Should Seller's Consider a Lease-Option or Lease-Purchase?

Maybe you are a seller that has found yourself faced with the reality that you can't sell your house or condo for a price today that will yield enough to pay off your loan, and you are not a candidate for, or don't want to do, a short-sale?  Or, maybe you are a seller with a house or condo that, for one reason or another, there is very limited demand for and, in fact, it seems that perhaps no one wants to buy what you have to sell?  If so, you may want to consider using a lease option or a lease purchase to sell your home?  After-all, there is a large demand for lease-options and lease-purchases by buyers but, there are risks you should be aware of and a lease option or lease purchase is not a sure thing.

Before considering selling your home using a lease option or selling your home on a lease purchase you should consult your attorney for advice (remember, I'm not an attorney and this article is not legal advice) as well as your CPA or tax professional (nope, I'm not a CPA either) however, from a 30+ year active broker, and an investor that has done many lease-options, below is a basic explanation of a lease option and a lease purchase as well as some pros and cons of selling your home utilizing a lease option or lease purchase as I see it:

• Lease Option - just like a normal lease on your house or condo, you are a landlord and you have a tenant.  The difference is you are also granting the tenant an option to buy the property, at a pre-determined price during the lease term - Typically, you will do a one or two-year lease option with the tenant's option to buy the house expiring at the end of the lease.  This is just an option to the tenant so there is no obligation for he or she to buy it, they could choose just to live there as a tenant and move at the end of the lease period.

• Pros-
  • Since the current demand for lease/options (as a result of people that have suffered financial difficulties as a result of the real estate crash and/or economy and are now working to get back on their feet but have not reached the point where they can obtain financing just yet) greatly exceeds the supply of lease/options and people seeking these are in a much weaker position to negotiate than a buyer able to get financing now, you can usually get someone to agree to pay a higher price than a buyer buying now would.  Both parties are also banking on the fact that, before the option expires, the property will have gone up in value (for the buyer making the deal a better deal, or at least the price not seem so high and for the seller making the odds of the property appraising out and getting the deal actually closed better).
  • Assuming you have done a good job on tenant selection, and your debt service is low enough for the rent to at least cover it, even if the tenant doesn't buy, but instead stays during the lease period and pays rent, you have managed to let time pass, hopefully while the market improves, at least somewhat, and carried the property without taking money out of your pocket.
  • Like any other lease, any net income you receive from the rental will be partly, if not fully, offset by the depreciation deduction, thereby giving you "tax-free" income.  If this property does not produce income and you have other passive gains, the depreciation from this transaction may help reduce taxes owed on other passive gains (see your CPA or tax accountant for info on this)
  • I have seen situations where people who had no desire to be a landlord do a lease/option to find that they got over their concerns about being a landlord, saw the demand for quality rentals, and then decided to buy more rental property, thereby turning to real estate as an investment for the future or for retirement, all as the result of having a house they couldn't sell.
• Cons-
  • You have the same risks as you would with any other rental property;
    • The tenant may not pay their rent causing you to spend time, and money, to pursue them, collect and possibly even have to sue them for rent and/or get possession of your property back.  Depending on how aggressive you are, and how cooperative (or not) your tenant is, this could result in the tenant being in the property for many months without paying you and, if they file bankruptcy during the process, it could add a couple more months to it.  In the end, if you have to evict them, it will cost you anywhere from a few hundred dollars to a couple of thousand dollars potentially to do so.
    • The tenant could do damage to the property or, at a minimum, not maintain it.  Normally, your insurance will not cover tenant damage (there are exceptions sometimes, depending on the policy, if what the tenant does is actually considered "theft" or "vandalism" possibly...see your insurance agent for more info.
    • The tenant may not buy, leaving you at the end of the lease where you are today, with an empty property that isn't sold.  However, depending on the terms of your Lease/Option, if you required "option money" (a payment by the tenant for the right to buy the property at a later date, usually a modest amount, maybe 1% - 3% of the price which applies to purchase if they buy but you keep if they don't) then you get to keep the option money as a little "bonus" to the rent paid.
    • Sometimes, even with the best intentions by all parties involved, the tenant just cannot get themselves in financial shape to get the financing in time to buy by the end of the option and the lease/option needs to be extended for a longer period if you want to try to have it end in a sale.
    • Since so many outside factors affect real estate value (economy, jobs, condition of neighboring properties, proximity to "negatives" such as commercial business, roads, financial health of the condo, or subdivision, association, etc) and some of these things could change for the bad during the lease option period, there is no guarantee that your property will be worth more at a later period and could even be worth less, leaving you in a worse spot at the end of the lease or when the buyer is trying to execute their option.
    • The tenant may fully perform on the lease as well as get themselves in shape financially to get financing, and still be willing to pay the option price when they are ready to buy only to find out that the appraisal comes in beneath the option price because the market is still not where you are leaving you with the choice of taking the lower price, or ending up back where you started with an empty, unsold property.  So, at the end of the day, even if you get someone to agree to pay more than you could get today, in the end, depending on the market and appraisal, you may go through all this to end up in the same place (or worse if the immediate market deteriorates) that you are today.

