Part Three: Lease With An Option To Buy
This financing strategy combines a regular rental lease agreement with an option to buy the property at a set price, with specific terms, for a fixed period of time.
The lease covers the terms of the rental agreement, along with how much of the rental payment may be credited towards the purchase price if the tenant / buyer decides to exercise the option to buy.
The Option to buy is what is known as a “unilateral agreement”, meaning that only one party to the agreement – the buyer, has the right to buy or not to buy the property. It is the buyers choice. The seller cannot force a buyer to exercise the option to buy. This is why it is called an option. It is simply an opportunity to purchase, without the obligation to do so. A purchase and sale agreement creates the obligation to perform, whereas an option is the right to perform, but without any obligation to do so.
From the buyers perspective, I like options because they give me a chance to try out a property or a business idea before I have to come up with the money to actually finance the deal. And if done with a flexible seller, an option can give a buyer time to gather the money to do the deal without the pressure to get it done in a short time frame.
Options may be for any period of time. A typical time frame is one to two years. Anything much longer than that may be ruled an installment sale by the IRS, creating tax consequences, so it’s advisable to use options in increments of one or two years at a time. But you can extend a one year option each year for 5 years if the seller and buyer agree to do that.
In my own case, I used a lease with an option to buy for a commercial property that I wanted to use to start a storage business. I found a property that was available, but I did not want to have to get a new loan or pay a lump sum of cash up front, until after I got the business up and running. I went to the property owner, who happened to be a savvy real estate developer, made a pitch for a lease with an option to buy, with the right to renew the option yearly for several years. I told the seller that I’d close on the property after I got the business up and running, but I did not know exactly how long that would take.
He agreed to my offer, and I started my little storage business on that property, while paying only $800 a month in rent. After several years I had grown my little storage business and was completely full. At that point I was able to take on an equity partner who funded the deal for a share of the ownership. I closed on the property with all cash and never had to get a new mortgage or make a mortgage payment.
I’ve also been willing to sell houses to tenant buyers using a lease with an option to buy. I collect $1000 up front for each option year. This money is non-refundable option “consideration”. It’s my fee as a seller for being willing to give the buyer the right to an option. The “consideration” can be any number that a seller and potential buyer agree to, and often depends on the value of the property involved. If the tenant / buyer never does exercise their option, and the option either expires, or they move out, I’ve got the option money to help me cover the expense of getting the property ready for a new tenant. If there is damage or unpaid rent, the option money is a handy way to avoid losing money on a bad tenant.
I also advise some real estate investors, especially newbies, to consider using an option to buy when they are planning to flip a property for a quick profit, and do not have the funds to actually close a purchase contract. Purchase contracts create a legal obligation to perform, and if the investor-buyer fails to find a new buyer to flip the property to, the seller could sue for “specific performance”. This does not happen often, but it can happen. I advise the use of an option to buy in order to avoid any legal issues with an irate seller.
You can also record your valid option agreement on a property, and the seller cannot sell the property to another buyer as long as your option is valid. It puts a cloud on the title. This is how you protect yourself as a buyer.
Once the investor finds a new buyer, they notify the seller that they will exercise their option to buy. The idea is to sell to a buyer at a price higher than your option agreement says you have to pay. Then the investor pockets the difference. It’s nice and clean and no pressure to close if you can’t find another buyer. You simply withdraw your option.
Generally the option agreement contains the terms of the option. For example the option may specify that Donna Robinson has the right to purchase from Bob Smith, the property at 123 Main St. for $50,000 for a period of one year, beginning on January 1, 2012 through December 31, 2012. The option should be attached to a filled out purchase and sale agreement which spells out the terms under which the purchase will take place if the buyer chooses to exercise the option. This agreement can then be used by you as a tenant/buyer or you may choose to assign the entire agreement to another buyer if that is not excluded in the agreement.
Options can offer buyers a lot of flexibility while helping avoid the pressure of creating a legal obligation to purchase immediately. And they can be a point of additional income or cash flow for savvy sellers as well.
Donna S. Robinson is a real estate investor, author, speaker and investing coach located in Atlanta, GA. Follow her on twitter at donnaconsults or join her email list on her website, www.RealtyBizConsulting.com