Why a Lease Option Could Be Your Safest Real Estate Strategy
You don't need to look far to find doom and gloom predictions about the post COVID-19 economy. Such dire forecasts can make entering the housing market seem like a scary proposition - especially for anyone buying their first property.
Every Millenial knows an aunt or a parent with a story about the sky high interest rates of 1982. Some still have grandparents with memories of the 1930s depression.
Let’s put those economic comparisons aside - eventually, we all get to an age where we want a house of our own.
If you’re planning to raise a family, customize your own space, or just put down your roots somewhere comfortable, staking a claim on the property ladder makes a lot of practical sense.
We can never control the timing of the housing market, or the conditions we’ll encounter when it’s “our time” to buy. But we can control how much capital we put at risk, and the methods we use to own a home.
Fortune favors the Bold.
An old investment adage says: Buy when others are fearful, and Sell when others are greedy.
If you’re planning on buying a home in Kelowna, you can use the prevailing emotion of fear to your advantage and negotiate a great deal.
Between 2008 and 2013, Central Okanagan home prices fell by 18%, presenting the best real estate buying opportunity of the last decade. Just 8 years later in 2016, Okanagan housing prices made a full recovery from their ‘Great Recession’ lows.
If you held on to your property over those years, the price dip was just a blip in history. By 2018 - a full 10 years from purchase - your home was up by 30% from the highs of 2008.
And if you bought at the housing market bottom in 2013, you’d be up 57%. That was the home buying opportunity of the decade.
Playing the Long Game
As you can see in the chart above, if you’re in real estate for the long game, dips in the market can turn out to be great buying opportunities - and especially in today’s central bank driven economy.
During recessionary periods the world’s central banks continue to print money, relax interest rates, and even buy up risk assets. This all leads to an increase in what economists refer to as the money supply.
As I discussed in a previous article, increases in the money supply tend to correlate to increases in housing prices.
In March 2020, the United States Federal Reserve started the largest asset purchasing binge in modern economic history, which led to a serious rally in equity and gold prices. If the Fed keeps buying and printing money, we could see price inflation across virtually all asset classes.
If you haven’t already noticed, grocery prices have also gone up this year. I don’t expect housing will be any different this time around.
It’s OK to feel hesitant.
If you’re still not sure about the prospect of tying yourself to a mortgage through this period of economic uncertainty, there is a far less risky method of accomplishing your goal of home ownership.
You won’t likely hear this from your neighborhood real estate agent, but it’s worth your time to consider a Lease Option as a means of acquiring your Okanagan property.
Lease Options, also known as a Rent to Own Agreements, provide the bulk of the housing market’s upside potential with minimal downside risk. For many would-be home buyers, this may be an ideal entry strategy.
How does a Home Lease Option Agreement work?
With a Lease Option, tenants agree to rent a property for a given amount of time, and have the added choice of purchasing the home throughout the term of the lease agreement at a pre-arranged price.
A lease option is just an option - if you enter into a lease option agreement, but decide you no longer want to own the property, you can simply walk away and let the option expire at the end of the agreement.
If you decide to exercise the lease option and purchase the home in the future, you’ll most likely need a mortgage to finance the transaction.
One of the advantages of using a lease option is that the monthly payments are generally far lower than standard mortgage payments. As a buyer, this gives you time to pay off any existing debts, build up your credit, and prepare for your inevitable mortgage application.
This means you can start enjoying life on a great Okanagan property without having to make a huge upfront layout in the form of a down deposit and mortgage contract.
Lease Options do come with an additional expense in the form of an option fee.
The Option Fee
A lease option fee is a one-time payment that secures the right to purchase a home at a negotiated price. When you exercise the option, the option fee usually gets applied towards your down payment. If you walk away from the agreement, you’ll forfeit the option fee, which usually starts around $10k, or 3-5% of the purchase price.
There’s no set price for option fees - I have successfully negotiated real estate options for as low as $1.
The Option Price
The option price is similar to the exercise price of a stock option - this is the pre-negotiated price at which you can purchase the property. With lease to own houses, you have the right to buy at the option price any time up until the end of the option agreement.
