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How do Lease Options Work?

December 10th, 2009

It is difficult to move in the property investment ‘circle’ these days without hearing about lease options in one form or another. Yet many investors seem confused about the fundamentals; mainly over if and how lease options actually work. This confusion arises from the fact that many investors operate different strategies when it comes to lease options, and although the fundamentals are similar, there are varying techniques being utilised. This is probably best demonstrated by way of example which we will get on to shortly, but first you must understand the basics regarding futures contracts.

A futures contract is a contract that upon signing, commits both parties to exchange something at a price agreed upon signing, but at a date in the future.

When a normal property sale contract is signed and entered into it commits both parties to buy / sell something – and any party that changes their mind has to pay a penalty for doing so.

Future contracts are different – they commit only one party to a sale and the other party can pull out at any time without penalty. When signing a lease option contract therefore, one party usually pays in one form or another to enter into the agreement, but for this have the benefit of walking away from the agreement at any time.

Some of the forms of options are demonstrated by the examples below.

1)     Investor and property owner enter into an option. The agreement gives the investor the option to purchase the property at a desired price within a timescale of 4 months. This allows the investor time to line up suitable finance, or to find someone else to buy the property for more money than the option stipulates. Depending on how strong a position the investor and property owner respectively are in often determines how much the option is bought and sold for. It is not uncommon in the current market for options to be entered in to for as little as £1.

2)     Investor owns a property and gives their tenant the option to buy the property at a date in the future for a pre-agreed price. In this instance the property owner and tenant will often agree on a rent figure that is above current market value – ie the tenant will pay a premium on a monthly basis for the privilege of the option to buy at today’s price in the future. If the option lasts for 2 years and the market drops during this time, clearly the property owner will benefit as he will have increased his income without having missed out on capital appreciation in the meantime. However, if the market rises significantly during the two years, the tenant may be better off as they can buy at a much lower level than they would have been able to otherwise.

3)     Investor and property owner enter into an agreement which stipulates that the investor will take over or subsidise the property owners mortgage payments in exchange for the option to buy the property at a pre-agreed price at some point in the future. With mortgages much harder to acquire these days, this type of lease option is becoming an increasingly popular way for investors to acquire property with good equity / strong cash-flow that they may not normally qualify for. Effectively, the investor does not need his own mortgage – so no being refused credit, no arrangement fees, reduced transaction costs. Normally, this type of option will also be transferable, so it can be sold on to other investors or first time buyers as a rent to buy. This type of option is often long-term to the investor’s benefit.

4)     Property owner and investor enter into an option similar to the option described in scenario 2 above. The option lasts for 12 months and stipulates that the investor can buy the property for current market value (for example’s sake). The property in question has a large plot of land at the rear which is prime for development. Once option is entered into, investor gets planning permission to build another house. Once planning permission is granted, investor exercises their option, buys the house and then builds the additional house on the grounds. Alternatively, the investor could sell their option to a local developer or national homebuilder for more than they have agreed with the property owner thanks to the increased value planning has added.

These are just a few examples of lease options. As you can see, they are varied and can become very creative. There are a few pitfalls and certain things to look out for. The main pitfall you must consider is that an option may become completely null and void if the property owner gets repossessed and becomes bankrupt. A mortgage lender will always have a first charge over the property and come before you when any monies from the sale of a repossessed property are distributed. Secondly, it is advisable to ensure you use a solicitor who is familiar with lease options when getting one drawn up. Leaving certain stipulations out of a contract can costs thousands, and may not become apparent until years of financial commitment and you try to exercise your option. Also always ensure as an investor that the property owner is represented by a solicitor. We have heard many stories from investors who have again lost out when trying to exercise options because a property owner claims in court that they did not know what they were signing / or that they were forced into signing something they didn’t understand. If a solicitor runs through everything with them and explains what they are doing, there will be no way to wiggle out of an agreement which suited them at a point in the past but not necessarily anymore.

For more information about options, please feel free to email us at options@ventispropertyinvestment.com or call us on 0208 9409 556

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