What is a Lease Option?
The lease option is a type of agreement between the lessorThe LessorA lessor is an individual or entity that leases out an asset such as land, house or machinery to another person or organization for a certain period. and lesseeLesseeA Lessee, also called a Tenant, is an individual (or entity) who rents the land or property (generally immovable) from a lessor (property owner) under a legal lease agreement. wherein the lessee has an option to purchase the property (commercial or residential) after paying at the end of the lease term or after some specific period of time.
Under lease option, X is buyer, and Y is a seller signed a contract wherein X has agreed to purchase the property $100000 at the end of lease say after 1 year after paying an option fee of $500.The lease rent is $1000 P. M. X will continue to pay lease paymentLease PaymentLease payments are the payments where the lessee under the lease agreement has to pay monthly fixed rental for using the asset to the lessor. The ownership of such an asset is generally taken back by the owner after the lease term expiration. of $1000 for one year, and he will pay $ 100000 at year-end and retain the title of the property.
How does a Lease Option Agreement Work?
Let’s take a few points to understand how it works.
- In a lease option agreement, the parties decide what would be the cost of purchase the option. It is normally non-refundable in case of buyer fails to exercise the lease option because it is not a deposit.
- They decide how much would be the purchase price at the end of the lease period. It is decided at the beginning of the option.
- Also, they agree to what would the period time after which the buyer ( lessee) will buy the property. It is normal for a period range of 1 to 2 years.
- The contractual agreement between parties is arrived at for how much would be the monthly lease rent, whether any lease rent has to deduct from the purchase price. The lease rent is normally higher than the market rent. For example, the market price of lease rent is $1300, but the seller might charge $1600 and $300 reduced from the purchase price.
Sometimes repair work is done by the buyer to make some profit when the buyer sells the property to another person.
Types of Lease Option
There are three types of Lease options
#1 – Buy and Sell Option
In this type of lease option agreement, three parties are involved. Here buyer enters into a contract with the property owner, and the buyer again enters into another with another party for the sale of the same property.
For example, Mr x is the owner (lessor)of the property and Mr. Y buyer of the property (lessee). Y enter into a contract with X to buy the property at $ 100000 after the end of some specific period of time say after 1 year and agreed to pay lease rent of $1000. Now Y will enter into another contract with Z for sale of the property at $ 120000 and agreed to receive a lease rent of $1500.As we can see, Y is making a profit of $500($1500-$1000) through lease rent and $20000 from the sale of a property, and his total profit is $20500($500+$20000).
This type of option is generally done for investment purposes.
#2 – Normal Lease Option
This is a simple way of leasing property here seller (lessor) is the owner of the property lease out the same to the buyer (lessee).
#3 – Assignment Lease Option
In this type of lease, Option Buyer entered into a contract with the seller and assigned the property to another person by charging some assignment fee.
Reasons for Using the Lease Option Agreement
We will understand the reason for using from buyer and seller points of view
Buyer: Buyer may have financial difficulties to make down paymentDown PaymentDown payment is the initial deposit made by the buyer to the seller when purchasing an expensive item, such as residential property or a car. It comprises a portion of the total purchase amount of the asset and takes place via cash, bank check, credit card, or online banking. .
- It generally happens when a buyer is moving to different locations, and he needs to sell the property before the end of the lease period.
- A buyer might have a shortage of funds that can be arranged during an option period.
Seller: Lease option allows sellers to sell the property at a higher price by making contracts more attractive, which he might not be able to sell otherwise.
- The seller can get more money as compared to sale in another case.
- The seller may avoid liquidityLiquidityLiquidity shows the ease of converting the assets or the securities of the company into the cash. Liquidity is the ability of the firm to pay off the current liabilities with the current assets it possesses. problems.
- The seller can retain the right of property by inserting the same into a contract in case of default of payment by which he can save himself.
Lease Option vs. Lease Purchase
Now we can see the difference between both of these.
- Under lease-purchase, both parties of a contract have obligation failure of one party simultaneously breach of another party.
- For example, sometimes it is happening that the buyer will bear the cost of repair and maintenance of property if he fails to do so, then the contract automatically becomes null and void for both parties.
Under the lease option, the seller has an obligation to sell the property. In this case, the lessee will purchase the property at the end of the lease term. Lessee will pay the option fee, which is sometimes adjusted with the purchase price.
The major difference is in lease-purchase. Both parties have an obligation, but in lease option, the only seller has an obligation to sell the property.
- Under lease option money paid towards option, the fee is not refundable.
- A seller might not transfer clear title of the property at the end of the lease period, which can create problems in case the lessee wants to sell the property.
- Under the lease, sometimes, if it is mentioned in the contract, if the lessee fails to pay the lease rent, then the entire amount paid is non-refundable.
Some of the advantages of a buyer and seller in a lease option are as follows.
- The buyer needs not to pay the huge down payment, which generally happens in a lease purchase.
- The lease option doesn’t bind the buyer to buy; rather, it binds the seller to sell.
- In case of default in lease payment, then the contract becomes null and void full value of consideration has surrendered to the buyer.
- The seller has a better opportunity to sell at a high price.
- The option fee paid by the buyer is not refundable in case of defaults.
- The seller will retain the owner until full is paid.
This type of lease is very useful in case of a shortage of funds. Proper care should be taken while drafting the contract. All terms and conditions should be clear, and it should be as per the prevailing law in that country.
This has been a guide to what is the Lease Option and its meaning. Here we discuss how the lease option agreement works along with its types, reasons, and risk involved. You can learn more about financing from the following articles –