Lease options explained

Lease options are all the rage in some landlord discussion forums having usurped BMV or Below Market Value property as the tool of choice for some landlords to pick up bargain property. But how do they work?

History of lease options

Lease options in the UK residential market are a relatively new phenomenon. They have been used extensively in the US and Australia since the 1970’s.

An option is a financial tool used extensively in financial markets. It allows the holder of the option to buy or sell a property at a fixed price (the exercise price) agreed in advance at any time during a pre-agreed future period (the option period). The purchase or sales price and the length of the option period are agreed at the time the option is created.

In the UK many residential investors have been using lease options to secure an option to purchase a property and then generating a regular income by leasing it back to the original owners. This gives the buyer the certainty of a pre-agreed purchase price along with a guaranteed income.

The purchaser of the lease option pays the seller for the option. This option can be then exercised in the future by the option holder or even sold on to a third party at a profit. The price paid for the option can be nominal e.g. as little as pound; or can be many thousands of pounds depending on the price agreed for the underlying investment property.

Lease options warnings  

My advice would be that investors need to tread very carefully & I would advise against shelling out large amounts of cash up front on potential leads. That said, landlords and property investors with access to potential properties and motivated sellers may be able to capitalise on the opportunities provided by this type of new financial instrument.

The reality is that lease options are totally unregulated. You are swimming with the sharks if you go down this route and also there are many who would argue that quite often they are used to exploit vulnerable people who happen to be homeowners by opportunistic individuals who don’t have a great moral compass. It’s worth being aware that both the Financial Conduct Authority warns against lease options, as does the Council of Mortgage Lenders.

The lease options are often promoted by a middle man who hopes to profit by taking a cut of the option fee rent and option fee. These middle men frequently promote lease options as a way of being able to buy a property for a pound. They are also often intertwined with Lease Option gurus who will tell you….sorry sell you the inside knowledge of how lease options work and lease option strategies which they claim will enable you the investor to make lots of money. Unfortunately, this profit is quite often at the cost of vulnerable homeowners that are in financial difficulty. However, morals aside there I’m sure is money to be made but by who is another matter.

One of these middle men is Mark L’Ansom who will show you how you can not only make money on lease options but set yourself up as a middleman. Clearly one could conclude that there is more money in showing people how to do it; rather than doing it yourself…is this the true definition of a Property Guru?

The main risk to anybody selling the option and entering into a lease option is that the name on the mortgage deed does not alter so that they are still liable for paying the mortgage. If the option holder fails to pay the mortgage then the original owners will still be liable to pay the accumulated debt. The owners then have little or no mechanisms to reclaim their money. This means that unwary sellers often have more to loose from lease options and particularly in a rising housing market where they could be contractually bound to sell a house for less than it is ultimately worth. The holder of the option on the other hand can always walk away from the purchase if house prices fall or fail to rise sufficiently to make a profit.

Martyn Morgan, solicitor at QualitySolicitors Talbots, says lease options are generally frowned upon by lawyers and the Law Society.

How to use lease options

There are many strategies a landlord can employ when using a lease option.

Typically the use of lease options relies on the landlord identifying a motivated seller.

Shimon Rudich is the founding partner of MS Law. A company at the cutting edge of lease options and other innovative property finance based initiatives. He has recently written a guide to various strategies employing lease options. Shimon sets out below the basic strategies that can be used by a property investor when using lease options.

Purchasing an option

This is for use when placing an option on a property not owned by you.

The terms of the option are, broadly speaking, on the best terms that you are able to negotiate with the vendor. Typically, they will include an agreement for the investor to make payment in an amount equivalent to the cost [cost of the mortgage is the interest rate – use outstanding amount] of the vendor’s mortgage(s) and buildings insurance on the property. If the property is a leasehold flat this may also be extended to cover the amount of any maintenance agreement, service charge or rent charged under the terms of the lease.

Subject to negotiation between the parties, this may additionally include the payment of a monthly or annual fee to the vendor but this is a matter purely of negotiation and bargaining power.

In return, you will be granted an option to buy the property during the option period at a set price or by reference to an agreed formula. In law, the option period may be any period up to a maximum of 18 years.

If there is any mortgage(s) on the property then under the terms of the documentation the vendor should also be prohibited from taking any further advances under them. Your solicitor should ensure this. A ‘consent to let’ from any existing mortgage lender(s) will also need to be obtained by you as it is likely that any existing mortgage will be a ‘buy to live’ mortgage.

