A lease with option to purchase (buy option) is a month-to-month rental agreement in which the tenant has a leasehold interest in the property with an option to purchase it. The option to purchase is a separate part of the rental agreement which specifies the price and terms of the purchase contract. Under a typical buy option agreement, the owner of a property gives the tenant  the right to purchase the rented property at a specified price and terms within a set period of time.

The tenant can pay the option fee in installments which are applied toward the established purchase price. For instance, say you can rent a house for $700 per month. But instead of simply renting it out, you offer the tenant a buy option, and the tenant pays you $200 a month (the typical amount) in option fees in addition to the monthly rent. Now, instead of merely collecting $700 per month, you collect $900 per month. The buy option strategy can be a lucrative tool in real estate investment. Buy options work. They have a broad market because many potential homebuyers like the idea of making their down payment on the installment plan (paying option fees that apply toward the purchase price of the home). You would be surprised at how many potential homebuyers earn enough income to afford to buy a home but don't have an
adequate down payment to purchase under other methods of financing.

Aside from being more profitable, the buy option has a number of advantages over renting: Buy option tenants take better care of the occupied property than renters. The holder of the option forfeits all option fees already paid, should he or she fail to exercise the option within the term of agreement. Because you don't have to hire a broker to find a buyer, you save a sales commission when the option is exercised. And the benefits of those great low-interest assumable loans come into play, because they are built-in financing. As you will learn in the next chapter, you can "wrap" the existing loans with a higher overriding interest rate and make a profit on the differential.

Let's see how an actual buy option works, consider this example:
Purchase price: $96,000
Down payment $10,000
Cost to renovate 1,200

Total investment Details of the purchase are as follows: 

The price is $96,000, and I put $10,000 down and assumed an existing $40,000 loan.
The balance of $46,000 was carried by the seller in the form of a purchase-money loan. Payment on the assumed first loan at 8 percent is $400 monthly. Payment on the second loan at 9 percent is $485 monthly. Monthly payment for taxes and insurance is a total of $90. Therefore, my total monthly payments for principal and interest on both loans, including taxes and insurance, is $975. After spending $1,200 renovating the property, I rented it out with a buy option agreement. 

Terms of the rental with buy option agreement are as follows: 

The tenant has an option to purchase the property for one year at a price of $115,000. The tenant is to pay a monthly rent of $1,075, of which $225 per month is applied to the purchase price. When the tenant exercises the buy option, he is required to pay a $5,000 down
payment. This amount consists of a $2,300 cash payment, plus $2,700 accumulated in option fees already paid ($225 monthly x ( 12 = $2,700). The balance of $110,00 is financed at 11.5 percent on a wraparound mortgage for 20 years. The "wrap" is a new all-inclusive loan created by the seller. The existing low-interest-rate loans are left intact and the seller continues to pay on them; in our example the monthly Loan payment is $885 on loans of $86,000. But the seller creates a new wraparound loan for $110,000 at 11.5 percent that the buyer pays to the seller at $1,173 monthly. Thus the seller earns the difference ($1,173 - $885 -- $288) in the amount paid on the underlying loans and the amount paid on the new wraparound loan.

The seller also earns $230 monthly, which is the amount the existing underlying loans pay down each month. (This equity buildup is a form of nonspendable income the seller receives as he gains from owing $230 less each month from paying down the underlying loans.) Consequently, the seller earns $288 monthly in cash flow, plus $230 in equity buildup, resulting in $518 in net income per month before taxes. Once the option is exercised, the buyer will pay a total of $1,263 monthly, of which $90 for taxes and insurance are paid elsewhere. Since the seller earns $518 monthly, including cash flow and equity buildup, now let's determine return on investment.

Return on investment equals total investment divided into annual return on the investment. Annual return is $518 X 12, which equals $6,216. If you divide this amount by the total of $ 1,200, which is the renovation cost of $1,200 and the $10,000 down payment, the result is 55.5 percent return on investment.

Furthermore, an additional gain of a $2,300 cash payment was earned from the buyer when the option was exercised. Such a phenomenal return is the result of a number of factors. The first is that the two underlying low-interest-rate loans were wrapped with a much higher all-inclusive loan. 

The second factor is that the property was sold for $19,000 more than what was paid for it.

The exact terms of the option must be spelled out in the buy option agreement. This way there will be no doubt or further negotiation. The buyer and seller will know exactly who is responsible for what, and for how much. An option to purchase can be as creative as the buyer and seller want it to be; however, it should be kept relatively simple to avoid any misunderstandings. Should your tenant require a longer term on the option, you essentially have two methods of determining the selling price for those periods. After the first year, you could set the option price at the existing price plus 1.5 times the consumer price index (CPI). The other alternative is to arbitrarily fix a selling price at which the tenant can buy the property during a specific term, such as $100,000 after one year, $110,000 after two years, and $120,000 after three years. (I prefer using 1.5 times the CP1 because over the last 20 years real estate values, on average, have increased about 1.5 times the rate of inflation, which the CPI measures.)

Structuring the Option Agreement The option agreement should spell out any arrangements that might be considered unclear, such as the disposition of pre paid deposits and appliances (washer, dryer, and refrigerator). For instance, the cleaning and security deposits, which
have been prepaid, can be applied toward the down payment. The exact disposition of all the appliances must be spelled out. If the appliances are to be included in the selling price, say so in the agreement; otherwise spell out the price you require for such items.

Another consideration is the rate of interest to charge the buyer on the wraparound mortgage. It makes good business sense to be fair and reasonable. Bear in mind that you will be competing with conventional lenders, because you are, in effect, acting as a conventional lender when you wrap existing loans, which in reality is creating a new loan. Then, as a rule of thumb, charge a rate of interest comparable to what conventional lenders are charging. But, since a wraparound mortgage is subordinate to the original mortgage, you do not charge loan origination fees.

This means substantial savings to the prospective buyer. This is an important selling feature that deserves further attention. Conventional lenders have a variety of incidental charges that they add to the cost of originating a new loan. These include the credit report, typically at $75; appraisal at $150; 1 to 2 percent of the loan proceeds in points; plus the inconvenience and time to complete the required paperwork. Therefore, remind your potential buyers of the convenience and cost savings they receive under the buy option method.

When the time comes for the buy option tenant to exercise the option, you can open an escrow so that you'll have a neutral third party carrying out the provisions of the agreement according to procedures common for your area. Once the escrow is closed, however, it's important to open a trust account for protection of both you and the buyer. Most title companies will also operate as a neutral trust.
The purpose of the trust is to act as a neutral third party that will take in the buyer's funds, make all disbursements (loans, taxes, and insurance), then send you a check for what is left over. This assures you and the buyer that everything is taken care of. You don't have to worry about the taxes or insurance being paid, and the buyer doesn't have to worry about the existing underlying loans being paid.

Finally, as part of your "tools of the trade," you will have to purchase a book that covers interest rates and associated monthly loan payments. Such a book consists of tables to calculate monthly loan payments for specific terms and inter est rates. Contemporary Books publishes Payment Tables for Monthly Mortgage Loans, and similar books are available in most bookstores.

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