Investing in commercial property requires a significant financial commitment. For those looking for a more flexible approach, a lease-to-own arrangement might be an attractive solution. While there are risks involved for both owners and tenants/potential buyers, there are advantages for both parties as well. In this article, our Pickett Sprouse Commercial Real Estate brokers explore the pros and cons of lease to own commercial property so you can make an informed decision about whether this type of agreement might be right for you.

What is Lease to Own for Commercial Property?

There are two primary ways of achieving lease to own for commercial property. They include lease option and lease purchase agreements. A lease purchase agreement is a legally binding arrangement where a tenant agrees to rent a property for a given time before purchasing it. A lease option, on the other hand, gives the tenant the right to buy the property at a set price during the lease term or at its end, but they are not obligated to do so. Because there are so many risks involved with a lease purchase agreement, this article will focus primarily on lease option agreements.

Pickett Sprouse broker Brad Gregory gives an example of an option to purchase agreement using a five-year commercial lease. The purchase price is set at the beginning of the lease based on what the property owner expects it to be worth at the end of the lease term. During that five years, the tenant has the option to buy the property or to exercise the option during a pre-established timeframe.

Sometimes an option fee, or a non-refundable payment made by the tenant for the right to purchase the property in the future, is included in the agreement. This amount can be a significant percentage of the purchase price and is typically applied towards the purchase if the tenant decides to buy. In reality though, Brad hasn't seen option fees used many times because that amount is usually "rolled into the purchase price."

Key Elements of a Lease to Own Agreement

A lease agreement with an option to buy should include several key elements. Brad says these include the following.

Names of the parties involved.
Description of the property.
Lease period or term of the lease.
Monthly rental payments.
Option price or price of the property to purchase.
Option period. According to Brad, this could be at the beginning of the lease, at the end of the lease, or at any time in between. "You may have it where the tenant has the option to buy the property during the first two years of the five-year lease. Or it could be that after you lease it for three years, you have a two-year option. With two years remaining on the lease, you have the option to buy the property."
Terms of purchase.
Responsibilities of tenant and landlord.
Incentives.

Possible Incentives

Sometimes, a seller or landlord may give incentives to a tenant to entice them to purchase the property. Brad provides this example. "Let's say our rent is $5,000 a month. If the owner is offering an incentive, they may give the tenant $1,000 credit per month toward the purchase price for every month that they stay in there. If they stay for 24 months, they would get $24,000 to go toward closing costs and/or to ease the purchase price. What that does is give the owner a new tenant, and the tenant an incentive to buy."

Brad points out that incentives are usually only a factor if the owner starts that conversation. If they are the idea of the tenant, there's probably not going to be an incentive offered.

Responsibilities of Tenant and Landlord

When talking about lease to own commercial property agreements, it's important that the responsibilities of the tenant and landlord in the lease be spelled out. In all cases, the tenant pays a monthly rent, and the landlord agrees to sell the property at a predetermined price. Beyond that, and as with any commercial lease, both parties have obligations to maintain the property, but the specifics often depend on the terms of the agreement.

Brad explains that some of the big questions include:

Who is responsible for maintaining the building?
Who is responsible for paying the taxes?
Who is responsible for the insurance?
Who is responsible for the paving of the parking lot?

"You've got full service leases, which means the landlord or the owner of the property is paying for all expenses. On the complete other side of that is what's called a triple net lease (NNN). A triple net lease means that the tenant is paying for all expenses."

Brad points out that in a lease to own scenario, the tenant will probably be responsible for at least all building maintenance. "He may own this property at some point, so it's in his best interest to make sure that it's maintained properly."

How Purchase Price is Calculated in Lease to Own Agreements

One of the most difficult parts of creating an agreement that includes an option to purchase the property is to project a future purchase price. Pickett Sprouse broker Mark O'Neal, CCIM says that this gets more difficult as time passes, so it's important to calculate the net operating income (NOI), which is the income less expenses related to the property. That's because rent typically escalates each year to reflect increases in expenses such as property taxes and maintenance.

According to Mark, one of the most reliable ways to determine commercial real estate value is to apply a capitalization rate to the NOI. Pickett Sprouse broker Emilee Collins, CCIM explains that "the cap rate is the rate of return on the income that is expected on a property in the first year of holding.”

Thus, in the lease purchase negotiations, Mark says, "You are also agreeing on an acceptable rate of return that applies to the risk from ownership of the property. The terms that both parties agree on in the lease become the foundation for the value calculation.

Pros and Cons of Lease to Own Agreements

Here's a look at what our brokers see as the pros and cons of lease to own agreements.

Brad Gregory

Pros: For the owner/landlord, the biggest advantage is that if the tenant buyer is doing a lease to own, they're probably going to take better care of your property because at some point they may own it. Cons: The negatives for a tenant in that lease-to-own scenario is that if they don't exercise the option to buy the property, they'll lose all of the improvements that they've made. For example, someone who puts $300,000 into building a fantastic restaurant kitchen will lose those improvements if they don't exercise the option to buy the property. Pros: On the flip side, if during the term of the lease, the tenant does all of these improvements, the value of the property will probably be more than what the pre-determined purchase price was at the beginning of the lease. So, the buyer will potentially be getting their money back, and they can rest assured that the property was well taken care of. Pros and Cons: If the market takes off during the option period, the purchase price could be much lower than the current value of the property. In that case, the tenant comes out on top and the landlord doesn't get as much money as he could have if he had sold the property outright at that time.

Emilee Collins, CCIM

Pros: Lease to own agreements with short terms, such as 18 months, are usually favorable for both parties because the market and condition of the property haven't had as much time to change.

Cons: Lease to own agreements aren't usually worth the time it takes to draft them because the option is rarely exercised.

Bottom Line on Lease to Own Commercial Property

The bottom line on lease to own commercial property is that it can be an attractive option for businesses looking to secure a long-term space without the immediate financial burden of purchasing. It provides flexibility and control over the property, while also offering potential tax benefits and the opportunity to build equity. This can be helpful for small or new businesses.

However, it is important to carefully review the terms of the lease agreement and make sure that you get legal advice to make sure that it is in line with your goals and financial capabilities. Additionally, you should consider your long-term business plans and weigh the pros and cons of leasing to own versus other real estate options.

How to ask us a question

Our brokers and other partnering commercial real estate experts will be answering your questions every month through the Ask a Broker series. If you have a commercial real estate question that you want to be answered, we’d love to hear from you at marketing@westandwoodall.com.