What Is a Lease Option? Requirements, Benefits, and Example

What Is a Lease Option?

A lease option is an agreement that gives a renter a choice to purchase the rented property during or at the end of the rental period. It also precludes the owner from offering the property for sale to anyone else. When the term expires, the renter must either exercise the option or forfeit it. A lease option is also known as a lease with the option to purchase.

How a Lease Option Works

A lease option gives a potential buyer more flexibility than a standard lease-purchase agreement, which requires the renter to buy the home when the lease ends. The price of the home is agreed to upfront by the buyer (the renter) and the owner. The price is typically at the current market value of the home, allowing the renter to buy the home in the future at today's price.

For that option, the renter is usually charged an upfront fee by the owner, which might be 1% of the home's sale price. The fee goes to the downpayment if the renter decides to buy the home at the end of the lease. The lease option is especially helpful to those who might be building their credit or don't have enough saved for a downpayment. However, there are several features of lease options to consider.

Requirements for a Lease Option

Leasing options come with a tradeoff for property owners, since they may lose the chance to sell the property for a higher price. In exchange, tenants pay more to rent with a leasing option than they would pay otherwise.

Rental Payments

The owner charges a premium in addition to the standard monthly rent for the option to buy at today's price when the lease ends. The premium might be a percentage added to the current rent, such as a 10% surcharge of the standard monthly rent for a home of that size.

The premium, which is often called rent credit, becomes part of the downpayment for the home if the option is exercised to buy the home by the renter. However, the renter forfeits the extra money paid above the standard rent if the home is not purchased at the end of the lease.

Some owners might take a one-time cash payment, often called "valuable consideration," which is similar to the premium paid for an option in the financial markets. This is not a deposit on the purchase of the property, meaning it's not refundable. The amount ranges from a token fee to 5% of the expected purchase price.

Bank Financing With a Lease Option

The good news for renters is that typically, banks will allow the total funds of the premium above the rental payments to go to the downpayment for purchasing the home. However, if the rent charged was an at-market rate, the bank may not allow any of the funds to be applied to the purchase price. It's important that buyers check with multiple banks to determine their policies regarding financing a mortgage for a home with a lease option.

The Term of a Lease Option

The term of the option may be any period on which the property owner and renter agree, but is commonly one to three years. The lease option contract also stipulates the property's purchase price at the start of the lease or how that price will be determined at the end of the option. More specifics on the lease option terms are in the following section.

Lease Option Terms

There are a number of lease option characteristics or terms starting with the actual lease term. This defines the period during which the tenant will occupy the property. The purchase option price is also a critical component of the lease agreement, determining the price at which the tenant can buy the property if they choose to exercise their option. In some cases, an exact dollar may not be given but instead a method of calculating the value (i.e. the Official Kelley Blue Book value at the date of lease termination).

The option fee, also known as option consideration, is a non-refundable upfront payment made by the tenant to the landlord to secure the right to purchase the property during the lease term. Rent credits, if applicable, are additional financial incentives in some lease option agreements that may sometimes be used to offset fees or the purchase price.

Lease options often have an exercise period that defines the specific timeframe within which the tenant must notify the landlord of their intent to exercise the purchase option. It is crucial for the tenant to adhere to this timeframe to avoid losing the right to buy the property.

Lease options usually have default and termination clauses. Default and termination provisions should outline what happens if either party fails to meet their obligations. Some lease option agreements may include an option for the tenant to extend the lease term or exercise period if they need more time to decide on exercising the purchase option. In some cases, this extension may incur a fee.

Last, the lease option may require an appraisal and inspection. This is to determine the property's current value and condition at the time of exercising the purchase option. In many ways, this protects the buyer from not overpaying for a less-than-valuable good.

Industries With Lease Options

This article primarily focuses on real estate; however, there are a variety of industries that often bake lease options into contract agreements. These industries include but are not limited to:

• Real estate: In real estate, lease options enable prospective homebuyers to rent a house with the opportunity to buy it later. This is the primary context of this article.
• Automobiles: Lease options are frequently employed for cars. Customers have the choice to lease an automobile for a predetermined time, often two to three years, with the option to purchase the car at the conclusion of the lease term for a predetermined cost.
• Equipment: Companies frequently rely on expensive equipment in a variety of industries, including manufacturing, construction, and healthcare. They can rent the equipment for a certain time period so they can evaluate its performance and suitability for their purposes by using equipment lease options. After the equipment has a diminished useful life (but still holds value), the company may have the option to buy the equipment.
• Technology: Software licenses, computer hardware, and other types of technological equipment can all be leased via technology lease options. In some cases, these services may then be permanently downloaded or owned in perpetuity (often because they may have been superseded by newer versions).
• Agriculture: Leasing farms is one use of lease options in the agriculture industry. Farmers who lack the funds to buy land might lease it with the possibility of buying it later if they produce profitable crops.
• Aviation: When leasing aircraft, airlines or private parties may employ lease options. It gives them more financial freedom by allowing them to use airplanes for a certain amount of time without having to pay the entire purchase price.

Reasons to Use a Lease Option

There are several reasons why the renter and the owner might enter into a lease option. It's important to consider whether the benefits outweigh any drawbacks for entering into the agreement.