Equity Build Up
This is a negotiated amount of the monthly rent payment that gets applied towards the principal amount of the home when you exercise a lease option. Equity build up lets you chip away at the purchase price without being strapped into a mortgage.
The equity build up can range from zero - in the event you want to stake your claim with the lowest possible monthly payment - to sizable amounts in excess of $1,000/mo.
The Option Term
The term is the length of time you have to exercise a lease to own option. The option term is negotiated as part of the initial agreement and typically ranges from 1 to 5 years.
There are no set rules to option terms, so if you can negotiate an option price that is reflective of today’s market value, and then keep this option for a long period of time, you have the potential to do extremely well in the housing market.
How to value a Rent to Own Agreement
When we design a Rent to Own contract, we model the monthly payment on three values to reflect the cost of ownership: The owner’s Mortgage Payment, Home Insurance, and Annual Property taxes. The difference between the Market Value of rent and the total monthly payment gets applied towards your equity build up.
A Lease Option vs a Traditional Mortgage
Let’s compare some numbers for a lease option agreement and a traditional mortgage on a home asking $500,000 in Kelowna.
The Home Mortgage
Let’s start with a 25 year mortgage at 3.24% interest using a 5% down payment of $25,000:
$25,000 Down payment (@5%)
$475,000 Mortgage amount
$2,300/mo Monthly payment (@3.24% interest)
$250/mo ($3000 annual property taxes)
$150/mo ($1800 annual fire insurance)
$2,650 Total monthly cost of ownership with a mortgage.
As shown above, using a mortgage of $475,000 leads to a $2,650 total monthly expense, with ~$1080 of that amount being applied to paying down the principal each month for the first three years.
The Home Lease Option
Now let’s see how $2,650 per month works out with a three year Lease to Own Option:
$2,650 Total Monthly Payment
$2,100 Market Value to Rent a $500,000 home in Kelowna
$550 Potential Option Paydown
Over 3 years, a lease option provides a total paydown of $550 X 36 months = $19,800.
The home mortgage pays down $1080 X 36 months = $38,880.
Even with a sizable monthly option credit, your payments using a mortgage will bank equity at ~twice the rate of a rent to own agreement.
Lease Options offer limited losses with unlimited gains
Now let’s compare the same mortgage and lease option if the housing market either booms or busts over that 3 year horizon.
If your property increases from $500K to $600K, that $100K gain is all yours when you exercise the lease option. Assuming that option cost you $20k, you’re looking at a potential 5x return on investment.
If the bottom falls out of the housing market in the same 3 years and the home falls to $400K, you would forfeit the option to buy at $500K and lose your $20K option investment.
The best part about using an option to buy a home is that there is no ugly - your worst case scenario is losing the $20K option fee. But if you take on a mortgage, your downside risk is virtually unlimited.
Since the homeowner is the one exposed to a market downturn, they’re still going to need somebody to pay rent and look after the home. This means you may be able to extend the option agreement and carry your $20K forward while you both wait for a market recovery.
What are the trade-offs with a lease option?
- You have fewer choices. Most home sellers are looking for a traditional sale or nothing at all, so your selection pool is much smaller with Rent to Own.
- You typically can't negotiate a screaming deal on the price. Discounts are reserved for Now Buyers who are willing to assume all of the market risk. If you want the hedged position of a lease option to minimize your downside risk, you’re probably going to pay market value for a home.This doesn't mean you will overpay; it just means that you will forfeit your right to make lowball offers in a buyer’s market.
- You give up the mortgage paydown. As our example showed, lease options provide about half of the debt reduction that you get with a mortgage.
A lease with the option to buy is a great way to hedge your housing bet.
If things turn sour, you’ll be far better off financially than those who saddled themselves with mortgages and huge down payments.
If things go well, you benefit from the upside, but your equity gains won’t be as big as those buyers who took the full plunge and bought in at a discount.
At the end of the day, you need to make your own decision about where you think the real estate market is headed for the long term.
Will we continue seeing full price recoveries in less than a decade? If you believe that in your bones, you may want to put on your big boy pants, apply for a mortgage, and buy a home.
If you’re not so sure, but you want to get a foothold in the property market, a lease to own home might be your perfect solution.