly from state-to-state. The typical real estate agent does not have the experience or credentials to properly advise on these contracts. Always have an experienced real estate attorney review your unique situation and prepare/review any applicable documents.

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.

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There are 28 comments to "Use a Lease Option to Lock in Low Home Prices".

  1. Tyler Tervooren says 08 October 2009 at 05:54

    I’ve been heavily considering this as an option for myself as I am close to being ready to buy with all of my ducks in a row, but want to have a substantial down payment as well as enough left over to continue my life as usual and handle any emergencies that might come up.

    But, I’ve always had a bias against lease-to-own situations and, for some reason, just feel generally uncomfortable while considering them. The first thing that comes to mind are those rent-to-own furniture stores that feel so sleazy.

    All the lease-to-own option homes I’ve looked at appear to have a considerably inflated lease price over comparable rentals.

    Adam, can you line out any specific things to look for (or look out for) in determining if a lease option is worth considering?

  2. Adam Baker says 08 October 2009 at 06:24
    Tyler, in this market, I wouldn’t go hunting for homes that were ALREADY being advertised as lease-to-own.

    I would position myself as a strong tenant and look for one of the situations that I listed above that might work. I’d find houses either for traditional rent or sale, inquire on them, and test the waters to see if the landlord or homeowner might be interested.

    In our current market a strong tenant has some leverage as far as negotiation goes.

    Like you said, though, a lot of the homes the a pre-advertised as rent-to-own or lease-to-own often ARE fishy or ARE overpriced. You’ll probably need a little grunt work and a creative approach to get a great deal! But the timing is right it seems.

  3. Tyler Tervooren says 08 October 2009 at 06:31

    Ah, great point! The best options probably aren’t the ones that are already advertised as lease-to-own. Like you said, everything’s negotiable, though, so perhaps all it takes is a little persuasion with the right seller or landlord on the conventional track.

  4. Little House says 08 October 2009 at 06:43

    I have always looked upon lease-to-own options as unsafe. My husband and I are in the process of cleaning up our credit and saving for a down payment for a house. What we’re learning is that it just takes time and patience.

    We live in a very expensive city and prices have come way down. Of course we are worried that prices will begin to creep up and then skyrocket, like they did 3 years ago, but I’d rather be ready when I’m ready, than go with a lease-to-own option. Especially since right now many of the lease-to-own homes are being sold by potentially desperate owners who are upside down on their house. I would definitely caution anyone who is seriously looking into this option. It’s good that you mentioned a real estate attorney for this kind of contract.

    thanks for the post-
    Little House

  5. Nancy L. says 08 October 2009 at 06:45

    Given, as you state, that the majority of lease-options fail miserably, the point you make about poorly written contracts can’t be stated loud enough. There are so many particulars to these sorts of arrangements that people tend to overlook in the excitement of setting up the agreement, that then cause problems down the line. Getting as much set out and agreed upon in writing with the aid of experienced lawyers is vital!

    Many people get so focused on the big picture stuff that they fail to think about the small details, such as what modifications are the tenants allowed to make to the property prior to gaining full possession, or whether or not changes are needed with the homeowner’s insurance policy for a lease situation. Then if those issues surface, it causes tension and disputes.

  6. Golfing Girl says 08 October 2009 at 07:16

    We did something like this with our current home. We had a home 700 miles away that we couldn’t sell for a year and half and found the perfect house here. So we made an offer contingent on renting until we sold our home. We ended up renting for 5 months and the developer was thrilled to be getting some income on a spec house that had sat empty for a year.
    This also benefited us by getting us out of our tiny apartment and our furniture out of storage. Our apartment rent/storage fee was the same as our rent on the house.

  7. John DeFlumeri Jr says 08 October 2009 at 08:12

    It works well, my son in law just did this.

  8. Mindy Jones says 08 October 2009 at 08:36

    When housing prices are down, this might be a good idea. However, my husband and I did this several years ago. All was well until the economy started to drop and housing prices went along with it. When our option came due, our house wasn’t worth what we had contracted to pay. Not a good position to be in.

  9. Sam P says 08 October 2009 at 09:46

    Great job Baker, suggesting an asinine tool to trap thousands of borrowers into god-awful properties. Why are you such a shill for the REALTORS?

  10. Jim says 08 October 2009 at 09:48

    An option is really gambling on the real estate market. This is only worth considering if you’re confident that home values will increase in the future. If the property doesn’t go up on value much then you are wasting your option cost and the higher rent. That could cost you thousands of dollars.

  11. Jeff says 08 October 2009 at 09:56

    Lease to own has the potential to work very well, but only if both sides are educated and treat it as a real estate transaction.

