A lease option is a powerful property strategy which enables an investor to make both income and capital from a property – often with very little financial outlay.
It is another strategy in my killer property strategies series.
It can look like a strategy too good to be true. But it is true and it can be good, but it is most certainly not a strategy for the property novice acting without assistance.
1. Nature of a lease option
A lease option is basically two agreements combined – a lease and an option.
Together they comprise a property strategy enabling an investor to:
- Control a property
- Derive an income from it – by renting it out
- Purchase/sell it at a later date if they so wish by utilising the option to buy.
I call this the “basic lease option”. There are some enhanced versions of this basic model which are outside the scope of this blog.
2. Key elements of a lease option
How does a lease option work in practice? In what circumstances can the strategy be effectively employed?
The strategy is perhaps most appropriate where an owner is in negative equity, needs to move (for instance because of loss of job or divorce) but cannot afford to do so.
Upon agreeing a suitable lease option, the owner is free to move out and move on with their life.
- In a basic lease option, the investor agrees a lease with the owner which allows the investor to rent out the property to a tenant – making a monthly rental income. The length of the lease is agreed by the owner and investor.
- The investor pays the owner a monthly rent from which the owner pays the monthly mortgage on the property.
- The investor also secures an option agreement from the owner in which the investor has the right (but not the obligation) to buy the property for a pre-agreed price during the option period. The length of the option is agreed by the owner and investor and is usually the same length as the lease – typically 2 to 5 years. The investor pays an option fee or consideration, which can be as little as £1.
- At any point during the option period, the investor can choose to exercise the option and buy the property – if it is to their advantage to do so.
- At the end of the agreement, the investor can walk away without penalty if they decide it is not in their interest to buy.
The strategy is so good for the investor it is a wonder more property investors don’t use it.
3. Control for just £1
The lease option is the source of the somewhat sensationalist advert you sometimes see:
Buy a property for only £1!
The £1 refers to the minimum option fee or legal consideration that the investor must pay for the option to purchase.
There is a bit of marketing speak at work. £1 does not actually buy the property in the strict sense of the term – it controls it.
Of course, controlling a property for just £1 is not to be sniffed at.
4. Advantages for the owner
The strategy has the following benefits for the owner:
- Not forced to sell at a loss in a negative equity situation
- Can agree a price which will give them a profit or enable them to break even on a sale at a later date
- Not compelled to remain at the property, and so free to move on with life, get a job elsewhere or otherwise take control.
5. Advantages for the investor
The pluses for the investor are manifold. If the investor gets everything right, they can control a property, get income from it and make a capital gain at a later date for as little as £1 by way of investment.
The investor benefits of the strategy include:
- Possibly, only a small investment is required – as little as £1
- The property is controlled; there is no need to own it – so no need for a mortgage
- Income is made each month – being the difference between what is received in rent from a renter and what is paid to the owner for the lease
- There is no obligation to buy the property under the option; if the investor will make a profit they can buy the property or sell on the contract to a third party for a gain; if there is no profit for the investor in buying by the end of the term, they can just walk away.
In simple terms, the investor is in a win-win situation.
6. Pitfalls of the strategy
The main pitfall for the owner is that the investor may prove to be unreliable – not paying the monthly amount to enable them to pay the mortgage. The outcome could be repossession by the mortgage lender if the owner goes into mortgage arrears.
The property remains owned by the owner who is therefore responsible if there is any damage to the property and any objections or proceedings by the lender.
Any owner looking to enter into a lease option agreement should secure specialist independent legal advice from the start.
Risks for investors include:
- The owner receives the monthly rent but does not pay the mortgage, resulting in the property being repossessed
- The owner does not comply with the option, making expensive court proceedings necessary
- The cost of maintenance, which is for the investor to pay, exceeds calculations, resulting in a marked reduction in anticipated profits or even a loss
- Problematic issues arise around insurance of the building
- Unwillingness of the mortgage lender to agree to the arrangement
- If the property is leasehold, the lease may not allow the arrangement.
7. Minimising the risks – investors
It is essential for both parties to have their own independent solicitor, especially to reduce the risk of the owner claiming that they were “unduly influenced” into entering the arrangement.
Investors need to ensure that their option is protected at the Land Registry and it is essential for them to employ a specialist property solicitor to deal with the complex legal paperwork and to give them the best protection possible.
8. Minimising the risks – owners
Owners need to ascertain the stance of their mortgage lender from the outset. They need to engage solicitors with knowledge and experience of lease options. They should carry out full due diligence in respect of the track record, reliability and integrity of the investor.
Have you been involved in a lease option? What were your experiences? Please leave your comments below.
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Rebel Property Coach
My website is: www.rebelpropertycoach.com