I got a call from an investor recently needing some help with structuring a deal. He was in the process of buying a property and wanted to do “one of those lease option, lease purchase things” as his exit strategy.
As we talked, I realized just how easy it is to get those two terms confused and how freely people use them synonymously. To be clear, a lease option and a lease purchase are two different things. Today I’d like to compare and contrast them so that you can have a better understanding of how they work and what the differences are.
Let’s start with a lease purchase.
A lease purchase is when you rent a house to a tenant and simultaneously enter into a purchase and sale agreement with them. There are two different contracts associated with this deal. The first one is the lease, which is the contract that establishes the tenant/landlord relationship. It defines what is expected of the tenant, what their rent rate will be, how long they’ll be allowed to rent and what will happen if they default.
The other contract associated with a lease purchase deal is a purchase and sale agreement or PSA. This contract defines the terms and conditions of the sale as far as when the tenant will buy the property from the landlord. It’s important to note that this agreement obligates both parties to the sale of the property. By entering into this contract, the landlord is agreeing to sale and the tenant is agreeing to buy at some time in the future. And because of that obligation there can be legal and financial consequences outlined in the PSA should one of the parties fail to perform.
Another thing to note is that there may be an earnest money deposit associated with the PSA. If there is, that money will need to be held in escrow and can only be dispersed according to the terms and conditions set forth in the PSA contract.
Now, let’s look at a lease option.
A lease option also has two contracts. The first, just like in a lease purchase, is the lease. The second is an option contract — option for short.
The landlord sells the option to the tenant, which gives the tenant the right to buy the property for an agreed-upon price sometime in the future. Something important to note here is that the tenant has the right, but not the obligation, to purchase the property. That’s different than what we saw in the PSA. It means the landlord understands that the tenant may not buy the house from them at the end of the option and that the landlord should plan accordingly.
Another difference is that the tenant has to buy the right to purchase the property from the landlord. The money needed to do this is called option consideration, and it’s nonrefundable.
That means as soon as both parties enter into the option agreement the option consideration belongs to the landlord and they can do with it as they see fit. That’s very different than how earnest money deposits are treated in a PSA.
The only similarity is that, most of the time, both option consideration and earnest monies will be applied to the purchase price at the time of the sale.
Remember how I said that the landlord understands that the tenant doesn’t have to buy the property at the end of the option and that the landlord needs to plan accordingly? Well, that goes both ways. In an option, the tenant understands from the beginning that if they don’t buy the property for any reason the option consideration they paid is gone.
With that in mind, I’d think landlords would find lease options more appealing. For me, being paid nonrefundable option consideration versus having to keep up with earnest money deposits that I can’t touch makes lease options more attractive.
But lease options and lease purchases have similar outcomes. They allow a tenant to rent a house while they work on buying it from a landlord. That’s probably why they’re often confused and used synonymously by newer investors. But each one has very different mechanics and implications, and now you know some of the differences.