It may be difficult to sell a home or investment property in today’s market, especially as prospective buyers delay their purchases in expectations of better deals, assuming home prices will continue to decline. However, with the market starting to show early signs of bottoming, there may be a possible, timely solution for both sellers who intend to sell their property and buyers who consider buying but still remain somewhat unsure whether this is the right time. That solution is a lease option.
A lease option is a transaction in which a property is rented to a prospective buyer for a specific period of time. The renter (tenant or lessee) has an option to purchase the property once the lease period expires. The lease terms, including specific rent on a lease option as well as the selling price for the property in case the lessee decides to buy, are set in advance. In addition, lease options specify the amount of option money to be collected. This amount is often regulated by state or local regulations, but, in general, it ranges somewhere between 2 and 4 percent of the agreed purchase price. The option money is set aside and used toward the down payment or the purchase price in case the lessee decides to buy the property. If the lessee decides not to buy, the option money is awarded to the owner.
Lease terms are usually negotiated for periods of up to two years, with short-term options resulting in sales more often than the ones negotiated on long terms. Longer options may be too speculative as regards the set sales price, given that prices may rise or fall significantly over periods longer than two years. In case prices rise well above the price agreed under the option and the lessee exercises the option to buy, the property owner is likely to incur an opportunity cost. However, if prices decline well below the price set in the lease option, the lessees are unlikely to exercise the option and the owner could be trapped in an unfavorable situation. This is exactly why it is important to have the realistic price set in advance.
Now, deciding whether a lease option is the right choice for the seller in the current market involves several considerations. A lease option may be a good investment management choice for property owners because it allows them to generate income from the property, which, for instance, may be used to finance monthly mortgage payments on a second home. Moreover, given that the ownership of the property does not change during the term of the lease, property owners are able to deduct mortgage interest payments from income taxes while earning income from the property.
However, some property owners, especially families selling their primary home, who need the money from the sale in order make a down payment on a mortgage or have other financial needs, may be better off by selling their home right away. This may hold especially true if prices in the area are most likely to decline in the next year or so. Moreover, all income from rent must be weighted against the costs of maintaining the leased property.
Depending on the behavior of the tenants, leased properties can suffer substantial wear and tear during the life of the lease. This could result in major expenses for fixing the property and preparing it for sale, in case the tenants choose not to buy the property at the end of the lease contract. While lease terms may require the lessee to cover the expenses of maintaining the property, sometimes the damages may be too extensive, requiring the owners to invest a lot of money in repairs.
Leasing property also does not exempt the owner from paying property taxes, homeowners’ insurance, and any other dues associated with homeownership. Therefore, if the property owners buy another house while waiting for the lease option to be exercised, they may be paying double property taxes. Finally, as many lease options are not exercised, property owners may have to begin the process of selling the property all over again after the lease term expires.
Lease options appear to be a good sales strategy for those homeowners who are not in a rush to sell their property. They may also be a particularly good way to earn some income while waiting to sell the house. Indeed, lease options could be a sure future sale if tenants with the highest potential to purchase the house are carefully screened and selected. However, as described, lease options have many pitfalls that may add to the cost burden of the prospective seller. Therefore, lease options should be weighted against all possible alternatives before the final decision about what to do with the property is made.