For investors wanting to buy property to rent to a third party, a purchase lease option agreement can be a way to build a portfolio without the need for a large deposit straight away.
It gives you the opportunity to take on a property and let it to tenants without having to pay the full purchase price up front. Purchase lease options are also increasingly being used by buyers who may be struggling to find the deposit they need in the short-term, although they are confident they will be able to afford this in the future.
If you are considering a purchase lease option agreement, you are strongly recommended to use a solicitor with experience in this type of transaction as it can be complex and the vast majority of conveyancing solicitors are unfamiliar with the process.
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What is a purchase lease option agreement?
Options have long been used in financial markets, but more recently have gained significant popularity with UK property investors.
A purchase lease option agreement gives property investors the chance to rent a property and generate income from it, with the right, but not necessarily the obligation, to buy it at a later stage. Alternatively, the person taking out the lease option can decide to live in the property themselves.
Either way however, at the end of the option they can choose whether or not to buy the property at a pre-agreed price. And the agreement stops the owner from selling the property to anyone else during that option period.
Lease options are known to property investors by a number of names – including purchase lease option agreements and contracts.
Is a purchase option different from lease option?
Yes – as you might guess, the purchase option simply allows you to purchase a property at a pre -agreed price and any time before the option period expires. Unlike the lease option however it gives you no control over the property in the meantime.
Purchase lease options – are any other documents ever involved?
If you enter into a purchase lease option, you will generally sign three legally binding agreements:
1. An option agreement
2. A lease(or management agreement)
3. A power of attorney
1. The option agreement
The lease option agreement gives the buyer the exclusive right to purchase the property during an agreed time frame, known as the option period.
Key clauses in an option agreement include:
· The price that the potential buyer will pay to the property owner for the option. This could be minimal
· The price that the potential buyer will pay for the property if they decide to exercise the option and buy the property – the eventual purchase price for the house or flat
· The length of the option period – from the point of view of the person taking out the option, you will properly prefer a longer option –to give time for capital growth to make the purchase, and any financing, easier
· The process the potential buyer will need to use to exercise their option to purchase, to include whether notice can be served at any time during the option period and the length of the notice period, e.g. completion within 21 days of the date of the notice
2. The lease
The lease will include obligations on the part of both the property owner and the individual taking on the purchase lease option in respect of the management of the property. It will set out what is expected of each party in respect of issues such as insurance and maintenance.
It will also set out how the person taking on the option can rent out the property and any requirements the owner has, such as approval of the potential tenant.
Key clauses include:
· The amount of the monthly payment that will be paid by the person taking on the lease to the owner of the property
· What date this is to be paid on
· Penalties for late payment
· Tenant’s responsibilities
· Any requirements the property owner has in respect of letting the property to a third party
And because the investor will be paying rent under the lease, purchase lease options are often used to add value – so quite often end up as HMOs or serviced accommodation.
3. The power of attorney
A power of attorney gives the person taking on the property under the purchase lease option the authority to sign certain documents on behalf of the owner. For example, the person taking on the option will be able to sign tenancy agreements and take action to enforce the terms of a tenancy agreement, should this be necessary. Importantly, this kind of general power of attorney is also used for whoever takes the out the option to gain the ability to pay both all mortgage payments direct as well as the buildings insurance.
Why choose a purchase lease option agreement?
Purchase lease options have become increasingly popular with property investors, particularly those who are relatively early in their property journey and have limited access to cash and borrowing. There are plenty of good reasons why there are so attractive – here are the main ones:
A) No requirement to pay a large deposit
High property prices can limit buyers’ ability to both invest and buy a home. If you want to start a property portfolio or step onto the property ladder, a purchase option agreement can allow you to do this, even if you do not have a large deposit.
You will only need to pay the upfront costs, which may include:
· A small deposit, similar to that payable when leasing a property
· The first month’s rent
· Legal expenses, to include:
o The normal due diligence work carried out before a purchase; and
o The costs of drawing up, negotiating and registering the purchase option agreement
If you are planning to let the property to a third party, you can also expect to pay the letting agent’s fees.
However, this is substantially less than finding a full deposit of 5% or 10% of the purchase price.
You will need to calculate the expenses carefully, taking all outgoings into account, to check that a purchase option agreement is right for your circumstances. It can allow you to continue to save towards the purchase price while having control of a property.
It can also be possible to generate a monthly income from letting the property.
B) Unable to secure a mortgage
If you cannot secure a mortgage at the present time, for example, because you need to address your credit score or existing debts, a purchase lease option allows you to tie in the property you want in the meantime. By the time you are required to pay the purchase price, you may be able to take out a mortgage.
C) Future purchase price is fixed
You have the assurance of knowing that you will have the chance to buy your chosen property and that the price you will pay has been fixed and cannot increase. and you get all the financial gain from any increase in the value of the house or flat
D) Possibility of flipping the property
It may be possible to sell the property on immediately when the time comes to buy it, known as flipping. This can be risky as a strategy however and you should not rely on being able to do this.
E) Instant profit
If property values rise, the property may be worth more than the purchase price you pay, meaning you have made an instant profit.
