What is a Lease/Option?

A lease/option is really a misnomer if structured properly.  There are really two separate instruments when a lease/option is constructed.  The lease is an exchange of space for an agreed-upon sum of money, which is customarily made in monthly installments. 

An option is the right, but not the obligation to purchase something of value at a specified price at some time in the future for an agreed-upon price in exchange for a fee.  The future price is called the strike price and the fee paid in exchange for an option to purchase at this price is called the option premium.  If the individual that purchases the option fails to exercise per the terms of the contract prior to expiration then it expires worthless.  If, however, the asset appreciates beyond the strike price the person holding the option can exercise it, purchase the property at a discount to fair market value, and profit from the transaction.  The option can also be sold in the market as a standalone asset when the market price exceeds the strike price because it carries value.  The option is said to be in the money when the market value of the asset is higher than the strike price and out of the money when the opposite scenario is true.

Many late-night TV gurus and hucksters promote charging premium rents when you give a seller an option to purchase the property.  They also tie these contracts together and make a mess out of the terms by calling it one thing.  Courts have ruled that engaging in this type of activity gives tenants equitable interest in the property, which could wreak havoc on a transaction that postdates an option expiring worthless.

The correct way to structure these transactions is to have two separate agreements.  The lease should be whatever you normally use to rent to tenants and rents should be set at market rates.  The option should be a separate instrument constructed to stand on its own.  I like to think of the option as a sweetener for potential tenants engaging in a long term lease.  They are kind of a hybrid renter and owner that may be saving for a down payment to purchase the property they are leasing at a future date.  In a swiftly appreciating market the option provides value for the tenant because the strike price sets a ceiling on their future purchase price.  In exchange for this value the owner of the property receives an option premium.

Options are fundamentally an instrument called a derivate.  A derivative has its price set based on the value of another instrument, like a stock, bond, property, etc.  Thus the aptly-named instrument derives its value from the price of another instrument.