I would recommend that a break clause is added in your favour or termination provisions in order to protect you should you not be able to secure a ‘sale option’ and let the property to a tenant buyer.

In order to allow you to enter into the ‘sale option’ as efficiently as possible we will also endeavour to obtain a signed transfer from the vendor so that there is no delay in locating the vendor should you wish to exercise the option to purchase.

In addition, a power of attorney should be obtained which, amongst other things will grant you an authority to let the property to a tenant buyer and deal with any buildings insurer and mortgagee(s).

Selling an option

This has two potential functions:

In combination with the purchase option (which is commonly termed the ‘sandwich option.’)
Can be used independently of the purchase option with properties currently within your portfolio.

Upon securing a purchase option in the correct terms, you will be in a position to seek a tenant buyer under a sale option. Alternatively, if you have a tenant buyer ready and waiting you can enter into the sale option immediately upon entering into the purchase option.

Ordinarily, this would entail granting an option to purchase the property to a tenant buyer during the option period at an agreed price or by reference to an agreed formula. The option period would obviously have to be made bearing in mind the option you have under the purchase option you already have, i.e. if you have a five year purchase option you will not be able to grant a seven year sale option to a tenant buyer. If the sale option can be structured on terms more advantageous to you than the purchase option then you derive the benefit from this, i.e. if you are paying £500 per month for the purchase option but secure a tenant buyer who will pay you £600 per month for a sale option then the profit derived here is £100 per month.

A power of attorney granted to you by the vendor under the purchase option will give you the authority to let the property under an Assured Shorthold Tenancy Agreement

(AST) to a tenant buyer

Similarly, if the purchase price under the purchase option is say £90,000 but under the sale option £110,000 then there is potentially profit of £20,000.

Giving a tenant buyer this sale option may distinguish you from other landlords and allow you to charge a higher rent or a fee for giving the tenant buyer such an option. It may also encourage the tenant to remain at the property longer and to maintain the Property in a better condition than a typical tenant. To encourage the tenant buyer to enter into the sale option, the deal may need to be structured so that part of the monies paid are to be credited towards the purchase price which can then act as the tenant buyers’ deposit and thus assist the tenants in obtaining a mortgage product which will enable them to complete the purchase during the sale option period. Records of these payments should be retained by all parties as the tenant buyers’ mortgage lender may require evidence of any payment when the tenant buyer seeks to obtain a mortgage.

Your solicitor will need to take care to ensure that the provisions for exercising the sale option agreement are in accordance with the purchase option. Similarly, any break clauses should be replicated in both purchase and sale options so that you are not prohibited from honouring your obligations.

The AST and options should also contain a provision that should there be a breach of the AST then there is a right to seek not only possession but that it also acts as a ground to terminate the option. For this reason I would also suggest that only a 6 month AST is entered into with a tenant buyer with a right to renew on a six monthly basis for the entirety of the option period should there be no breach of the AST and option agreement by the tenant buyer.

Those who currently own a portfolio may also market their properties on the letting market to tenants looking to occupy under an AST with an option to buy for a set price during the option period. This gives many of the same benefits described above in terms of distinguishing yourself from other landlords and attracting longer term tenants who will maintain the property to a higher standard.

Exercising the option

Correctly prepared option agreements will contain a mechanism to exercise the option and proceed to the purchase of the property at the agreed price or by an agreed formula i.e. a percentage of the valuation. This will usually entail a form of notice being given by the purchaser with completion to follow a specified time thereafter. Having already having obtained a signed transfer document from the vendor at the outset will assist with this as their signatures will be required on the prescribed transfer form.

Why use lease options?

The main reason for a landlord to use lease options is obviously to make money.

They can be helpful in circumventing the need to obtain expensive property finance and also a way to expand a landlords’ property portfolio. They could be particular useful to secure an undervalued property or where a landlord wants to bet on a rapid change in the properties value. However, there are risks. This is a complicated and newly evolving area in the UK and investors should not use lease options without fully understanding how they work and the resulting implications of any transaction.

The success of any lease option arrangement is contingent on the property investor being able to identify potential sellers or a potential buyer who are open to this arrangement. There in lies the rub. In order to do this it is often necessary to use property sourcing companies. These sourcing companies will charge for their leads and services.