    We have a house for sale and have had conversations with several interested parties about lease-to-own. They almost universally stop calling back when they realize that it is not a cheap way to buy an expensive house. The mortgage on a 500k home with $xx down is going to be $yy no matter whether you are paying it to a bank or a landlord, and a smart landlord will indeed look at the credit situation and make their decisions based on that, not on the tenant’s personal desires.

    I got the feeling from every single one that they all wanted a fantastic deal and they wanted me to provide it, like a wealthy uncle. I feel for them, but I dislike being the teacher in the situation. JD’s article is spot on, and I will direct future inquiries here.

  12. Craig says 08 October 2009 at 10:07

    Frankly, I have trouble recommending any kind of a rent-to-own situation. They’re very sophisticated and tricky arrangements, and the nature of the things is that they tend to be pushed on a financially unsophisticated audience. No prizes for guessing who comes out best in most of these arrangements.

    Rent-to-own is a rental payment with a call option on top, and options are generally a bad bet for people who don’t know _a lot_ about what they’re doing. Up through 2007, with the housing bubble swelling visibly from month to month, buying call options might just have turned out okay for many people–but let’s always be careful not to confuse financial brilliance with a bull market.

    Find the cheapest rental you can that will meet your needs, pile up as much down payment as you can, clean up your credit, and learn as much as you can about your local market–where you want to live, what houses are selling for, and so forth. Make house-hunting a Saturday afternoon hobby for the next year or whatever, so you _become_ that terror to sellers: an informed buyer.

    I think that’s much better advice for the overwhelming majority of people considering rent-to-own.

  13. Neal Frankle says 08 October 2009 at 10:10

    Many of the real estate books telling landlords how to get rich quick suggest the use of these instruments. That sends up a red flag for me (for the people who buy them).

    It’s not to say they are always a bad idea. But it’s just a speculative gamble and I prefer not to participate in that kind of “investing”.

  14. Adam Baker says 08 October 2009 at 10:52
    @ Nancy – You are 100% right. The small details are often offer looked at your specific examples are spot on.

    @ Golfing Girl & John – Good to hear you or your family has had success with this!

    @ Sam – Did you read the post? I’m actually very critical of Realtors in two separate spots. Hardly, a shill. 🙂

    @ Jim – I’ve tried to present this as an alternative to rushing into buying. For me, rushing to an actual purchase is even MORE of a gamble, although admittedly most people could/should avoid both scenarios.

    @ Craig – I’ve never seen options on leases used for benefit on a month-to-month situation as your pointed out. Most lease-options I’ve seen have been 2-5 years. I do, however, agree with the basic advice you provided. Lease-options are just one tool and, as I pointed out, should be approached with caution.

    @ Neal – Yep, and those books are why the majority contain desperate landlords and/or desperate tenants. Like you admitted, there are cases where they could be of a benefit, although it’s certainly not the many in which they are being used now.

  15. J.D. says 08 October 2009 at 10:57

    By my count, Baker just got four hours of sleep. 😛

  16. Doug Armey says 08 October 2009 at 12:13

    Lease options are powerful tools. They are the ultimate leverage. And with all powerful tools have both tremendous potential and huge risk.

    If you are going to use them get truly educated first. If you don’t you will get educated later and it will be a lot more expensive.

  17. Brian says 08 October 2009 at 16:05

    I am a commercial broker, and I have written a couple lease options this way. When they are thoughtfully written, they can be very powerful. I really understand the “sleezy” stigma about them, but they can open windows of opportunity that might not otherwise be available.

    Real estate is about control. If you have a lease option, you have WAY more control than as a mere tenant. Especially a fixed price option. Sure outright ownership is better, but don’t pit good against perfect.

    Be aware of your maintenance responsibilities as a tenant/potential owner. That is a line that needs to be well defined. As an example, some owners will expect you to do HVAC maintenance (i.e. what if its a 30 year old model????)

  18. Adam Baker says 08 October 2009 at 16:14

    Wow @Doug and @Brian. You guys really summarized my opinions well. I should’ve hired you both write my conclusion!

    I couldn’t agree more.

  19. LM says 09 October 2009 at 03:14

    As a real estate investor offering a property under a lease purchase I really see it beneficial to both myself and future tenant. Because I know they will take better care of the property if they want to eventually own it and because this option gives people with good but not stellar credit the ability to eventually own since right now is such a difficult time to get a loan.

  20. Kevin says 09 October 2009 at 16:07

    I don’t usually post when I have a negative opinion about an article, but I’m getting sick of reading things these days where people are afraid of giving out real advice. When the best advice you can give is “consult a professional”, then perhaps you aren’t in a position to be giving advice.

