In brief: They're very good for someone with bruised credit; it allows you time to repair your credit. They're very good for someone with little downpayment; you can accumulate some through rent credits, and it gives you time to save more money. They're very good for some self-employed people. They're very good if you don't have much credit at all. They're good if you want to "test drive" a house. Or, if you're from out of town, "test drive" the neighborhood.
They're not as good if your credit is solid, you have a sufficient downpayment, and you can find a house that meets your needs in your price range today. Not that they're bad; it's just that you probably don't need a lease/option in that case.
A major "pro" is that you can control the property for little more (if any more) than straight rent. And if you don't like the property (or prices decline sharply), you can just walk away at the end of your lease, and only lose the amount of option fees and credits you may have accumulated. Another "pro" is that it puts you in the driver's seat: If you exercise your option, the owner must sell to you. On the other hand, if you choose not to exercise your option, the owner can't force you to buy. Another "pro" is that you're opening your prospective properties up enormously. You're not just restricted to properties listed "for sale." You're opening your horizons up to all the properties listed "for rent." Not all of them are suitable candidates for lease-options, but many of them are.
There are a number of "cons," some of which you can protect yourself against. First, if you fail to exercise the option, as most lease-options are written you'll lose your option fee and credits. Second, if the price of the property declines, it wouldn't make sense to exercise the option. (To protect yourself, make sure there's a provision allowing you to extend the option for another 1-2 years, perhaps for additional consideration. Alternatively, the option might provide that the option price can be adjusted downward if an independent appraiser comes in with a lower figure than the option price.) Another drawback is that the owner might go into foreclosure, or incur a judgment that would cloud the title. There are a number of ways to protect yourself here. First, you want the owner to sign "Authorization to Release Information" forms that will give you the ability to verify with the lenders that payments are being made on time. It's not a protection against the owner's default, but rather an early warning system. A better solution is to use a land trust. The owner puts the property into a land trust, with an independent trustee. You pay the trustee; the trustee pays the lender.
From your perspective as a tenant-buyer, it would be to your advantage to have the lease and the option in the same form. From the perspective of the seller (or the investor in the case of a lease-option), it would be better to have the lease and the option in separate forms. You should also be looking at rent not much higher than straight rent, and an option credit of maybe 15%-30% of your total payment.
Another comment: Absolutely make sure a lawyer reviews the documents. But...and this is a big but...make sure the lawyer knows and understands lease options. Many don't. True story: I'm both a Realtor and an investor who does lease-options. A few years ago, I went to a lawyer recommended by my accountant to have my draft documents reviewed. The lawyer told me: "I don't like lease-options. They're unilateral [one way] agreements." Well, duh! That's the point. They're perfectly legal. They're perfectly ethical. But this lawyer, for some reason, just didn't like them. And many lawyers out there don't understand them at all. (Fewer lawyers understand land trusts.) Just make sure that whoever you consult with knows and understands lease-options (and, as appropriate, land trusts). Similarly, many of my fellow Realtors don't understand lease-options.
Another comment: Some Voices on Trulia, mostly Realtors, will say that few if any lease-options ever get exercised...that it's all a scam. Not true. It is true that some investors structure lease-options so that it's more difficult for tenant-buyers to buy. Many, however, structure it to make it as easy as possible. And you'll find that the "conversion rate" may range from 5%-10% at the low end up to about 60%-70% at the high end. Maybe even a bit higher. It really depends on how the transaction is structured.
I'd be glad to suggest a few professionals who might be able to help. (And--just curious, since I'm a Realtor and an investor in Northern Virginia--if you would, send me an e-mail off-line with the names of the investors you've talked with. It's possible I know them.)
Hope that helps.
If you wanted to save money for a down payment, or take time to repair your credit, why wouldn't you rent and save the option money and the rent premium in an interest bearing vehicle? or invest it? or use the money for credit repair? If you don't trust yourself to save it, have auto deductions from your paycheck or checking account go to an financial advisor for investments, give it to your grandmom to hold, or at the very least, put it under your mattress. Why give it to your landlord for him to hold with no guarantee you will ever have use of that money again?
Better option for those self-employed or those with bruised (but not TOO bruised) credit who want to buy right now and take advantage of distressed. or discouraged, sellers is to purchase by way of Land Contract. DO NOT DO THIS WITHOUT LEGAL REPRESENTATION!! Basically, this is where you are actually purchasing now, without obtaining your own financing. There is an upfront down payment, then you pay an attorney or trustee the mortgage payment every month, who then in turn pays the seller's original mortgage. The seller retains title to the property until your obligation is satisified- usually by a balloon payment at the end of a 2-5 year term. But the end of that term, you have to either pay up in cash, get your own mortage or renegotiate the deal. If you ever default on the contract, the seller has the right to evict you like a tenant and keep whatever he has collected. This contract is risky to both sides, but has benenfits to both as well. As the buyer under a land contract, you get the mortgage interest deduction and actually have ownership interest in the property. Not so with an option to purchase- you are just a renter with your landloard acting as your "banker."
Ask your trusted, experienced Realtor about Land Contracts, its been awhile, but we used to do these all of the time in the 90's, a market similar to this one with excess inventory and lower appreciation rates. In my town, at least, there are always seller who HAVE to move and have a minimum equity in the home. they would be happy to just get out with their mortage covered every month.
Thanks for taking time to respond though.
I cannot express the importance of having a real estate attorney working on your behalf in this type of transaction!!! It may cost up to $750 at the closing table, but well worthy it in the long run.
Contact a local real estate firm in your area for attorney recommendations, or look in the yellow pages.
Frank Biganski, Realtor ABR