How does the lease option to buy work?
When a lease option is in place, a few things happen. First, the tenant will pay what's called an option fee up front; the option money reserves their right to purchase the home once the lease period ends (usually around three years in these arrangements). In some cases, the renter and landlord will agree on a purchase price up front; in others, the two may agree that the home's fair market value will be used when the time comes.
Once the initial lease goes into effect, the tenant will pay a monthly rent, just as in a standard lease agreement. In some cases, a landlord may opt to offer what's called a "rent credit." This is a portion of each month's rent payment that's set aside for the tenant's eventual down payment. When landlords offer this, they will typically charge a rent premium to account for it.
Finally, once the lease period ends, the tenant has the option to purchase the home, should they desire. This typically requires mortgage financing (unless the buyer has saved up a good amount of cash). If approved, they can purchase the home from the landlord and own it outright.
Pros of lease options
For landlords, the biggest benefit of a lease option is both the short-term and long-term returns it offers. As with a traditional rental, you'll still get consistent monthly income. On top of it, there's also the chance of a big payoff years down the road.
Another big perk is that you typically get better renters this way. Because the tenant plans to purchase the home at a later date, they're more likely to care for the home -- as well as pay rent on time to stay in your good graces. With the right tenant, you might even consider offloading all maintenance and upkeep tasks onto the renter. This can lower your costs as well as your burden as a property owner.
Finally, lease options tend to be longer-term agreements, meaning fewer vacancies and less turnover on your property.
- Consistent monthly income and cash flow.
- Possibility of a big payoff years down the loan.
- Potential to offload maintenance and upkeep.
- Likelihood of better, more responsible tenants.
- Decreased vacancies and turnover.
- Ease of finding tenants -- especially during an economic downturn.
- Benefit from the home's appreciation (as long as the tenant agrees to pay market value at the time of purchase).
Cons of lease options
There are lots of benefits to using a lease option, but they're not without fault. For one, the tenant may not actually buy the home. Since their purchase likely hinges on mortgage financing, their credit, income, and savings will all play a role in their ability to follow through.
There's also the chance that home values drop by the time their purchase option rolls around. If you were banking on a certain level of profits, it could leave you disappointed with the results.
Last but not least, lease options often come with very strict regulations in some states. (In Texas, for example, these are called "contracts for deeds" and usually require an attorney to execute properly.)
- The buyer could back out, especially if it hinges on mortgage financing.
- Home values could drop, reducing your profits.
- There may be strict regulations, depending on your state.
- You could lose a stream of income if the tenants follow through.
- It might mean fewer profits than selling now (especially if the property is in a seller's market).
Tips for lease-option success
If you're considering a lease option, the best thing you can do is thoroughly screen the tenant. Run their background and credit, and make sure they're responsible and trustworthy. You should also evaluate their profiles with a qualified mortgage broker. They'll let you know how likely it is they'll qualify for financing down the line.
You should also carefully consider your market before drawing up your agreement. Locking in a sales price up front can help guarantee profits, but you also run the chance of low appraisals, which could throw off your deal altogether. Opting for a market-value price is more standard, but as noted above, that also comes with risks. Work with a local real estate agent to better understand your market, as well as where home values may go during the initial lease period.
At the end of the day, you'll also want a back-up plan in place. In the event the tenant doesn't exercise their option to purchase the home, what will you do? Will you sell the home, find a new tenant, or list it on Airbnb? Having an alternative plan can help you minimize financial loss if plans change.
The bottom line
A lease option to buy can be a smart way to secure both long- and short-term profits, but it doesn't always work out as planned. Make sure you only use these agreements after fully evaluating a tenant and talking with a local agent and mortgage broker. You may also want to consult a real estate attorney to gauge how difficult these agreements may be in your state.