    Expand on the pros and cons, give me specific examples of all this experience you claim to have. To me, this just reads as lazily trying to get something in print rather than trying to share knowledge.

  21. Rich says 10 October 2009 at 08:57

    Another thing to consider is that this is all orthogonal with respect to interest rates. My buy decision is feeling rushed right now because I want to lock in a mortgage at these super-low interest rates, and so far as I can tell, there’s nothing I can do to lock in the rate now for a home purchase I’d rather do a year from now.

    The “cost of money” that would come from a 2% increase in interest rates would likely far outweigh any price increase in my new home in the next year.

  22. Mark Wolfinger says 10 October 2009 at 16:50

    There is one serious problem with these lease options. I see their attractiveness, but as an equity options trader, I understand the importance of not overpaying for an option.

    There is no way for the layperson to determine a fair value for the option to purchase the property. But you can be certain the property owner has taken the time to know the true value of the option – and is overcharging for it. Big time.

    No one would go to the Chicago Board Options Exchange and say: “Tell me what you want me to pay for an option, and I’ll pay it. It’s okay to ignore the current bids and offers, I’ll just pay whatever you ask.”

    That’s the game here. The lease may be reasonable (or not), but the option portion is virtually guaranteed to be a rip-off.

  23. Janie says 10 October 2009 at 21:11

    I’m on the other side of the lease option as a seller. I have a large commercial building for sale, and potential buyers keep asking if I will do a lease with option to buy. I was totally ignorant about it!!

    I finally did my homework and discovered happily that 1) there’s a non-refundable option fee I can collect that is 1-3% of my price, 2)I can choose a 12 month lease option which seems a heck of a lot better for ME if value goes up, and 3) the buyer would be responsible for repairs. Sounds good to me.

    I also discovered that I should probably be the one to continue paying insurance and taxes. I was alright with that. And I’d use a real estate attorney to draw up the contract.

    But what COMPLETELY hit me in the face was to discover that because I’d still be paying on my mortgage (because I can’t come up with the total sum), I’d have to keep the lease option a secret from my bank! Wow. And if I got caught…terrible potential consequences.

    Sounds like many people do the above, but….not at all sure what I’m going to decide here.

  24. JR of Sun City Real Estate says 11 October 2009 at 21:52

    a real estate investor like myself also see a lease purchase as a WIN_WIN situation for both the buyer and the seller. Since nowadays it is very difficult to avail a loan and guidelines are getting tougher, this one is very applicable to also encourage the tenant to take care of the property until such time that they will eventually own it.

  25. Shannon says 12 October 2009 at 13:05

    I recently bought a house using a lease-to-own agreement and it worked great for both me and the seller.
    One thing that people might want to watch for is that my bank’s appraiser came in with a lower home value than what was in our lease option agreement. The bank made us lower the price by $8k even though I was putting $57k as a down payment. Makes no sense to me.

  26. DR says 14 October 2009 at 03:42

    I’m a landlord who regularly offers single family homes under a lease-option. From a landlord’s perspective, there are two big advantages to a lease-option. First, it gives us the chance to sell the home without paying realtor fees. Second, the cash up front for the lease option helps offset costs associated with getting the property ready to rent.

    From a renter’s perspective, I’d suggest a few things. First, treat the transaction like you are buying the home. I’m amazed at how many people shell out $2,500 for a lease-option on a $100k home, and then never buy. In fact, the vast majority never buy in my experience. Make sure you want the home. Second, negotiate the purchase price. Even though it may be a two or three year option, take the purchase price seriously. Get comps and negotiate. In all the years I’ve been doing this, I’ve never had a prospective tenant negotiate the purchase price. Also, make sure the purchase price is fixed; I wouldn’t rely on future appraisals.

    Finally, make sure you get a monthly credit that will go toward the purchase price. About 15% of the rent payment is a good target.

    One more thing (sorry for the long comment). Some lease-options will transfer maintenance obligations to the tenant. This is always negotiable, but if you do accept this obligation, I would make sure it doesn’t transfer to you for the first six months of the deal. That gives you time to get to know the house and makes it less likely you’ll pay to repair a problem that existed before you moved in.

  27. Janie says 14 October 2009 at 08:01

    Aspects I have found confusing about lease options is whether 1) a down payment is required (which doesn’t fit a lease, even if it’s to eventually buy) or 2) if there is a non-refundable “option fee” instead and how much they generally are. I wish there was a checklist somewhere of what to expect with lease options, whether for the buyer, or for a seller in knowing how to do it.

  28. Sayjaybay says 13 November 2009 at 11:11

    @DR:

    Have you ever had to take a non-paying tenant to eviction under a lease-to-own contract? What happened?

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