Wednesday, June 5, 2013

What Is a Lease-Option? Should You Do One?

In down markets when nothing seems to be selling, home owners are sometimes tempted to explore a lease-option. Similarly, buyers think that they might find a terrific deal on a home with very little money down. They also don't have to qualify for a loan.

A lease-option is actually two transactions on two separate property rights--a lease and an option. Each can exist without the other. You may rent out your property. You may also sell an option on your property (and if you're a buyer, you may purchase an option).

The payment of a real estate commission may enter into the discussion. See below.

In my earlier days as an investor-developer, buying options was fairly routine. Say we wanted to explore the feasibility of developing someone's property and not want to gamble by buying it with no assurance of getting it re-zoned or development-ready. We'd pay the owner a sum of money for the right to buy the property at an agreed-on price within a certain time frame.

For example, an owner may have wanted to sell his raw land for $300,000. We'd pay him, say, $10,000 for the right to buy his land within six months for the $300,000. This right to buy is the option, for which we paid $10,000. If we did not exercise the option, he'd keep the $10,000. If we exercised the option, the option price would be credited against the $300,000 purchase price.

When a home buyer and home seller agree to a lease-option, the option gives the buyer the right to buy the home at a price both agree upon, within a certain period of agreed-upon time. For this right to buy at a set price--the option--the buyer pays something.

How much? Nothing is set in stone. For argument's sake, use 3% to 5% of the purchase price. The length of the option will be one consideration in negotiating the amount, as will the house price. The buyer needs to know the option cost will be non-refundable if the option isn't exercised.

Next is the lease, which is an entirely separate transaction. Here, the seller rents to home to the buyer at whatever the market rental rate is, or whatever both parties agree upon. The option agreement may or may not be referenced in the lease. Whether or not the term of the lease is concurrent with the term of the option is up to the parties.

The price of the home will likely be influenced by the length of the option. If the option runs two years, for example, the home will probably have a higher price than if the option runs three months. Sellers need to set the price low enough to make sense to the buyer, but high enough to account for inflation and market forces that may occur within the option period.

It's never a good practice to fight for the last dollar. When both sides feel they made something at the end of the transaction, it's been a good deal.

Real estate commissions: If your real estate broker secures a client willing to enter into a lease-option, the broker will expect a commission, usually based on the future purchase price. This situation may present a problem for the seller. First, the buyer may not exercise the option--his right-to-buy--and the house won't have sold. Why pay a commission on a sale that doesn't happen?

Second, the seller probably won't collect enough in the option price to pay the broker. Is payment of a commission a solvable problem?

One solution is to offer to pay the commission when the buyer exercises the option. That way, if it isn't exercised, no commission is owed, and the broker takes the same risk as the seller. Some of the larger brokerage houses won't permit delayed payment of a commission. Some will, and independent brokers can do what they want. I know I wouldn't pay a commission on a sale that may or may not happen. You may also work out a flat fee or hourly rate with the broker.

Do not let a broker prepare the option agreement. Some firms have pre-printed forms that seem to address all issues, but I strongly advise people to have an attorney prepare the option agreement.

And the lease? Some brokers are also licensed to engage in rental properties and have pre-printed leases. An attorney may also prepare the paperwork, which is what I'd recommend.

Disclaimer: Nothing in here is meant as either legal or real estate advice. If you want to enter into a lease-option arrangement, consult with appropriate professionals.