Lease option agreements
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 1970s.
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 option period's length are agreed upon when 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 generate 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 exercised in the future by the option holder or even sold to a third party at a profit. The price paid for the option can be nominal, e.g. as little as a pound or many thousands of pounds, depending on the price agreed for the underlying investment property.
HOW TO USE LEASE OPTIONS
When placing an option on a property not owned by our company, the terms of the option are negotiated with the vendor to secure favourable conditions.
These typically include an agreement for our company to make payments equivalent to the cost of the vendor's mortgage(s) and building insurance on the property. For leasehold flats, this may extend to cover maintenance agreements, service charges, or rent as stipulated in the lease.
Negotiations between the parties may involve additional payments, such as a monthly or annual fee to the vendor, subject to mutual agreement and bargaining power.
In return, our company is granted an option to purchase the property during the agreed-upon option period at a set price or by reference to an agreed formula. Legally, the option period can span up to a maximum of 18 years.
If there is an existing mortgage on the property, the vendor is usually prohibited from taking further advances under its terms. Our solicitors ensure compliance with this provision. Additionally, obtaining a 'consent to let' from any existing mortgage lender(s) is necessary, given that the existing mortgage is likely a 'buy to live' mortgage.
To safeguard our interests, we recommend incorporating a break clause or termination provisions in the agreement, providing protection in case securing a 'sale option' and letting the property to a tenant-buyer becomes challenging.
For efficient entry into the 'sale option,' we also work to secure a signed transfer from the vendor to eliminate delays in locating the vendor when exercising the option to purchase. Furthermore, obtaining a power of attorney is crucial, granting our company authority to let the property to a tenant-buyer and handle matters with the building's insurer and mortgagee(s).
PURCHASING AN OPTION
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.
Selling an option
When considering selling an option, our company recognises two potential functions:
1. In combination with the purchase option (commonly known as the 'sandwich option'):
-After securing a purchase option with favourable terms, our company can explore the opportunity to secure a tenant-buyer under a sale option.
-This can be seamlessly integrated with the purchase option, creating a comprehensive strategy.
2. Independently used with properties within our portfolio:
-The sale option can be employed independently, especially for properties currently held in our company's portfolio.
Upon securing a purchase option with favourable terms, our company can seek a tenant-buyer for the property under a sale option. Alternatively, if a tenant-buyer is already identified, we can promptly enter into the sale option, even simultaneously with the purchase option.
Typically, this involves granting an option to purchase the property to a tenant-buyer during the option period at an agreed price or based on an agreed formula. The option period must align with the terms of the purchase option; for instance, if a five-year purchase option is in place, a seven-year sale option cannot be granted to a tenant-buyer. If the sale option terms are more advantageous than the purchase option, our company stands to benefit. For example, if the purchase option costs £500 per month and a tenant-buyer is willing to pay £600 per month for a sale option, the profit derived is £100 per month.
A power of attorney granted by the vendor under the purchase option provides our company with the authority to let the property under an Assured Shorthold Tenancy Agreement.
(AST) TO A TENANT BUYER
In a scenario where the purchase price under the purchase option is £90,000 but under the sale option it is £110,000, there exists a potential profit of £20,000.
Providing a tenant-buyer with this sale option can set our company apart from other landlords, enabling us to charge higher rent or a fee for granting the tenant-buyer such an option. It may also foster longer-term tenancy and encourage the tenant to maintain the property better than a typical tenant. To incentivise the tenant-buyer, the deal may be structured so that part of the payments contributes towards the purchase price, acting as the tenant buyer's deposit. This assists tenants in securing a mortgage product to complete the purchase during the sale option period. Maintaining records of these payments is crucial, as the tenant buyer's mortgage lender may require evidence during the mortgage application process.
Our solicitors will ensure that the provisions for exercising the sale option agreement align with the purchase option. Additionally, any break clauses should be consistent in both the purchase and sale options to avoid any prohibitions on honouring our obligations.
The AST and options should include a provision that a breach of the AST gives the right to seek possession and acts as grounds to terminate the option. Therefore, it is recommended to enter into a 6-month AST with a tenant-buyer, with the right to renew on a six-monthly basis for the entire option period if there is no breach of the AST and option agreement.
For those who own a property portfolio, marketing properties on the letting market with an option to buy for a set price during the option period provides similar benefits. This approach differentiates our company from other landlords, attracting longer-term tenants committed to maintaining the property at a higher standard.
EXERCISING THE OPTION
Properly prepared option agreements within our company will include a mechanism for exercising the option and proceeding with the purchase of the property at the agreed price or according to an agreed formula, such as a percentage of the valuation.
Typically, this involves the purchaser giving notice, with completion to follow within a specified timeframe.
Obtaining a signed transfer document from the vendor at the outset is beneficial, as their signatures will be required on the prescribed transfer form during the exercise of the option.
Why use lease options?
The primary motive for landlords within our company to utilise lease options is to generate income. Lease options offer a means to bypass the necessity for acquiring costly property finance and serve as a strategy to enhance a landlord's property portfolio. They can be particularly beneficial in securing undervalued properties or when a landlord wishes to speculate on a rapid change in property value. However, it is crucial to acknowledge the associated risks.
Given the complexity and evolving nature of lease options in the UK, investors within our company should exercise caution and refrain from using lease options without a comprehensive understanding of their workings and the resulting implications of any transaction.
The success of any lease option arrangement depends on the property investor's ability to identify potential sellers or buyers open to such arrangements. To facilitate this, it is often necessary to engage property sourcing companies. However, investors are advised to tread carefully and avoid significant upfront expenditures on potential leads.
While sourcing companies may offer valuable leads and services, landlords and property investors with access to potential properties and motivated sellers within our company may capitalise on the opportunities presented by this innovative financial instrument.
Lease options warnings
We strongly advise caution when considering lease options, as these financial instruments are currently unregulated. Investors should avoid substantial upfront payments for potential leads. While landlords and property investors with access to potential properties and motivated sellers may see opportunities, it is essential to be aware of the risks associated with lease options.
Lease options lack regulation, exposing participants to potential risks. The Financial Conduct Authority and the Council of Mortgage Lenders both caution against lease options due to their unregulated nature. Often promoted by intermediaries seeking to profit from option fees, these arrangements may be used to exploit vulnerable homeowners.
One significant risk for those selling the option and entering into a lease agreement is that the name on the mortgage deed remains unchanged. In such cases, the original owners remain liable for the mortgage payments. If the option holder fails to fulfil the mortgage obligations, the original owners may face financial consequences without effective means of reclaiming their money.
Unwary sellers may stand to lose more from lease options, especially in a rising housing market where they could be obligated to sell a property for less than its market value. Meanwhile, option holders can choose to walk away from the purchase if house prices do not rise sufficiently to generate a profit.
Copyright © 2024 Atta Capital - All Rights Reserved.
Powered by GoDaddy