Control or Ownership? Lease Options
Having just finished our Foundations Course, one of the questions that a lot of investors struggle to get their head around is the concept of making money out of property that they don’t own. So in this article I wanted to talk about the concept of controlling an asset (in this case property but it could be something else) to make money from it.
There are a number of potential strategies you could use to control an asset but in this article I want to focus on a strategy called Lease Options.
History of Lease Options
Lease options In the UK are still relatively new but came to the forefront of property strategies at the time of the last property crash in 2008/09 when investors found that it was difficult to buy properties at a discount as the crash in property prices had meant that many people could not sell due to negative equity so a Lease option was and is a viable alternative.
So what is a Lease Option?
The definition of a Lease Option is: the right but not the obligation to buy at a future date at a rate agreed NOW (the option exercise price) with the ability to Lease out the property in the intervening period. A lease option is comprised of two main contracts, which combined create the Lease Option. There is the option contract and the lease/management contract.
Option contracts have been around for many years and as an instrument have been used in many guises (check out option contracts on the stock market). Options in the property market have been used by developers for many, many years to secure parcels of land for potential development i.e. they would secure an option on a parcel of land subject to planning for example.
Once planning is obtained they would then exercise the option to buy the land at whatever price was agreed prior to the planning being obtained. However, they are NOT OBLIGED to exercise the contract and they could simply walk away - in reality this would only usually happen if planning was not obtained but happened quite a lot in 2008/09 when the market crashed because land values had dropped as well and the land was often worth less than the option exercise price that had been agreed so the option holder had to walk away with nothing.
The benefit to the land holder was that they kept any benefit that had been obtained during the option period – for example planning.
In order for an option contract to be valid, consideration must change hands. This could be as little as £1 but can also run into thousands – it is whatever is agreed between the two parties to the contract.
In the situation of a Lease option, the option holder will also agree to various other terms, which may include refurbishing the property, maintenance issues etc.
The LEASE part of the Lease Option gives the option holder the ability to rent out the property during the period of the Lease Option via a Management Contract. This means the Lease Option holder will pay a ‘rent’ to the vendor but keep any rent they collect by renting out the property and thus making a margin.
When agreeing a Lease option, you would start with a Heads of Terms something like this:-
- Vendor Name
- Investor Name
- Property Address
- Agreed option price
- Option period
- Solicitor details
- Initial Fee to the vendor
- Any Monthly fee to the vendor (for example to cover the mortgage)
- Building insurance details, mortgage details etc
- Other terms, for example upto £500pa maintenance to be covered by the option holder
Essentially a Lease Option contract is a blank piece of paper and is a summary of the terms agreed between the 2 parties.
When constructing the Heads of Terms, you should be aiming for a WIN/Win scenario – you are not aiming to take advantage of the vendors situation but to help them.
To be successful with options, you should understand the vendor’s pain and help to satisfy that. If you can satisfy their pain then you will have a good contract. Lease Options are NEVER about the price but about CIRCUMSTANCES – become a problem solver and create a WIN/WIN scenario and you will be successful. They are not complicated structures – it is how you put the deal together that requires some creativity.
You would then send the Heads of Terms to your solicitor and a solicitor to act for the vendor - BEWARE, not all solicitors are familiar with Lease Options so use a recognised authority in this field and agree with the vendor that you will put them in touch with a solicitor who can help them as well. Generally any firm of solicitors with a commercial property department should be able to help but there are many Option solicitors available on the various forums who can help.
To help explain further, I have detailed a live example of a lease options we did a few years ago.
Lease Options Live Example
My business partner, Jackie Reeves and I were sitting in a hotel reception
waiting for our guest when my mobile rang. It was call from a vendor who was desperate to move from their property. Her and her husband were living in a 1 bed starter home in the South of England and their property had been on the market for 3 months without any viewings. So what does that tell you? – Clearly the property was overpriced!
But what was their pain? During the conversation, it transpired that the couple had a small child and another on the way so quite simply the property was not large enough for their growing family! There was potential here for a deal so we agreed to meet with them at their home later that week.
Prior to our meeting, I carried out some due diligence on the area and prices. I also searched Land Registry to check when they had purchased the property, whose name it was registered to, the price they paid and who the mortgage was with. My research suggested that the property was worth around £140k-142k – so why was it on the market at £155k?
When we arrived at the property, we could see very clearly why they needed to move: not only did they have a baby and another on the way, but they had a menagerie of pets – 2 dogs, a cat and a parrot in a cage that took up almost a quarter of the living room - bear in mind this is just a 1 bed starter home! We also established the reason for the £155k sale price – their mortgage was £139k and they had worked out that they needed the extra for the deposit on their next home -but the house was not selling!
We discussed the likely current value of the property to be around the £140k mark so at that level they couldn’t afford to move. How would you put the deal together? The thing with options is that there isn’t one size fits all so this is what we offered:
- A monthly amount (to cover the mortgage)
- £10000 to help them move (and to come off the purchase price)
- 10 year option
- Option price £145k
What we ended up with was a 7 year option but with everything else agreed.
Between agreeing the option and getting it signed the deal changed to £1 instead of £10000 and they moved into rented accommodation instead of buying!
We obtained consent to let from the mortgage company and managed to rent the property @ £695pm giving approximately £250 net per month cashflow after a £4000 refurb.
Fast forward to 2017 and we have just put the property on the market for £229k, which would give around £80k clear profit on sale and approximately £18k throughout term – all for a £4001 investment.
We have maintained regular contact with the vendor throughout the process and because they were on a repayment mortgage, they will have an additional lump sum paid to them when the mortgage is repaid.
To succeed with Lease Options, you need to become solution orientated – don’t worry if you’re not, it may just mean that Lease Options are not for you!