What are the basics of lease option deals?

A buyer and a seller unable to enter into a traditional home sale contract may find the lease-option deal an attractive alternative. In a lease-option, the landlord sells the property to the tenant at the end of the lease, provided that both parties agree to certain terms and meet specific requirements.

The landlord and the tenant first agree on the sale price. This represents a significant stumbling block for many parties because neither landlords nor tenants are protected from property price appreciation (or depreciation) and lease-option deals typically last three years.

Also, the tenant pays the landlord a lease-option fee at inception. The lease-option fee guarantees the tenant the right of first refusal on consummating a sale at the agreed upon price at lease end. The fee equals 1 to 5 percent of the sale price and the landlord applies it to the tenant’s down payment.

In addition, the tenant agrees to pay the landlord above-market rent for the property, called the rent premium. The landlord applies the portion of the rent that’s above market value toward the down payment, in addition to the option fee.

The tenant must understand that neither the option fee nor the rent premium accumulate equity and if the sale doesn’t close, the tenant forfeits both payments, which is a significant risk. Of course, if the value of the home depreciates significantly over the course of the lease then the tenant may prefer to take the loss. Conversely, the landlord must agree to transfer the home to the tenant at the agreed-upon price even if the property appreciates significantly in value.

Finally, the tenant must work hard to save money for additional down payment funds and diligently maintain excellent credit for adequate loan eligibility. Both parties should hire experienced representation to help iron out details such as property maintenance responsibilities and insurance requirements. Both should evaluate the other’s backgrounds carefully, lest money – and time – become wasted.

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