So what's the deal with lease options? In this article, you'll have all your questions answered…
What is a lease option?
A lease option is a legal agreement that allows you to control a property and generate income from it, with the right (but not the obligation) to buy it later.
It's actually two separate agreements bundled into one, and it's easier to understand when you separate them:
- Lease: You agree a monthly payment to the property owner, which allows you to manage the property and rent it out to tenants for a profit.
- Option: You agree a price at which you can buy the property later, if you want to.
At the heart of any lease option agreement, there are 4 main terms that need to be agreed:
- The monthly payment – which is usually whatever the owner needs to cover their mortgage and any other costs
- The purchase price that you have the option to buy the property for in the future
- The length of the agreement – after which you have to hand the property back if you haven't used the option to buy
- The upfront payment you'll give them in exchange for the option (which in law is called a consideration)
For the agreement to be legally binding there needs to be at least some upfront payment – but this can be as little as £1. So if you've seen people talking about “buying a house for £1”? It's lease options that they're talking about.
Why would you use a lease option?
As the buyer, the question is…why wouldn't you use a lease option?
(OK, there are actually reasons why you might not – we'll come to those later.)
If you structure the deal correctly, it's wins all the way:
- You invest very little cash: just the consideration – as little as £1 – rather than a 25% deposit
- You don't need to take out a mortgage
- You make money every month, just like you owned it
- If the value of the property goes up beyond the agreed purchase price, you can buy it and have “instant equity”
- But if it doesn't, you can just hand the property back – having made money from it in the meantime!
Let's cement all this with an example…
Let's say I agree a lease option with the following terms:
- The property is worth £90,000 now, and I have the option to buy it for £100,000
- The option period lasts for 5 years
- I pay the owner £1 to have the option
- I pay the owner £300 per month, which covers their mortgage payment
I rent the property out for £600 per month, and on average my monthly expenses (repairs etc.) come to £100. So every month, I make £200 profit.
Fast-forward 5 years, and there are two possible scenarios:
- The property is still worth £90,000. Obviously I wouldn't want to buy it for £100,000, so I let the option expire and give the property back. Oh well – I've still made £12,000 in rental profit, minus the £1 I paid upfront, for a total profit of £11,999!
- The property is now worth £110,000. I take out a mortgage and buy the property in the normal way for the £100,000 we agreed. I just bought a house at a £10,000 discount…and I've made £12,000 in rent in the meantime!
There's actually a third option: I could sell the option for £10,000 to someone who wants to buy the property. They would pay £10,000 to me and £100,000 to the property owner, and end up buying the property for its current value.
I'd walk away with £22,000 in cash: £12,000 from the rent, and £10,000 from selling the option. Not bad!
An option actually allows you to buy the property at any point within the option period, not just at the very end.
So lease options are sounding pretty great, from our point of view: it's all upside, because there are two ways of profiting from the option and we can just hand the property back with no consequences if things don't work out.
Which leads to an obvious question…
Why would a seller ever agree to a lease option?
Well, if they have any other options…they won't.
After all, they're committing to a sale price now and locking themselves into a lengthy agreement…while you are free to pull out with no consequences other than losing the upfront fee.
Would you agree to that?
So, the only people who'll grant you a lease option are those who don't have any other choice. And, for the most part, that means owners in negative equity.
“Negative equity” means that they owe more on their mortgage than they could sell the house for. As long as they want to keep living there and the bank is OK with the situation, it's not a major problem. But if they need to move…they're stuck.
Say the house is worth £90,000, the mortgage balance is £100,000, and the owner needs to relocate for work. They can't get a quick sale by offering below the market value, because it wouldn't be enough to clear their mortgage. They can't even sell it at the market value, unless they've got £10,000 in cash to pay the bank the difference.
All they could do is rent the property out…which is a whole lot of hassle, and they might not be able to afford the mortgage payments if the tenant doesn't pay for some reason.
So is a lease option a brilliant option for the property owner? No: they'd far rather get rid now, or at least have the certainty of the sale later. But if it's the best option they've got, they might well go for it.
How can you find lease option opportunities?
