What’s A Lease Option Rhett Lewis What’s A Lease Option? A lease option is an abbreviation for ‘lease with an option to purchase’ or ‘lease with an option to buy.’ When you purchase an investment property and have a mortgage on it, instead of just letting your property to a tenant, you also give your tenant the right to buy the property by granting an option to purchase. With a lease option the buyer pays an agreed upfront option fee that gives that person the right to buy should the option be taken up within the specified time limit. The buyer can exercise their option to purchase at any time during their option period in accordance with the term of the option. The option period runs exactly over the same time as the lease that has been set up alongside it. The paperwork used in a lease, or to be precise, an Assured Shorthold Tenancy Agreement (AST) combined with a separate document called an Option Agreement. For simplicity this course is written from the prospective that you are the seller (vendor) who is providing vendor terms to sell to a new buyer. Technically, when you sell using a lease option your new buyer is actually a tenant/buyer until they exercise their option to buy. Deposit When I talk about a deposit, I am using it in the context of a purchase deposit, and not a rental deposit. The characteristics of the deposit, or option fee, are, more like that of a purchase. So you should be careful with the language you choose, otherwise your buyer may be expecting only to pay something like one month’s rent as their option fee. The lease option buyer has the opportunity to live in the house and choose whether or not to exercise their option to buy. They get to ‘try before they buy.’ The buyer’s commitment to buy isn’t firm until they exercise their option to buy. In a lease option, the seller will apply the option fee towards the purchase of the house. However, unlike a traditional rental deposit, the option fee is non-refundable if the buyer decides not to exercise the option. This is the trade-off for fixing the sales price of the property. Having said this, the option agreement still has the legal implication of a sale, but just over a longer timeframe where the option is duly exercised by the buyer. This is, of course, if the buyer eventually exercise their right to buy at a later date. Buyer’s Level of Commitment The way you structure the lease option, you are targeting people with buyer mentality that are likely to be in a position to purchase the property from you within the space of 1-2 years. You may choose to make your agreements longer, but I’ve experienced higher quality buyers when they focused on buying, and not bringing in some degree of de facto welfare mentality. Should they decide not to buy, which is rarely the case, then it’s usually something unforeseen and outside of your control, provided that you properly vetted the applicants in the first place. Term of Paperwork A lease with option to buy can be written for any length of time. However, in order to satisfy lender requirements, we normally offer a fixed 12-month tenancy, with the buyer able to request another fixed term tenancy towards the end of the first year. This is provided that the tenant has met the terms of the agreement up until that point in time. I also allow their option fees to rollover into the next year as credit towards the eventual purchase. I have agreed this rollover for one or two terms after the initial first 12 months. For higher–risk buyers coming in on a low deposit or having past credit problems, I suggest using an initial 6-month period for them to prove themselves to us, whilst giving us the most legal protection in removing the buyer should the arrangement not be working out. I will structure the lease option so that our buyer will either be in the likely position to be offered a mortgage, but they may perhaps need some added personal savings at the time to help with the purchase. Why Choose Lease Options? A buyer can establish their credit. As the seller, I still have the assurance that if things don’t work out and our buyer defaults, I can eventually get possession of the house back as per the Landlord and Tenant Act. Although there is an element of ‘try then buy’ with a lease option, I have found that once a few thousand pounds of hurt money has exchanged hands, It’s likely that we’ve got a committed buyer who fully intends to eventually purchase. By making premium payments over the course of 1-2 years that go towards the purchase of the house, the buyer is not as overstretched financially as with coming up with a lump-sum payment all at once. And by locking in the sales price today the buyer is protected against renewed inflation in housing prices. Under a lease option, we choose to have the option fees paid upfront and periodically paid by way of monthly installment payments made concurrently with the rent. How we structure our lease options From my experience, I have found that people will often have a few thousand pounds available in savings, but not enough to meet the deposit requirements for a mortgage. Accordingly, the default payment structure allows the buyer to build a consistent savings pattern by way of contributions above the market rent, but which is also realistic for the combined household income of our buyer. As mentioned at the beginning, lease options are highly flexible, so there is no one right way on how to set up the terms and payments. When structuring the terms and payments you should be matching up what’s affordable for your buyer, determine if it meets your exit strategy, and finally, the likelihood of the buyer being offered a mortgage during the term of the lease option. In the past, I have chosen to keep rent payments and purchase payments separate from one another. The rent is payable under the Assured Shorthold Tenancy Agreement, and any lump sum and instalment option fees are payable under the Option Agreement. This prevents any gross distortion of rent payments and makes the