Could someone please explain to me how a lease option works? I was originally looking at a deal with seller financing, but was wondering if there are benefits to a lease option instead.

You have a property to sell. I come to you and I want your property, but I don't want to tie up a lot of my money buying it.

So, what I do is offer you a lease-option. I pay you a fee in exchange for an option to buy the property at some point in the future up to some end date. The fee may be non-refundable, or it might be partially applicable to the down payment when I do buy. If I don't exercise the option to buy, you keep the fee and upon its expiration control of the property reverts to you.

Then we sign a lease, and you become my landlord. I now have control of your property - you can't sell it out from under me because of the option, and I pay you rent. Typically, the rent I would pay you would exceed fair market rent by some fraction, and the extra amount would be applied toward the purchase of the property.

At any time before the option expires, I can exercise it to purchase the property.

As an investor, I typically, would then turn around and place a tenant in the property. The tenant's rent would come to me, my payment would go to you, and you would make your mortgage payment (or - and more commonly - I would make your mortgage payment for you).

Alternatively, I might turn around and sell the property to someone else (commonly, I would intend to sell it to the tenant I placed in it) and let them get the financing to close the deal. When they arranged financing, I would exercise my option with you and we would have a "double closing" - where my purchase from you and my sale to my buyer were consummated at the same time. I would sell it for more than I agreed to pay you, plus option fee. I would expect to walk away from the closing with a profit in my pocket.

Obviously, to accomplish this, I must have purchased the property for a price that makes it possible for me to turn a profit. Typically, for me to do this, you would be in distress and would need a resolution to your problem immediately. I would offer you this with the option fee and the cash stream to handle your mortgage.

I might go one step further and offer to buy your property subject to your current mortgage - which would mean that you would sign your property over to me and I would notify your mortgage holder to send future bills to my address. This constitutes a sale that would ordinarily trigger the "due on sale" clause in your mortgage, but as a practical matter most lenders will ignore that so long as the payments arrive on time. For me this is a good thing - I get your property nothing down and I get all your equity. For you, it might be the way out of a hole, but the big downside is that the mortgage remains in your name and if I default, your credit goes south.

Thanks for the explanation. Now I have a few followup questions.

1. Is there any particular way that you arrive at a number for the option fee?

You as the seller try to figure out how much you can extract from the buyer for the option. You as the buyer try to figure out how big a sucker the seller is. You know, the usual capitalist negotiation thing.

2. Generally, how far in the future do you make the option for?

You as the buyer want an option that is as far out as possible (5 years, 10 years, whatever you can get) since this maximizes your flexibility and minimizes your risk. You as the seller want that option to GO AWAY because it locks you up. As a practical matter, you will usually settle on something like 12 to 18 months.

3. Is the option price of the property pre-determined? Is it typically the same price that you would pay if you bought it without the option?

Of course the option price is predetermined, but the determination might include an escalator formula (you as a seller want that, you as a buyer want to avoid that) which will permit the seller to capture some or all of the capital appreciation that occurs while the seller is waiting for the option to be exercised.

You may purchase at any price. As an investor, you will be looking for a distressed seller who will jump at the option fee and sell at a bargain price. Again as an investor on the other side, you will sell LO to a tenant/buyer who really wants to own, but has credit problems which he hopes to repair in time to exercise the option. In this event, you will normally sell at a premium price, with a rent structure that permits a fraction of the rent to be applied to the downpayment - if the payment is made on time each month.

About the Author: Jim Locker is a technical guy who has done a lot of real estate investing and landlording. The experiences he writes about and advice he gives are either first hand, or in answer to specific questions posed by others. He is commonly known as jiml8 around the internet.