Lease Options

Definition of a Commercial Lease Option

In the context of commercial real estate and financing, a Lease Option is a legal agreement where a tenant leases a commercial property for a specific period with the exclusive right to purchase the property at a predetermined price before the lease expires. It is essentially a "lease-to-own" strategy for commercial assets. This arrangement consists of two distinct parts: a standard commercial lease agreement and an option to purchase.

The tenant pays an upfront fee for this right, known as an option consideration, which ensures the landlord cannot sell the property to any other party during the option term. While the tenant is not legally obligated to buy the property, the landlord is legally obligated to sell if the tenant chooses to exercise their option.

Detailed Components of a Lease Option

• Option Fee: This is a non-refundable payment made by the tenant to the landlord at the start of the agreement. It serves as the consideration that makes the option contract legally binding. If the tenant eventually purchases the property, this fee is typically applied toward the down payment.
• The Option Term: This is the specific timeframe (usually 1 to 5 years) during which the tenant has the right to exercise their purchase power. If the term expires without the tenant buying the property, the option is lost.
• Agreed Purchase Price: The price is usually locked in at the beginning of the lease. This can be a significant advantage for the buyer if the market value of the property increases during the lease term.
• Rent Credits: In many lease option structures, a portion of the monthly rent paid by the tenant is credited toward the eventual purchase price or the down payment. This helps the tenant build equity while they are still technically renting.

Lease Options and Commercial Mortgages

For many business owners, a lease option serves as a strategic bridge to securing a traditional commercial mortgage. This path is often chosen when a business does not currently meet the strict underwriting criteria of commercial lenders but expects to do so in the near future.

Common reasons for using a lease option in anticipation of a mortgage include:

• Time to Improve Credit: The lease term allows the business owner to improve their credit score or clean up their balance sheet to qualify for more favorable interest rates.
• Seasoning of Income: Lenders typically require two to three years of stable tax returns. A lease option provides the time necessary to document the required income levels.
• Down Payment Accumulation: Through rent credits and the initial option fee, the tenant can effectively "save" for the required down payment, which is often 20% to 30% in commercial lending.

Key Considerations for Lenders

When a tenant eventually applies for a commercial mortgage to exercise their option, lenders will look closely at the Lease Option Agreement. It is important to note that many lenders will only credit "excess rent" toward the down payment. For example, if the fair market rent is $4,000 but the tenant pays $5,000, only the $1,000 difference may be counted as equity by the bank.

Furthermore, an appraisal will be required at the time of the mortgage application. If the property value has decreased below the predetermined purchase price, the buyer may find it difficult to secure a loan for the full amount, requiring them to bridge the gap with additional cash.

Advantages and Risks

For the Tenant/Buyer, the primary advantage is the ability to control a property and lock in a price while working toward mortgage eligibility. The primary risk is the loss of the non-refundable option fee and any rent credits if they are unable to secure financing before the option term ends.

For the Landlord/Seller, this arrangement provides a higher-than-market monthly income and a committed tenant who is likely to maintain the property better than a standard renter. The risk is that if the property value skyrockets, they are still legally bound to sell at the lower agreed-upon price.