As we've just seen, to find a property owner who'd be interested in a lease option, you're looking for someone in negative equity who needs to move because:
- They're getting divorced
- They need to relocate
- Their family has grown
- They've lost their job and can't pay the mortgage
- Or any other reason you can think of
So to start with, you need to target your search on areas where there are likely to be properties in negative equity. Five years ago, this was much of the country – but as prices have bounced back from the last crash, fewer and fewer areas have significant numbers of properties in negative equity. Now, the North East and some parts of the North West are probably the areas where people who bought around 2005-2006 are most likely to still be underwater.
Then you need to find people who need to move house, so can't just carry on as they are. I won't get into lots of detail about the different ways to do this, but common ones are:
- Writing to everyone in an area where you know there's a lot of negative equity, in the hopes that some owners will meet the right criteria
- Running online adverts (on Google or Facebook) targeting people who are actively searching for a solution, or have the demographics of someone who's likely to be a match
- Looking for properties being advertised for sale at more than they're worth, where you can find out that they bought the property for an equally high amount in the past
It's not easy: the needle/haystack ratio is not in your favour. Then once you have found them, a lease option is going to be a completely new concept that you need to explain. And they're not going to fall in love with the idea, because it's not their dream solution (even if it's the only option they've got).
But as we've seen, from your point of view as an investor, lease options are brilliant – so you might decide that the juice is worth the squeeze.
Are there any downsides to lease options?
Put it this way: given the choice, it's still better to own a property outright. No property strategy is perfect, and lease options are no different.
Remember: a lease option was never the first choice for the owner, and their finances are probably somewhat precarious if they were put in this position in the first place. You're relying on their cooperation for as long as the agreement lasts, which exposes you to risks like:
- The owner failing to pay the mortgage (despite you paying them enough to cover it every month), and the lender repossessing
- The owner refusing to let you exercise the option, forcing you to take expensive legal action (which probably wouldn't be worth it)
- Having to do expensive maintenance work to keep the property rentable, wiping out your profit, then still not being able to buy at the end
There are also issues around the lender agreeing to the arrangement, having the correct insurance, and avoiding breaching the lease if the property is a flat – all of which you'd need to take advice on from an expert.
How do you put together a lease option agreement?
A lease option agreement is actually two separate agreements:
- The option agreement: stating the length of the agreement, the upfront payment due, and the purchase price – among other things
- The lease (or a management agreement): which states how much you'll pay each month, the conditions you need to abide by, and so on.
You'll probably also want an additional document, such as a restriction on title, which will give you some degree of protection against the owner selling the property to someone else.
Unlike rent-to-rent where you could probably get along with just a well-drafted document and no further advice, for lease options it's imperative that both sides have legal representation.
You'll want to have a solicitor to make sure everything's done properly and the agreement is legally binding, and you'll also want the owner to have a solicitor so they can't claim later that they were coerced or didn't understand what they were agreeing to. Because the owner is unlikely to be able to afford it, you'll probably end up paying for both sets of legal fees.
When negotiating the terms of the agreements themselves, the key points are:
- The option period: From your point of view, the longer the better to allow time for capital growth to work its magic
- The option price: The lower the better, so you're “in the money” sooner
- The upfront payment (consideration): Again, the lower the better so you can walk away with minimal loss
- The monthly payment: Which will probably be whatever the owner needs to cover their costs and leave them in a neutral position
You probably won't get everything exactly as you want it – but with some combination of these four factors you should be able to come up with something that limits your downside and gives you a reasonable chance of a good upside.
Personally, I'd want the monthly income alone to make it worth my while over the option period – because I've got no control over capital growth (or the behaviour of the owner), so really don't know whether I'll want to buy the property at the end or not. (In this sense, I'm basically treating it as a rent-to-rent agreement with the added bonus of being able to buy if I want to.)
Why isn't everyone using lease options?
Mostly because it's much, much easier said than done – and it's not even that easy to say, because it's a complicated concept to get your head around!
Finding the opportunities is difficult, especially now there's much less negative equity around than there was. Convincing the owners isn't a walk in the park either. And I'd file it under “not for beginners”, because there's a lot that can go wrong if you don't keep your eye on the legals and manage the relationship with the owner well.
But lease options are well worth knowing about, because:
- You might be looking for something else (like a rent-to-rent or below market value deal), and stumble across the perfect lease option opportunity
- There will be points in the property cycle when it'll be much easier to make them work than it is now
- The concept might just be absolutely perfect for what you want to achieve in property, and you're willing to put in the effort to make it work
And now you do!
What have I missed out or got wrong from this post? If you’re experienced in using lease options, let me know.