Lease to own can be a beneficial method for buying and selling real estate. It gives a prospective buyer the right to purchase a property after renting it for a predefined period. It's a great option for homebuyers with bad credit or those who want to make sure the property is a good fit for them before they buy while also providing the property owner with a pleasant return.
Learn what lease to own is as well as the pros and cons of using a lease agreement in residential and commercial real estate (CRE) to help you determine whether a lease option is the right move for you.
What is a lease-to-own agreement?
Lease to own is a contract between a property owner and tenant that allows the tenant, whether purchasing a residential home or commercial property, to rent the property for a length of time with the option to buy at a predetermined price.
Lease to own can also be referred to as a rent-to-own contract or a lease option. Be careful of lease-purchase agreements as they are different from lease-to-own or lease options. A lease-purchase agreement requires the tenant to purchase the property as a part of the agreement.
The specific terms of the lease agreement can vary significantly, since all portions of the contract are negotiable. Most require a nonrefundable deposit, which can range from 2% to 7% of the sales price, and they may require the tenant to pay property taxes and maintain the property during their lease option term.
Typical terms you might see on a rent-to-own contract include:
- Purchase price, which can be the asking price or above market value.
- Length of contract (usually one to three years).
- Monthly rent amount and how the monthly payments will be applied if the option to purchase is executed.
In an example lease-to-own sale, the property owner has a home listed for $200,000. A prospective buyer requests a lease option, agreeing on a purchase price of $200,000 with a $6,000 nonrefundable option fee and a monthly rent of $1,500 for a two-year term. The contract states that 40% of the rental rate will be applied to the purchase price if the option is exercised.
After one year, the buyer decides to exercise their option to purchase, so $7,200 (40% of the $18,000 they paid in their first year) and their $6,000 option fee, in this case, would be applied to the purchase price as a $13,200 down payment. The buyer secures a loan from a traditional lender for the remaining $186,800, completing the sale and contract.
Advantages of leasing with the option to buy a house
A lease with an option to buy a house typically occurs with hard-to-sell real estate. The seller is usually asking for too much money or the market has a lot of inventory that isn't moving. While this arrangement may initially seem like a negative, it has advantages for both the landlord/seller and tenant/buyer.
The lease agreement allows the landlord to get an acceptable purchase price at a later date while allowing the tenant to move into the home immediately while typically applying a portion of the money spent on rent toward the purchase of the real estate. Rent-to-own homes can be a great way to access a home that would otherwise be outside the buyer's budget, reduce the amount of money they need to bring to the table at closing, and allow them time to improve their credit score while renting, if necessary.
Disadvantages of leasing with the option to buy a house
Potential disadvantages of rent-to-own homes could be an above-market-value purchase price, a nonrefundable lease option payment, and, in the case of a lease-purchase agreement, there may be penalties for not purchasing the house when the lease ends.
There are also no guarantees that you will get approved for a mortgage when the time comes. It's important to note, too, that if you intend to use an FHA loan for your mortgage to purchase the home, there are limits to the amount of the monthly payment that can be applied toward the down payment.
Advantages of a commercial lease-to-own agreement
A lease option for commercial property has several distinct advantages to a business owner. As a tenant, it allows you to build your clientele and ensure that the property location will work for your business long term while also guaranteeing that you will have the right to purchase the real estate if desired instead of risking having it sold to another buyer after you have established your customer base.
It also typically has a portion of monthly rent go toward your down payment, and, if stipulated in the lease option, you can apply any tenant improvements to the property as well. This can result in a significant amount of money being applied toward the down payment over time. Having the purchase date in the future also gives the business owner time to prove their financials to the bank, which could otherwise be difficult as a new business.
Disadvantages of a commercial lease-to-own agreement
Oftentimes the agreed-upon rent payments are above market average to compensate the landlord for the delayed purchase of the commercial property. The tenant is also just that, a tenant. Any improvements you make to the property are still subject to the landlord's approval, which may or may not be an issue.
If you do decide you want to purchase the real estate when your lease ends, you are dependent on bank approval for the mortgage. If your sales do not support the purchase price of the commercial property, then you will lose the property and any improvements you have made to it. Also keep in mind that although you won't need to bring as much to the closing table, the cost is higher in the long run.
Lease to own in summary
A lease-to-own contract can be a great way to purchase a property, but it's important that both parties have a clear understanding of the contract terms and understand the rights, responsibilities, and obligations of the contract before signing.
You should consider having a property inspection and appraisal done prior to signing the rent-to-own contract, and look to see whether there are any liens or second mortgages that could impact your option to buy at the end of the contract. It's always a good idea to have an experienced real estate attorney review the contract.
Remember that all terms should be negotiable. If the seller is unwilling to negotiate, it may be a red flag that this property has underlying issues and you may want to look for a more attractive alternative. Ultimately the decision of whether you should lease to own a property depends on your specific circumstances and desires.
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