•  Lease Purchase - Pretty much the same as a Lease/Option with the only difference really being that the tenant is agreeing, and is obligated, to buying the property and closing by the time period stated in the lease purchase.   The pros and cons of this method are the same as with Lease/Options above, with these differences:

• Pros -
  • The tenant is obligated to buy the property from the start.  So, assuming they honor their contractual obligation (and all contract contingencies are satisfied) this results in a sale in the end.
  • If the tenant is obligated to purchase, versus just having an option to purchase, the thought is they will be more committed to obtaining their financing, taking care of the property, etc.
• Cons -
  • Logic would tell us that if the tenant was already in a financial position to be able to secure financing, they would go ahead and buy a property outright to take advantage of the low prices and dirt cheap interest rates.  Therefore, anyone doing a lease purchase most likely, is going to be like the lease/option buyer I described above, so there is still a risk they will not be in a position to get their financing.
  • A serious buyer is not going to enter into a Lease Purchase that is not contingent upon financing, that does not give them the right to have a building inspection (and most likely negotiate over issues that arise), title and survey contingency, etc....in other words, the buyer is still going to want the rights and protections they would have if they were buying the home outright which is reasonable.  However, by the time you address, and make the contract contingent upon, all these items, you pretty much have about the same thing as a Lease/Option at the end of the day.  Granted, some of these things could be addressed up front, you could require the buyer to do their building inspection prior to taking possession, obtain a title insurance commitment, survey, etc and basically get everything but the financing out of the way up front.  This would require a pretty serious time, and money, commitment by the buyer however and would probably be difficult to find a buyer willing to do it.

•  Things that can be done to minimize risk and increase your chances of success:

• First and foremost, it all starts with tenant selection.  You want to make sure you have thoroughly evaluated the tenant you are considering doing a transaction with to make sure you are aware of their credit and finances and have reason to believe that, buy the time it comes time for them to buy, they will be able to get their financing.  To this end, I would recommend two things:
  • Use a third-party to screen your tenant.  There are good ones out there that will allow your tenant to apply online, then will run credit on them, do criminal checks, verify previous landlords, etc for you and then produce a report with their findings.
  • Require that the tenant meet with a loan officer for a mortgage company or bank to get "pre-approved" for mortgage financing.  Realistically, they won't be in a position now to obtain financing but this exercise, if done by a competent loan officer (I would suggest using one you are familiar with)  should result in a clear road map for you, and your buyer, of what steps they will need to take, or how much more time they will need to pass since a derogatory event occurred on their credit report (ie; short-sale, foreclosure, bankruptcy, etc) before they can get a home loan.   As long as this seems doable by your tenant and the time-frame is within the time frame of your agreement, you will have confidence moving forward.
• Require option money if a lease/option or an equal amount of earnest money if a lease purchase.  As I said above, something modest, perhaps in the 1%-3% range is probably reasonable.  Once again, you have to remember the person wanting to do this type of transaction has probably had some financial challenges so you have to be realistic on their means.
• Collect a one-month security deposit (Missouri state law actually allows you to have a security deposit as high as two months but, again, you have to be realistic as to how much cash the buyer can come up with...I would rather have a smaller deposit, which is refundable, and more option money, which is normally not refundable if they don't buy) as you would typically on a lease as well as require the first month's rent be paid in advance.
• Use a great REALTOR that is experienced in these areas, knows how to guide you through the process and has access to all the necessary forms, etc.   MORE, REALTORS has qualified, professional agents that can handle this.  Click on the Contat MORE button below and we'll be glad to help.