Why Renters Enter Into a Lease Option

A potential buyer may have many reasons to use a lease option rather than buy the property outright at the start. A major consideration is not having enough money or credit to make the purchase. Renting can allow the potential buyer to save money for the purchase and at the same time, build their credit by making regular, on-time payments.

The renter has a chance to buy a property in the future at today's prices. If the renter doesn't have the money saved today to buy the home but is worried the home's value will increase in the next few years, the lease option is a good choice. Also, if the renter loves the home, the school district, or the neighborhood, the lease option takes the home off the market—allowing the renter to save enough to buy it when the lease ends.

Even if the potential buyer has the means to purchase the property, they may not want to commit to it right away. For example, if the potential buyer is from another place, they might want to live in the new town before committing to the purchase. Or, they may still have their old property to sell before being able to buy the new property.

Finally, the property may not qualify for certain loans, including a VA loan, due to needed repairs or upgrades. By renting first, the potential buyer can make those improvements in order to qualify for the loan later.

Why Owners Enter Into a Lease Option

A property owner may enter into a lease option agreement because they had trouble selling the house outright. The option can make the property more attractive to different types of potential buyers.

Also, if a homeowner is thinking of selling the home in a few years, the lease option allows the owner to collect a premium above the current market for rent. The worst-case scenario is that the renter doesn't buy the house; the owner places it on the market to sell and keeps the extra funds paid above the standard monthly rent.

There may also be tax issues involved in selling the property outright now instead of selling it later. The option, while not a guarantee to sell later, does make it more likely that the owner has a buyer ready to go at the end of the option.

Lease Option vs. Right of First Offer

In many ways, a lease option (or lease-to-own agreement) is similar to a right of first offer. A right of first offer (ROFO) is a contractual provision that grants a specific party the first opportunity to purchase a property.

If the property owner decides to sell the property, they must first present the terms of the sale to the party holding the ROFO. This gives the holder the chance to accept or decline the offer.

If they decline or fail to respond within a specified timeframe, the property owner can then proceed to offer the property to other interested parties. However, should the negotiated price of the property materially vary from the price that was originally offered to the original tenant, there may a clause that requires the seller to re-approach the original tenant with the same package.

Lease Option vs. Right of First Refusal

A lease option is slightly different from a right of first refusal (ROFR). A ROFR is a contract that gives a specific party, usually a tenant or lessee, the right to match the terms of any offer made by a third party to purchase the property before the property owner can proceed with the sale.

For example, Party A owns a property and receives an offer from Party B to buy it. The tenant, Party C, has the opportunity to match the terms offered by Party B and, if Party A agrees to sell, they must approach Party C first.

Though this feels similar to a lease option, there are substantial differences between the two. In a lease option, a tenant may be presented with an upfront opportunity to buy a property; should they decline, they may not be approached with the opportunity again. With a ROFR, it is on the seller to decide whether or not to pursue a sale; only at that time is the tenant looped into a potential deal. Instead of the clause being enacted based on the passage of time, a ROFR is triggered by the decision to sell.

Special Considerations

Renter's insurance is typically required for the renter's personal belongings. Renter's insurance protects for any loss in value of belongings and furnishings in the home. Also, it's important that it be mandated that the owner also have homeowner's insurance in the event something happens during the lease term that could adversely affect the property's value such as a fire or water damage.

An appraisal contingency should be included in the lease option agreement. In other words, when the lease ends, the home's value could have decreased. An appraisal provides an updated value of the property before the purchase and sale go through.

It's important to calculate the exact amount of money to be paid to the owner at the end of the lease option. Remember, the owner is taking the house off the market and forgoing any gains in the home's market value by entering into the lease option. The owner will want to be adequately compensated for not being able to sell the house to another person who was ready to buy it.

For those considering a lease option or a lease option to buy, they should ideally have a lawyer who is familiar with lease-option transactions to review the fine print to make sure there aren't any surprises when the lease term ends.

Example of a Lease-to-Own Option

Suppose that a landlord wishes to sell their home, valued at $500,000. The house has a long-term tenant, who is currently saving to buy their own home. Both parties could try their luck on the housing market, but it would likely take several months for the landlord to find a suitable buyer and the tenant to find a suitable property and seller. Moreover, selling the house would require the property owner to vacate the tenants, thereby losing a source of monthly income.

Instead, the landlord could offer their tenant a leasing option, providing an easier transition for both parties. In a typical lease option, the prospective buyer-tenant would pay an additional 3% to 5% of the house price ($15,000 to $25,000) as an option fee, as well as an additional premium to their monthly rent. In exchange, they would have the option to buy the house in two years, at today's price. The monthly premiums would contribute to the downpayment.

This arrangement works out to the advantage of both parties, although there is a tradeoff. The buyer-renter can lock in a favorable price on the home, but if they do not exercise the purchase option, they will have paid more money than they would have paid for an ordinary rental. In addition, they may also be responsible for maintenance costs that are normally the landlord's responsibility. The seller-landlord makes more money initially, but they lose the chance to take a higher offer.

The Bottom Line

Leasing options are a popular way for homeowners to secure a potential buyer without having to put the property on the market. After paying an upfront fee, the tenant gains the right to buy the home at the end of their tenancy, often for a preferential price. This arrangement gives additional flexibility to prospective homebuyers, allowing them to build their savings and credit as they prepare to buy a home.