Lease options: Explained!

Last updated: 21 June 2018

They're hard to understand. They're hard to pull off successfully. But everyone seems to be talking about them, and some people in property absolutely love them.

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

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It's actually two separate agreements bundled into one, and it's easier to understand when you separate them:

At the heart of any lease option agreement, there are 4 main terms that need to be agreed:

  1. The monthly payment – which is usually whatever the owner needs to cover their mortgage and any other costs
  2. The purchase price that you have the option to buy the property for in the future
  3. The length of the agreement – after which you have to hand the property back if you haven't used the option to buy
  4. 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:

Let's cement all this with an example…

Let's say I agree a lease option with the following terms:

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:

  1. 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!
  2. 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:

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:

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:

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:

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:

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 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:

And now you do!

How can you get started with lease options?

First, you need to understand that a lease option is just one type of “deal” in property – and work out whether you need deals as part of your strategy to achieve your goals in property. It all starts with how much cash you have, and how fast you want to go…

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