F) Option not to buy
Where values have fallen or you do not feel you can afford to buy the property, you do not have to go ahead with the purchase.
G) Time to apply for planning permission
Purchase lease options can be a really useful way of controlling a property while putting in an application for planning permission and both taking benefits from any rental income in the meantime and then getting an additional return from any uplift in the value of the building with planning – which you can then exercise the option to buy at a pre- agreed price
What are the benefits for the property owner?
Lease options can be quite attractive for owners sometimes. Many lease options are for relatively long periods – commonly 7 to 10 years, although they can be for any length agreed by the parties.
For the property owner, a purchase lease option gives them the opportunity to pass on the management of the property while potentially retaining ownership. They will be certain of a set monthly income and not need to deal with finding tenants or having months where the property stands empty and they do not receive any payment. And of course, in effect, they won’t have to make any mortgage payments during the option period.
If the owner has been unable to sell the property for the price they want, a purchase lease option means they can potentially sell for the higher amount in the future. that can be be particularly useful if they are in “negative equity” and can’t meet mortgage payments. In these circumstances a lease option will almost certainly be better than facing repossession.
And sometimes it’s possible to time completion of any future purchase to minimise the owner’s potential Capital Gains Tax bill.
Are there any issues for the potential buyer to be wary of with a purchase lease option?
Although these type of agreements often work extremely well for the potential buyer, there are potential risks which you need to be aware of. These include:
• If the property owner fails to keep up with payments on the mortgage- in the worst-case scenario this could even result in the property being repossessed. However, you can prepare for that eventuality with a general power of attorney under which you can pay the owner’s monthly mortgage instalments directly – the same applies for the risk to non-payment of insurance – see below
• Poor levels of maintenance of the property, reducing potential rental profits. Depending on the nature of the agreement, it could well be that the vendors keeps responsibility for maintenance. That has its own risks – as does the person taking out lease option being responsible for maintenance while the lease is ongoing
• The property owner refusing to honour the lease option. Even if the lease option is watertight and you are successful, litigation is always stressful and potentially expensive, and can drag on. That’s why it is particularly important that the paperwork is all drafted properly in both parties get independent legal advice – especially the owner
• The agreed purchase price may be substantially higher than the current value of the property. For example, the price that you agree to pay at the end of the option period could be £250,000, but the property may only currently be worth £220,000.
If as is the case, and property prices do not increase enough or if the value of the property falls, you will probably not want to go ahead with the purchase. If this happens, you will be back to square one and need to start looking for another property. But of course the option means you don’t have to buy if you don’t think the property is good value.
• If you move into the property yourself and spend money on improvements you could find you ultimately end up unable to keep the property if you are still unable to afford to buy or to secure the mortgage you need when the time comes to exercise the option.
• Also bear in mind that many owners agreeing to lease options only do so because it is the least worst option for them. And they are not always grateful for the help – so you need to be aware of that possibility as you will continue to have joint responsibilities with regard to the property, which is never easy if the other party is unhappy uncooperative
• Don’t forget that the owner’s mortgage company may need to approve the lease arrangement. While they will have no involvement with the purchase element, there may well be a clause in the existing mortgage document that prevents any subletting of the property
• Whether or not the lease agreement makes you liable for insurance, or that responsibility remains with the owner, you need to make sure that there is valid insurance in place – and that it covers any arrangement you have. Again if you are subletting, make sure that does not invalidate any existing insurance policy
• if the agreement involves a flat or leasehold house, then you need to make sure that the lease doesn’t prevent subletting
• And lastly, although it sounds obvious, you need to ensure that any rent you receive equals or exceeds the rent you’re going to need to pay the owner. Bear in mind you might end up with voids or periods when you can’t rent out the property – but you will continue to need to pay regular rent to the owner
Are there any issues for the property owner to watch out for with a purchase lease option option agreement?
The first point to note is that if you have a mortgage over the property, you will need to obtain your lender’s consent to the purchase lease option.
They may stipulate terms and conditions which must be met.The property will be tied up for the period of the option agreement. During this time, as an owner you will not be able to realise your capital. If you have an expensive mortgage, this could leave you in difficulties if you are not able to meet the monthly mortgage payments.
While you will receive a monthly income, this could be smaller than if you had leased the property yourself on the open market.
You will not have any guarantees that your property will be looked after and maintenance issues dealt with.
If you are in financial difficulty, you may be happy to agree to a deal, but there is a risk you could have to sell your home at the end of the option period. If prices have risen, you could miss out financially on the profit.
There is also the possibility that the person who commits to paying a monthly income simply stops the payments. If this was to happen, you would be left without possession of your property and without any income. This could result in repossession by the lender if mortgage payments cannot be made.
Our advice to any potential seller thinking of a purchase lease option is to make sure you get independent legal advice on the agreement from a solicitor who really understands lease option agrrements. Too many solicitors, who don’t understand lease options, will simply advise you not to get involved – which may not be in your best interests.
Negotiating a purchase lease option
Both parties need to be very clear on the terms and conditions they are agreeing to before entering into a purchase lease option.
