One of the more creative methods of buying real estate is the utilization of a Lease Option Agreement. Let’s take a look at how it works.
In a previous post, Creative Financing, I mentioned the Lease Option as a method of financing a personal residence. This post is more focused on using the Lease Option Agreement as part of a BRRR strategy.
What is a Lease Option Agreement?
A lease option agreement is essentially an agreement whereby the buyer agrees to lease a property for a specified period of time, at a fixed rate of rent. At any time during the lease period, the lessee has the right to purchase the property for a specific price.
Why would I want to use a lease option agreement?
There are several reasons you might want to use a lease option agreement.
You are unsure of the neighborhood or at the present time, you are unsure of your employment situation. There might be the potential of a promotion or transfer to another city or state. By committing to a limited lease, you have more flexibility.
Perhaps you found a great deal but you lack the funds for the down payment and closing costs. By leasing the property for a year or more, you have the time to save the funds required to close the deal.
Cost-Effectiveness as Part of a BRRR Strategy
The first 2 reasons are self-explanatory. Using a lease option agreement as part of a BRRR strategy is a little more complex. If you are unfamiliar with the BRRR strategy, read my previous post here.
When purchasing a property that you intend to renovate and then rent or resell, the lease option agreement is a method where you can use your cash much more efficiently. Instead of using available cash for the down payment and closing costs, it can instead be used to cover the renovation costs.
Once the renovations are complete, the property should appraise for a higher value than the agreed-upon price in the lease agreement. Obtaining a mortgage should be much easier since the loan to value ratio will be much lower.
The Lease Option Agreement
The standard lease option agreement consists of three parts;
The lease agreement
This section of the agreement is very much like a standard lease agreement with all the usual terms and conditions. You can review a standard residential lease agreement here.
The option agreement
The option agreement section spells out the terms and conditions of the option.
- The period during which the option can be exercised.
- The notification period to the seller. For example, the seller may require 90 days’ notice of your intention to exercise the option.
- A clause specifying how any security deposits are to be reimbursed. Since you are purchasing the property in as-is condition, the security deposit should either be applied to the closing costs or returned to you on the closing date.
The purchase agreement
The purchase agreement section of the agreement states all the terms and conditions that you would find in a standard purchase and sale agreement. You can find a standard purchase and sale agreement for your state here.
The only modification required will be the closing date as it will correlate with the terms under the option agreement part of the overall lease option agreement.
Additional Clauses for the BRRR Strategy
Whether you are intending to purchase the property in your own name or the name of an LLC or other entity, it is important to add the phrase “and/or assigns” after the buyer’s name. This gives you the flexibility of assigning title to anyone you choose. We will discuss the importance of this later.
In the lease agreement section of the agreement, a clause must be inserted that gives you permission to make the renovations you desire without the approval of the landlord/seller. Sometimes that will make the seller uncomfortable and he may specify that all renovations be permitted and inspected.
Limited Power of Attorney
If you are planning extensive renovations that you know will require permitting, you may want to insert a clause that gives you the authority to obtain permits without the seller’s permission. The last thing you want is the seller delaying or obstructing your renovation project.
Permission to Sublet
As part of the lease agreement section, you may want to insert a clause that allows you to sublet the property. This is important if it is your intention to hold the property and rent it. It is to your advantage to have tenants in place before you exercise your option to purchase. A lender will look at the income of the property as a factor in granting a mortgage.
If it is your intention to resell the property, there are two ways to facilitate the sale under the lease option agreement.
As I mentioned earlier, if you added the “and/or assigns”, you can simply assign the lease option agreement to someone else. In essence, you are selling the agreement, NOT the property.
2. Transaction Loan
Instead of selling the contract, you can exercise your option to purchase and then obtain a transaction loan to bridge the closing. You can structure the sale so that the sale to your buyer closes on the same day as the closing of your purchase from the seller. For more information on transaction loans, read my post on Hard Money Loans.
On the surface, the lease option agreement method of purchasing real estate appears very attractive. However, there are two significant risks that need to be addressed.
1. Unexpected Renovation Costs
You may encounter unexpected problems during the renovation process that could result in additional costs or delays. Make sure that you conduct thorough inspections to minimize any surprises. Also, make sure you have sufficient cash reserves to address any potential problems.
2. Change in Market Conditions
Depending on the length of the term of the lease option agreement, there is a possibility that market conditions may change abruptly. This could result in the property appraising for less than the agreed-upon price in the lease option agreement, even after the renovations are complete.
You should definitely have a contingency plan for this possibility. One plan is to add an option to extend the lease and thereby extend the option period.
Another option is to complete the renovations and either rent or sell the property as quickly as possible.
If you are unable to obtain sufficient financing to exercise the option, you run the risk that all your renovation costs could be lost.
The Seller’s Perspective
It is important to note that not every seller will agree to this strategy. Even if the seller agrees, he will likely include additional clauses to protect his interests. He may require a large non-refundable deposit if you do not exercise the option to purchase. He may also require an indemnification clause whereby you will be personally responsible for any accidents during the renovation process or for any substandard work.
To increase the likelihood of acceptance of your lease option agreement, you might want to insert these clauses yourself.
It should be noted that in a hot market, most sellers will not agree to a Lease Option Agreement unless the option price is higher than the current asking price.
THE BOTTOM LINE
The Lease Option Agreement is a very attractive option when purchasing real estate. It is best suited to single-family homes or condominiums. The logistics of structuring this type of agreement with multi-family properties can be difficult.
Lease Option Agreements can be complex so you should not attempt to structure one on your own. Consult with a real estate attorney that has experience with this type of agreement.
The information provided here is for educational purposes only and is not to be construed as professional legal, tax, or financial advice. Every situation is unique and you should consult with an attorney, tax accountant, or financial adviser to determine the best options for your personal situation.