Option Agreement a much more independent document in its own right. Another reason for this separation of payments was to remove the notion of ‘cashback’ if the combined payment had been incorporated into an inflated rent. The language we use to customers parallels that of a purchase deposit, where the purchase deposit goes from the buyer to the seller, except over an extended period of time. This helps even more to remove confusion with a rental deposit, which infers the eventual return of that money paid. Additionally, it is very clear to all concerned that one document relates to rent, and is therefore bound by the Landlord and Tenant Act, whereas the other document relates to a purchase, and comes under contract law. How do you set our sale price? There is no hard and fast rule on this, as it may depend in what direction the market is moving. In a falling market we would normally expect a more substantial reduction to be possible that in a rising one. In a rising market you may not easily get the same reduction, but people are willing to pay a purchase premium to lock in a price today. To answer this question, you should be looking at is whether the sale price is likely to be achieved during the option period. Although you can still work around this should the property not value up at the time, it is obviously a better outcome it is does. You may need to be a little more conservative when stating out, and get a feel for what the market tells you it is willing to pay. In Summary Vendor terms sales are an alternative means of offering home ownership to the many people in the UK struggling to get their foot onto the property ladder, especially first time buyers. As an investor, it can also provide you with enough positive cash flow today instead of having to wait for years to realise any possible capital growth. Lease options are just one method of vendor terms selling. However, in my home study course, I will focus only focus on lease options. Are Lease Options New? Lease options have been used in buying and selling for a very long time. They are especially common in the commercial sector, and are often used by developers to acquire properties for refurbishment to improve value before purchasing to let out, or to just on sell to other buyers. Just because lease options have been commonly used with commercial property, there is nothing to prevent them being used with residential property either. The fundamentals of this financial instrument are identical in both cases. This approach to Rent-To-Own is different to what is generally understood here under government schemes known as ‘Right to Buy’ or ‘Shared Ownership’. These schemes are normally reserved for key workers, public sector tenants that are housed by housing associations, local authorities, registered social landlords, and the like. Under these types of schemes the buyer usually get a lump-sum equity loan, or buys on a part-rent-mortgage basis that is apportioned in quarters, e.g. 75% rent 25% mortgage. This approach is to offer terms that we clearly define the buyer’s financial commitment needed in order to purchase the house sooner rather than much later. From the beginning they will know and easily be able to explain to anyone else, especially family and friends everything about the purchase in terms of: Purchase price Monthly rent Upfront option fees, that reduce the purchase price Installment option fees (if any), that also reduces the purchase price Option period I want my buyers to feel that the eventual purchase is highly achievable in the given timeframe. If that’s not the case, then I am selling to the wrong person and I’ll tell them that they are not the person that we are looking for. The result is that I usually have a highly motivated buyer for the duration of the option period that is unlikely to give us much cause for concern, so long as I’ve been thorough with my due-diligence checking beforehand. Know Your Exit Strategy Before You Buy a Property How will you make money? Determine before you buy an investment property how you plan to exit or sell the property. What are possible exit strategies? 1. Buy investment property and hold Buy investment property and have you tenant pay off the mortgage. 2. Buy investment property, refurbish and sell for cash 3. Buy investment property. You refurbish the property making cosmetic, mechanical and/or structural changes and sell for cash. Sometimes it’s called ‘Buy-to-Sell’, or a ‘flip,’ if you hold it for a short length of time while making changes and then resell. 4. Buy Investment Property and Sell on a Lease Option Buy investment property. You on sell the property to your tenant/buyer using a lease option; they choose to exercise their option to purchase sometime in the future. Why the Most Common Exit Strategy Doesn’t Always Work! In recent years the buy-to-let market in the UK has grown enormously, with the buy-and-hold strategy being the most popular. However, such has been the saturation level of buy-to-let in some areas that an over-supply of properties is leaving exposed those investors with highly geared portfolios. So, in good times when capital growth is skyrocketing, rents increase with each renewal, and tenants not always well treated, the landlord was definitely king and property investing a piece of cake. However, what happens when the market turns the other way? Here are common questions every buy-to-let investor must take into consideration: Did you pay retail price when you bought your property? What happens if your property is empty for a couple of months? And your mortgage interest rates start rising again? And you’re forced to accept a lower rent in order to tenant your property? Whatever the reason, you still have to come up with the money to maintain the mortgage payment each month. And worst still, what will you do if you have multiple properties where the above happens? Despite how easy it all seemed in good times, do you know how to handle things when the market turns the other way? You