Most property owners understand the seller’s market has quickly turned to a buyer’s market requiring them to think creatively and consider concessions.
As sellers try to shorten listing times, entice buyers, and compensate for the tightening credit markets, they start turning to creative financing solutions like lease options and seller financing.
A Lease Option allows a potential buyer to lease or rent the property with an option to later purchase the property. The option money paid by the buyer is generally nonrefundable however, a portion of the lease payments are often applied towards the purchase price.
Seller Financing involves a property sale where the owner agrees to finance all or a portion of the purchase for the buyer. Also known as owner financing, the buyer makes payments over time to the seller rather than obtaining a traditional mortgage or bank loan.
With many owners, investors, and real estate agents taking these old standbys down from the back shelf it is a good time to blow off the dust and take a look at the pros and cons of each option.
- Pro: A down payment is generally greater than the upfront option consideration.
- Pro: The real estate taxes, property insurance, and upkeep are the responsibility and cost of the buyer.
- Pro: The buyer is more likely to show the care and mindset of an owner since they have already purchased the property. While a lease option tenant is usually better than the average renter, they still are not an actual owner until they exercise the option.
- Con: If the buyer becomes delinquent on payments it can take more time to foreclose than an eviction process.
- Pro: The seller can earn interest on the amount financed. In general, a 30-year mortgage can result in a buyer paying back about 2.5 to 3 times the amount financed depending on the interest. For example, a $100,000 mortgage note financed at 8.5% with 360 payments of $768.91 will result in the buyer paying back $276,807.60 over 30 years.
- Pro: There is greater liquidity with note payments than lease payments. It is easier to find investors that will pay cash now for real estate note payments.
- Con: The term or time of repayment repay can be longer on a seller financed note. If 10 to 30 years feels like a long time to collect payments simply include a 3-5 year balloon payment as part of the original note terms. This can also help pricing should the seller ever decide to sell the note payments to an investor.
- Con: The seller will have more expenses since they generally pay for the real estate taxes and property insurance (although some lease purchase agreements might commit the buyer for these expenses).
- Pro: If the buyer misses payments the eviction process can be faster than a foreclosure process, especially when bankruptcy filings are involved.
- Con: There is no guarantee the tenant will exercise their option to buy. This could leave the seller starting the process of finding a buyer all over again.
- Pro: In an appreciating market the seller might gain some upside from increased value if the agreement allows or the tenant fails to exercise the option to purchase.
So is it better to owner finance or lease option? As you might have guessed, the final answer is “It depends”.
While the list of pros might give weight to owner financing there are times a lease option will make more sense. If the offer involves a potential buyer with a small down payment and weak credit, the lease option would have a strong advantage. Not only does it give the buyer time to improve their credit and financing options, it will be easier to remove them from the property if they default. The less equity and the lower the credit quality, the more likely a payer will default.
The final decision between a lease option versus seller financing will depend on the financial needs and tax considerations of the seller balanced by the buyer’s stability, credit history, and down payment funds.
It pays to seek the advice of competent professionals when considering creative financing like seller financing or lease options to sell property in a soft real estate market.