What it means
A lease option combines two contracts in one: a normal lease and an option to purchase. The option fee is paid when the contract is signed, and it buys the tenant the exclusive right to buy at the agreed price for the term of the lease.
If the tenant decides not to buy, the option fee is normally lost, but the tenant is under no obligation to complete the purchase. The strike price, meaning the agreed purchase price, may be fixed at signing or set by a formula.
A fixed price protects the tenant if values rise, while the owner gives up the chance to sell at a higher price. Some agreements also allow part of each month's rent, called a rent credit, to be set against the purchase price.
For tenants, the arrangement is attractive when they cannot yet get a mortgage or loan, for example because of a short credit history or a small deposit. For owners, it brings steady rent, an upfront fee and a likely buyer, and it can help to fill a property that is hard to sell.
Lease options are used for homes and commercial premises, and the same idea appears in equipment and vehicle leasing. The terms need careful reading.
A lease purchase, where the tenant is obliged to buy, is a different thing from a lease option, where the tenant may walk away. The tenant should also understand what happens to the fee and rent credits on default, who pays for repairs and insurance and whether the price is fixed or open.
From an accounting view, the lease and the option are assessed together, and the classification can affect whether the asset appears on the tenant's balance sheet. Rules differ between accounting frameworks and countries, so businesses should take advice.
Lawyers also check how the option is registered, to protect the tenant if the owner sells to someone else.
In practice
Real-world examples.
Example
A young couple with a limited deposit rents a house under a lease option for two years. They pay an upfront fee of 3% of the price and repair their credit record during the lease. At the end of the term, they qualify for a mortgage and buy the house at the price fixed at the start.
Example
A restaurant owner leases a commercial unit with an option to buy at the end of three years. The business is uncertain, so the option fee protects the right to buy without forcing a purchase. After two profitable years, the owner decides to exercise.
Example
A construction firm leases a piece of heavy equipment with an option to buy it at the end of 36 months for a stated residual price. The firm gets the use of the machine immediately. It buys the machine only if the work pipeline justifies it.
Formula
Calculation
Balance due on exercise = agreed purchase price - option fee credit - accumulated rent credits
An owner agrees a lease option on a property at a purchase price of $300,000. The tenant pays an option fee of $9,000, which is credited to the price if the option is exercised, and pays rent of $2,000 a month, of which $400 a month is a rent credit, for 24 months. The rent credits total 24 x $400 = $9,600. The balance due on exercise is $300,000 - $9,000 - $9,600 = $281,400, which the tenant usually pays with a mortgage. If the tenant walks away instead, the $9,000 fee and the credits are lost.Case study
Seen in the real world.
Birchwood Bakery is an illustrative, fictional business that wanted to buy the premises it rented but lacked the deposit that a bank required. The landlord offered a lease option on a price of $450,000, with a fee of $13,500, rent of $3,000 a month and a rent credit of $500 a month for 30 months.
Over the lease the bakery built its profits and saved the deposit it needed. When it exercised the option, the credits and fee reduced the price by $13,500 + (30 x $500) = $28,500, leaving $421,500 to be financed. The property had risen in value to an illustrative $480,000, so the fixed price gave the bakery an immediate advantage of $58,500. The lesson is that had values fallen, it could have walked away and lost only the fee and credits.
Watch out
Common mistakes.
- Confusing a lease option with a lease purchase, when only the second one obliges the tenant to buy.
- Assuming the option fee and rent credits come back if the tenant does not buy, when they are normally forfeited.
- Skipping legal advice, and missing clauses on repairs, insurance, default and what happens if the owner sells or borrows against the property.
Questions
People also ask.
Does the tenant have to buy at the end of the lease?
No. The tenant has the right but not the duty to buy, and may let the option lapse.
Who benefits if property values rise?
The tenant, because the purchase price was fixed at signing, so the tenant can buy below the market value.
Is a lease option available on assets other than property?
Yes, equipment, vehicles and machinery are often leased with an option to buy at a pre-agreed price at the end of the term.
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