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					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.

				
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