Lease Option Frequently-Asked Questions

What is a Lease Option?  A lease option is a contractual agreement between a tenant (Buyer) and the owner (Seller) where the tenant will lease the property for a given period of time, and has the option to purchase the property during their tenancy at a price agreed upon in advance.  Thus the tenant leases the property and secures an option on it to secure his or her future right to purchase.   The Buyer has the unilateral option to buy, or not to buy the home from its owner.  It is considered unilateral since only one of the two parties are bound.  If the Buyer wants to buy and exercises his option to do so, the Seller must sell.  The tenant/Buyer secures his option by paying an option consideration to the Seller. 

What is an option consideration?  The option consideration is non-refundable money paid up-front by the tenant (Buyer) to the Seller for the right to buy the home in the future at an agreed-upon price.  It typically ranges from 1.5% – 2.5% of the sales price of the home.  The Seller is effectively taking the property off the market for the option period, typically one or two years.  As such, the Seller wants to ensure the Tenant will go through with the purchase so that their return can be realized.  In the event that the Buyer exercises the option to purchase, the option consideration is applied to the Buyer’s down payment on the house.  Should the tenant violate the terms of the lease, or elect to not exercise their option to purchase the home during the term of the option, the option consideration is forfeited and kept by the Seller.  This gives the Seller some insurance with regard to the sale and intent of the tenants.  In many respects the Seller wins if they sell the house, and wins if they don’t (by retaining the option consideration).

What is the option period (option term)?  The option period is the term for which the option is valid.  Options are typically set up in yearly increments.  A two year option would allow the Buyer two years to decide to buy the property, after which time the option expires.  An important feature of lease options is that the future sales price of the property is determined at the beginning of the lease option contract period.  As an example, if a home currently valued at $100K appreciates at 5% per year in a given market, the seller might set the price of the home for a one year option at $105K, or at $110K for a two year option.

What fees are involved?  Aside from typical closing costs, Meridian Pacific Properties, Inc. charges a fee to locate and place the lease option tenant in the subject property.

Why would a Landlord want a lease option?  There are many benefits afforded to a Landlord holding a lease option:

1)       The Landlord receives a non-refundable option consideration from the Buyer. 

2)       The sale price is pre-determined and agreed upon by both parties at the time the option is written, which is typically the full appraised value of the property plus an allowance for reasonable appreciation.  Returns are predictable.

3)       If the option is exercised by the Buyer, the Landlord is able to sell the house without the typical 6% sales commission typically charged by Real Esate Agents.  The Landlord also avoids the usual expenses associated with fixing up the property to get it ready for sale.  In addition, the Landlord avoids having the property sit vacant while the home is being marketed for sale while paying holding costs without collecting rent.

4)       Since this is one of few alternatives for people with weak credit, but otherwise strong financials to purchase a property, tenants are willing to pay higher-than-market rents.

5)      The Landlord typically gains a solid tenant.  Since the Tenant anticipates someday owning the home, vacancy is usually zero, since the tenant would lose his or her option consideration money if they moved out and failed to exercise the option.  Due to this, many property management companies offer reduced management rates for lease option tenants, as they wind up being easier tenants to manage. 

6)      Maintenance is usually low as the tenant is also a homebuyer, and homebuyers usually take care of their homes.  We require tenants to pay the first $250 of any maintenance expense on the home. 

7)      It is likely that rent will always be paid on time.  The tenant is working to improve their credit so they can buy the home, so an eviction or other payment problems will adversely affect their credit and may ultimately prevent them from purchasing the home.  This would result in the loss of their ability to qualify for a mortgage and forfeiture of their option consideration. 

8)      The Landlord has a solid exit strategy.  In a real sense, the house is ‘pre-sold’.  The house does not sit idle for months at a time, with no income while the Owner tries to sell it thorough traditional methods.

9)       If the Tenant doesn’t buy, the Landlord still benefits.  The Landlord keeps the option consideration, has received higher-than-market rents, and the house has probably appreciated.  The tenants likely took better care of the property and honored their lease, so vacancy and maintenance costs should have been minimal.  The Landlord may decide to continue to rent the home and/or extend the lease option (for an additional fee and at a new sales price), or place new lease option tenant in the home.  In both cases the cycle continues and the Landlord benefits.

Why would a tenant want a lease option?  A lease option allows a tenant to move into the house they like and intend to purchase without immediately qualifying for a loan.  It allows a credit-challenged tenant the time to repair their credit, save for a down payment, or otherwise qualify for the purchase of the home, all while currently residing in the home.   Their option to purchase protects their right to purchase the property at any time during the option period. 

Can you provide an illustrative example of how a lease option works?

Acquisition

• Meridian Pacific Properties sells the home to the new investor/owner for $124,500 and secures a lease option tenant. 
• The new Owner puts 10% down on the property and finances the balance.  Regular closing costs are ~$3,000, Meridian's tenant placement service cost ~$3000, for a total of $6000 in closing costs.
• The tenant signs a two year lease option with the new Owner and agrees to an option to purchase the home for $136,950 in two years. 
• The tenant pays a $2,000 option consideration to secure the option to purchase the home in the future
• The total acquisition costs to the new Owner are $16,450 (10% of $124,500 + ~$6,000 in closing costs less the $2000 in option consideration).
• Meridian enrolls the tenant in a credit repair program.

Cash flow

• Cash flow after all rents are collected and expenses are paid, is ($157) annually or ($315) over the two year term of the lease. 

Sale to Tenant

At the end of the 2^nd year, the tenant exercises the option and purchases the home. 

• Closing costs to the owner (Seller) are about $850. 
• Since the tenant exercised the option, the lease option consideration ($2,000) is applied at closing as a down payment credit to the tenant-buyer. 
• During the term of the lease (2 year), the new Owner has made mortgage payments consisting of principal and interest and has paid down the mortgage $2,471.  This reduction in the mortgage balance is equity in the home and will be recaptured when sold. 

The owner has deployed a total of $16,450 and winds up with an $8,386 cash return in two years (51% return on investment).