It is important to work out the figures over the whole period and look at what might happen in the worst case scenario, for example, if purchase prices were to fall, if it was not possible to find tenants to pay the necessary level of rent or if the property owner was left at the end of the term with an unsold property.
Your solicitor will be able to ensure that your option agreement and lease provide a robust basis for the transaction. They can negotiate certain points on your behalf to try and protect your interests as far as possible.
Are there any limitations on the Option Period?
No, the option period can be any length. However with lease options (unlike purchase options where there is no lease in the meantime), it’s unlikely that you’d want a short lease – because that would reduce the possibility of making good money from subletting the property out at a higher rent. If you’re looking at a shorter period for an option, and the real attraction is the possibility of buying the property in future at a pre-agreed price, then a straightforward purchase option may suit you better.
Relatively few agreements of this type are for less than 5 years – because they don’t make sense, especially if the person taking out the option has to spend cash upgrading or maintaining the property. And equally they tend not to last beyond 20 years.
Use of the option period
A lease option will give you the possibility of managing and renting out the property during the option period. But not all lease options are accompanied with management agreements and subletting. Lease option agreements are often used by investors who provide time for the purchaser undertake work on the property (or obtain planning permission). That way, when you come to exercise the option, finance available may be greater if you have increased the value of the property by undertaking improvements or refer or getting planning permission.
Can an option agreement allow for some form of bonus payment to the owner, depending on future value of the property?
Yes, there’s nothing to stop the parties inserting a term into the agreement that when the property is sold, the current owner will get a payment representing a share of any increase in value – say 10%. Including this kind of clause may make it more likely that an owner will agree to a lease option .
Are there alternative property strategies to options?
Depending on both your circumstances and what you’re looking for, there may be some alternative property strategies to consider, which may suit your circumstances better. Delayed completion, for example, is what happens when both parties exchange contracts but agree to put off completion of the transaction until a later date.
Click here to read more about delayed completion as a property strategy
Protecting your purchase lease option
Any purchaser should consider whether or not they want to protect their position. One of the most effective ways of doing so is to register a restriction with the HM Land Registry. And it’s essential that the vendors receives independent legal advice – to help avoid the risk of any argument in future that in buying a lease option, you took advantage of a vulnerable vendor.
What are Heads of Terms and can they help us?
Heads of terms come in handy for many legal contracts. They simply provide an initial list of what has been agreed. They’re not usually legally binding, but are useful way of making sure both sides understand the deal before going to the expense of getting solicitors to draw up contracts.
They might typically include some of the following;
- the parties’ name and addresses
- the address of the property
- the option fee
- the length of the lease option
- the final price to be paid for the property if the option is eventually exercised.
Purchase lease option heads of terms don’t need to be in any particular format.
Heads of terms could include things such as the parties’ name and addresses; the property address; the agreed purchase price; the length of the lease option agreement; and agreed option fee (the consideration.
Entering into a purchase lease option agreement
If you are considering taking up a purchase lease option, your solicitor will investigate the title of the property, raise enquiries of the seller’s solicitor and carry out searches in the same way as if you were buying a property.
This will give you the assurance of knowing that the property is sound and mortgageable.
When the transaction is complete, your solicitor will enter a restriction on the Land Register on your behalf. This will prevent the owner from selling the property in breach of the agreement without you knowing.
If you subsequently decide to buy the property, your solicitor would need to go through the due diligence work again on behalf of your mortgage lender, to include applying for fresh searches. This is because your lender will need your solicitor to sign a certificate stating that the property is sound and mortgageable.
How to exercise your option
The option agreement will set out the way in which you can exercise the option. It is important to follow this precisely or you may compromise your right to buy the property.
You will usually need to serve an option notice on the property owner. Your solicitor will be able to do this and put in motion the work needed to complete the purchase.
Your lender will send your mortgage offer to your solicitor who will be able to order your mortgage advance in readiness for completion.
The transaction will be completed in the normal way and your purchase and mortgage registered at HM Land Registry.
What happens at the end of the option period?
If you reach the end of the option period, you can choose not to go ahead with the purchase if you want. This could be because the property is not worth as much as you had hoped or because you are not financially in a position to buy the property.
You will need to advise the property owner of what you will be doing, as set out in the terms of the option agreement.
The property will need to be handed back in good repair. If a third party is renting the property, you may be able to transfer over this tenancy to the property owner if the agreement provides for this. Alternatively, you will need to give the tenant notice in plenty of time so that they vacate by the date of hand-back.
Finding a purchase lease option property
You are advised to tread very carefully when looking for opportunities to take on a purchase lease option. The area is unregulated and there are some unscrupulous operators who may offer to act as middlemen and take advantage of home owners who are in financial trouble.
Your solicitor will be able to advise you on the terms of the agreement you are considering, but you may want to take financial advice as to whether the deal is right for your situation.
The importance of using a specialist Purchase Lease Option Solicitor
It is really important that you instruct an experienced lease option solicitor if you are thinking of entering into this type of agreement. It is a highly specialised area of law, and very few solicitors deal with. And it’s critical that your documentation is accurately drafted to cover all eventualities and give you the certainty you need.