Sunday, March 15, 2009

Costs of Lease Options

How Much Does It Cost Buyers to Obtain a Lease/Option (Option to Purchase)?
How Much Will Sellers Make If They Grant a Lease/Option?

Earlier blog posts have addressed the issues of buyer and seller motivations for entering into options. Please refer to those discussions when necessary, but let’s make these assumptions:

  • The property has been on the market for over a year. The sellers are highly motivated.
  • The prospective buyers have poor (but repairable) credit and little cash. These buyers are also highly motivated.

I’m going to set up a scenario which presumes these transaction elements:

  • The property is in California.
  • Asking price is $379,000.
  • Home Owners Association dues of $2000 annually.
  • Comparable rentals are $1500 per month.
  • Both sides are represented by licensed real estate agents.

Fundamental to any option calculation is the variable of time. Generally, longer option periods are more expensive and incur more risks, especially for sellers. So, what is a “normal” option period? I don’t have that answer. Most of the options I see are one year or two year options, but the period is negotiable. For this exercise:

  • The option period proposed by the buyer is one year.

Central to the negotiation is the percentage of the option fee and the percentage of monthly rent that the sellers will credit to the purchase price, usually as a credit toward the down payment. These percentages can range from all (100%) to none (0%), and are not necessarily keyed to each other. For instance, the sellers may credit 50% of the monthly rent to the purchase price, but none of the option fee. Or vice versa. This is a key negotiation point in the transaction. One final caution:

  • The proposed lender must allow seller credits to apply to the down payment. Some lenders will; some won’t.

The option proposal must include a statement from a lender. This usually comes in the form of a feasibility letter in which the key strategy is to cover the lender’s ass, and the key terminology is the word “if.” Such and such a loan is possible in one year if the buyers repair their credit, if the house appraises at the purchase price, if the loan interests rates are still in such and such range, if we’re still in business, if an asteroid doesn’t destroy the earth. This letter will never be a commitment or a pre-qualification. (If the buyers were pre-qualified, why didn’t they just buy the property?)

  • The proposal includes a one-year feasibility letter from a lender.

OK, with all that said, the buyers propose this structure:

  • Full price ($379,000)

  • 20% down payment at close of escrow ($75,800)

  • Option fee of $10,000 of which $6200 will be applied to down payment

  • Monthly rent of $1800 of which $800 will be applied to down payment ($9,600).

  • Closing costs to be divided as customary.

If the sellers (and lender) accept these terms, the sellers will eventually credit $15,800 to the buyers' down payment ($6200 + $9600). This will require that the buyers come up with $60,000 additional down payment, plus some closing costs, in one year. Can they really do that? Really? In my opinion this question is where the rubber meets the road.

Now we get down to it. How much cash-in-hand do the buyers need to enter this option as set up in the above scenario?

$10,000 Option fee
$ 1,800 First month rent
$ 1,800 Security deposit (remember, this is a lease for one year)
$ 2,000 Pre-pay one year of Home Owner’s Association dues (hmmm?)
$ 900 50% title and escrow costs (customary in Nevada County)
$ 500 Property inspections (pest and whole house)

Buyers costs to enter this option($15,600 goes to the sellers)


What are the seller costs to grant the option?

$ 7,580 Real estate commissions figured at 1% to each side. These fees will be recovered at close of escrow, if the option is executed, because they are pre-payments against the total commission owed. If the total commission is 6% (3% to each side), at close of escrow the sellers will now owe 4%. Did you get that?

$ 900 50% title and escrow costs

$ 2,000 Estimated pest and other repairs. There is no way to really estimate these repairs (if any). I include them so the sellers are not surprised when the expenses arrive like unwelcome guests.

$ 2,000 Home Owner’s Association dues during the option period

Sellers’ cost to grant this option:


The buyers pay the sellers $15,600, the sellers incur expenses of $12,480 and the sellers keep $3,120 as the net option fee.

During the year, the sellers pay the property taxes and insurance.

The sellers keep $1000 per month of the $1800 per month rent.

At close of escrow the sellers’ gross profit will be $366,320 ($379,000 purchase price minus $15,800 credits to buyer plus $3120 already recieved as initial option net). Out of this profit, the sellers will pay the remaining 4% commission of $15,160 plus remaining closing costs of about $1,000 plus return of buyers’ security deposit of $1800.

Assuming the sellers own the house free and clear, the estimated net profit to sellers will be about:


Adjust this, of course, to pay off any existing liens.

What about the $1000 per month rent kept by the sellers? If the property is owned free and clear, add that to the net profit. If there is an existing mortgage, apply it to the monthly mortgage payments.

Taxes. Sellers, don’t forget to obtain professional tax help to calculate capital gains taxes, re-capture of depreciation, and other ugly items of this nature.

What can go wrong? Lots of things. There are numerous risks, and those will be the topic of a future post.

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