could be forced to sell due to negative cash flow. In many instances you’ll lose money instead of breaking even or making a profit, as everyone bails out at the same time as you. I don’t like or believe in negative cash flow. It will give you stress, sleepless nights and fights with your partner. Such times will affect your health and that of your family’s. Why I Like Positive Cash Flow Whilst positive cash flow is a pre-requisite when taking out a buy-to-let mortgage, there is no guarantee that you will be able to sustain that positive income during the entire life of the investment. Provided I’ve done my due diligence before buying and kept my financial exposure to acceptable limits, then I can ride all the ups and downs of the market that removes me from the everyday stress that comes with just making a living. I like property investing, but I love the lifestyle it has provided me over the years. Shouldn’t your property be making positive cash flow each and every month? If it is not providing positive cashflow, then you should consider this option. How a Lease Option Works The option agreement will list the selling price, length of option period, the option fee and any other specific terms relevant to the transaction: Buyer must pay a lump sum option fee at the beginning, and perhaps also when rolling over into a new fixed-term tenancy agreement. Option periods can be designed for any length of time determined at the very beginning, for multiple fixed-term periods of 6 to 12 months each, to coincide with concurrent AST’s. Seller may give buyer installment option fees payable concurrently with the monthly renal payments that the buyer can apply to purchase, only if they exercise their option to purchase. Options can be renewable. At any time during the option period, the buyer can exercise their option to purchase. If the buyer chooses not to exercise their option agreement, they forfeit all option fees paid to date. The vendor is responsible for maintenance, building insurance, and gas and electrical certification. Investors may choose to lease option during time of high rental voids. When the buyer exercises their option to purchase, you receive the back-end profit. Otherwise, they may choose not to exercise their option to buy, in which case you can re-market the property to another buyer, collect another option fee and start the process again. What are the exit strategies for the lease option buyers? The buyers are ‘renting to own’. At no time are they ever under any pressure to purchase, except from their own personal commitment they feel under to actually purchase the house. Buyer chooses not to purchase after their lease option is over, they can simply walk away. Or they can stay on as a tenant if it’s agreeable with you. Or they can ask for an extension. In this case, you may choose to re-negotiate some or all of the terms such as sales price, length of lease option, amount of option payments credited towards the purchase. The seller may choose to collect another lump sum option fee and different installment option fees that may be applied to the sales price of the property. If a buyer chooses not to exercise their option, you keep their option fee and the rent. You won’t collect their back-end profit, but you can re-market the property and sell it again on a lease option. When a buyer exercises their option, you keep the option fee(s), the rent, along with the back-end profit. How a 1 Year Lease Option Works Buy, Finance and Lease Option A house is listed for £85,000. Your offer of £70,000 is accepted which is 18% reduction off the sales price. You Buy £70,000 Purchase Price of Investment House You Finance £70,000 Purchase Price of investment house £17,750 Your 25% deposit £52,250 You borrow at 5% over 25 years on a mortgage: monthly interest only Payments of £217 You Sell on 1 Year Lease Option £ 90,000 Sales price (Added £5,000) £ 3,000 Lump sum Option Fee (non-refundable) £ 87,000 Balance Due £ 590 Monthly Payment Note: If the weekly market rent is £109 (typical rent in my area), multiply this amount by 25% to give a weekly (non-refundable) installment option fee of £25. To convert these amounts to a monthly equivalent, simply divide your weekly rent by 7 to get a daily amount, multiply that by 365 days to get an annual amount and finally divide that by 12 to get a monthly amount (with rounding): Rent Payable: £109 wk = £472 mth Instalment Option Fee: £ 25 wk = £109 mth Monthly Payment: = £590 mth You make money 3 ways: 1. Lump Sum Option Fee (non-refundable) Tenant pays £3,000 non-refundable option fee as a lump sum upon signing. The option fee is for 1-2 years only. (Note: option fee will be credited towards purchase if buyer exercises option.) 2. Monthly Positive Cash Flow Your tenant is now willing to pay more to eventually own, and is willing to pay extra in the knowledge that is going towards the purchase of the house. As a result, your monthly positive cash flow is £317 after deducting your expenses. Tenant Monthly Payment: Rent Payable £472 Instalment Option Fee £108 Total £590 Your Monthly Costs: Mortgage £217 Building Insurance £ 15 Management Fees @12% £ 56 Total £288 Monthly Positive Cash Flow £302 (*) Note: don’t forget that the Installments Option Fee of £109 is inclusive in your monthly positive cash flow. You are therefore receiving some of your profit on sale in advance, even if the buyer chooses not to purchase. 3. Back End Profit With your tenant is now able to get a mortgage and buy the house, you now get the unpaid balance of £15,592 on your resale profit. Sales Price £90,000 Purchase Price £70,000 Profit on Sales £20,000 Less Total Option Fees PAID Lump Sum Option Fee £3,000 Installment Option Fee £1,308 (1 year of additional payments) Total £ 4,308 (*) Back End Profit £15,692 (*) Note: This amount is credited towards your buyer’s deposit for the purchase of the house. Your buyer may also have other personal savings at this stage to put towards the deposit when applying for a mortgage.