Is the Lease/Option Making a Comeback in San Carlos?

May 19, 2009

Tough Market = Creative Solutions.

It's no secret how tough the real estate market has been for the higher priced homes in San Carlos and elsewhere on the Peninsula.  This segment of the market gets a “double whammy” that isn't as prevalent in the sub $1M, first-time buyer's market — tight credit, and lack of able buyers.    We'll talk about the latter group in this post, and how both sellers AND buyers are having to get creative to move some of these expensive properties.

The Lease/Option.

What is a lease/option?   It's a standard real estate lease, but with the added twist that the renter can purchase an option to buy the home at the end of the lease period.    Here's a hypothetical example of how it works:

Seller has a very nice $1,600,000 home on the market.   A qualified buyer is very interested in the home, but needs to rent it for a year before deciding to purchase the home (for reasons we'll discuss below.)    They agree on a deal where the buyer will lease the home for one year at $5,000/ month, and pays $50,000 up front for an option to buy the home for $1,500,000 at the end of the lease period.   It's also agreed that if the buyer exercises his option to purchase the home, then 50% of his lease and 100% of the option cost will be credited toward the purchase.

So what happens at the end of the lease period?   If the renter decides not to purchase the house, the seller keeps the $50,000 option money and 100% of the rent.  But if the renter decides to exercise his option to purchase the home, he can now buy the home for the purchase price minus the credits…or $1,500,000$50,000 (option credit) – $30,000 (rent credit of 12 months x $5,000/month x 50%)  = $1,430,000.

(Obviously, I used nice round numbers and simplified the terms in this hypothetical example to to demonstrate the concept.  The purpose of this post is to discuss the “why” behind real estate purchase options, not necessarily the what.   Be sure to consult the appropriate experts if you're considering this avenue.)

Why a Lease/Option?

First of all, lease/options are more prevalent in slow real estate markets.   In hot markets, properties move quickly so there's little incentive for a seller to offer this when he can sell the home outright.  But it's important to realize that a significant percentage of buyers in this price range are what we call “move-up” buyers — they currently own a home that they need to sell before they can purchase the more expensive home.  But in a slow market, sellers are less likely to accept offers that are contingent upon the sale of another home.

So a lease option buys them one precious commodity to make the deal work:  Time.

Risks and Rewards.

Just like an option that you'd purchase in the commodities market, there are risks and/or rewards in this approach, and they're heavily influenced by the performance of the market.  Let's take a brief look at the risks and rewards for both buyer and seller:

  • Buyer.  A big benefit of the lease/option for a buyer is that it allows him to “lock-up” his dream home without having to sell his current home first, thus making his offer more competitive.  The big risk is that if the price of the home drops significantly over the lease period, it may not make sense to exercise the option at the end of the period.  Unless he can re-negotiate the terms of the purchase, it may make the most sense to walk away from the purchase and forfeit his option money.   The other risk is that he's essentially carrying two payments until he can sell his own home.
  • Seller:  The benefit for the seller is that he's able to secure much-needed cash instead of having his home languish on the market for an extended period of time.   The risk is that if the real estate market gets hot again, the sales price that he's obligated to honor at the end of the lease may be below market value.

A Comeback?

Admittedly, this method of purchasing a home isn't taking the area by storm, but lease/options are starting to pop up around San Carlos and in other high-value areas on the Peninsula, and I hear questions about them far more this year than in the past.   Besides the price impact that I discussed above, it's very important for you to discuss the legal and tax ramifications of a lease/option with the appropriate professionals before you decide to venture down this path.


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