Q. What's the difference between a lease-purchase agreement and the more frequently mentioned lease-option?
A. Both are simply what their respective names imply. A lease-option is a property lease with an added option to buy it, which the optionee is not obligated to exercise. Only if he or she chooses to exercise the option to purchase the property is a sales contract initiated.
A lease-purchase, on the other hand, is already a purchase. It's drafted on a purchase and sales agreement and is merely awaiting the fulfillment of a term or condition before it culminates in a closing (the date of which is predetermined). Here's an example:
A prospective buyer, who lacks some of the total down payment needed to purchase a property, asks the property seller if he'd accept a lease-purchase arrangement. The contract would set a future closing date, as well as spell out all other terms of the deal, such as financial arrangements and the payment of closing costs. If agreed upon, the buyer would typically take possession of the property, subject to the terms and conditions of the occupancy.
In addition, the buyer might also ask that a portion of his or her monthly lease payment be applied to reducing either the purchase price or closing costs. Be careful here, because where the money is applied could have other implications. For instance, if on a $1,000 per month lease payment $100 of that amount is to be put toward the buyer's closing costs when the sale closes in six months, then there should be a third party involved to escrow the $600 ($100 monthly for six months) so that it's sure to be available at the closing. On the other hand, it would not be quite so necessary to place the $600 into escrow if the total amount were merely to be subtracted from the property's sale price.
It's important to note that most sellers will usually only allow a credit to the buyer if the monthly lease payment exceeds the property's fair market rental amount. Going back to our previous example of $1,000 per month payment, monthly credit would only be given if the lease payment exceeded the fair market rent. So, if $1,000 is actually the fair market rent (this is usually determined by an appraiser or other market expert) the buyer would have to pay $1,100 in order to receive a $100 per month credit toward the property's sale price or closing costs.
Q. Are there advantages in using a lease-purchase contract if you're a seller? What should the seller look for in a prospective lease-purchase buyer?
A. Yes, there can be. A lease-purchase could make sense for a seller if the real estate market is down and the property is slow in selling, or if the seller needs to relocate quickly for whatever reason. Also, the seller might feel that a prospective buyer would take better care of the property than a renter would, and might even add improvements. But, the seller should also remember that only a trustworthy buyer can reasonably be expected to do this.
Ideally, the buyer should be basically financially strong, only needing a little extra time to consummate the deal because of some special circumstance. For example, the buyer's prior home may be in the final stages before closing, the balance of his or her down payment funds may be coming from a verifiable estate, or the buyer may be waiting for some certificates of deposit to mature in order to avoid the penalty for early withdrawal. It's sometimes difficult to tell how legitimate the lease-purchase buyer is, so here are some questions to pose:
- Is the down payment source valid and timely?
- Is there sufficient earnest money? Depending on the area and price of the property, minimums can range from $1,000 to 5 percent of the sale price. Also, what happens to the earnest money should the sale fall through? Is it returned to the buyer or defaulted to the seller? (This should be spelled out in the purchase and sales agreement. Most contracts stipulate the latter.)
- Has the buyer had a preliminary financing prequalification for the type of loan that he or she will need to buy the property? Further, will the seller incur any costs for the buyer to secure this financing?
Q. How about advantages for the buyer?
A. Again, there certainly could be. As in our example buyer-seller example above, a lease-purchase agreement could allow the buyer time to accumulate the needed balance of a down payment, establish a two-year work- or residence history (often necessary for mortgage loan qualification), or meet some other lending requirement, such as paying off debts.
Q. Is it difficult putting a lease-purchase deal together? Are there any guidelines that should be followed?
A. Crafting a good lease-purchase transaction can be a bit tricky, and if engineered incorrectly it can result in an absolute nightmare situation. That's why lease-purchases should be utilized only for the right reasons.
Either directly in the purchase contract or a lease-purchase addendum to the agreement, the following questions should be answered:
- Who pays what and when with regard to the lease? (For example, when are utilities prorated and deposits transferred?)
- Are improvements to the property allowed prior to closing? (This is one area the seller should consider carefully, because mechanics' liens for unpaid labor or materials could attach to the property and become the seller's debt.)
- Who has insurance coverage? (It's usually a good idea for the seller to keep his or her existing homeowner's insurance until closing, with the buyer adding any additional liability insurance policy if deemed necessary.)
- What are the provisions and the remedies for default? (They're typically the same as those of a standard purchase agreement.)
- Will a monthly lease payment credit amount apply and, if so, how much and toward what expense? (For example, closing costs or reducing the purchase price.)
- Additionally, it might be wise to order a preliminary title report prior to the buyer taking occupancy. This will uncover any possible title defects, liens against the property, and judgments against the seller.