For decades, real estate investors have been using lease options as a creative way to buy, sell, lease and flip property.
What isn’t widely known is how these contracts can become a legal and financial nightmare for either the buyer or the seller, if not done right. As they say, the devil is in the details.
What exactly is a lease option?
Simply put, it gives someone the option to purchase a property they’re leasing at the end of a specified rental period. Commercial lease options can be more complicated, but here’s the basics for residential:
A contract is drawn up between two parties: the tenant (also called the lessee or tenant-buyer), and the landlord (lessor), who owns or has the right to lease the property.
Most state laws require that the tenant-buyer provide “valuable consideration” in order to enforce the option. An option fee is generally used as that “valuable consideration” and can be as little as $1, but most landlords charge around 3%-5% of the purchase price. This is not a deposit, but rather a non-refundable fee for the purchase of something of value – the option.
The option gives the tenant the right to purchase the property at a later date for a set price. There is no obligation to buy – just an option to do so. The landlord, however, does not have the option but rather is bound by the sales contract at the agreed-upon option price and timeframe. It is a “unilateral” or one-way agreement.
The purchase price can be decided at the time the option is purchased, or it can be based on the appraised value of the property at the time the option is exercised (usually in 1-3 years).
In contrast, a lease-purchase is a bilateral, or two-way, agreement and is binding for both the seller and the buyer. Some states treat lease-purchases as a transfer of ownership, even if the contract is not recorded and the tenant-buyer is not yet on title.
Here’s where things can get tricky:
In the case of default, the landlord/owner might have to foreclose rather than evict the tenant-buyer. If the property is located in a judicial state, it could literally take years to foreclose! And during the process, the tenant-buyer could live in the property with out making payments.
In judicial states, a foreclosure goes through a court system. If the tenant-buyer has a good attorney, they could potentially argue that the contract was not valid or was done incorrectly.
You may be thinking, “Well, gee whiz. I’ll stick with lease-options then!”
That may not necessarily be the solution. Some states treat lease-options as the same as a lease-purchases. That’s why it’s imperative that you understand the local state laws before ever entering into any purchase/sale agreement, and have a knowledgeable attorney draft the contract.
If these risks exist, why would a landlord want to offer a lease-option?
Benefits of Lease Options to Landlords
- Many landlords prefer lease options over regular leases because they believe the tenant will feel a pride of ownership in the property. If the tenant-buyer expects to take title someday, they may decide to take better care of the property.
- The tenant-buyer pays a non-refundable option fee, whether he or she can exercise the option or not. Statistically, the majority of tenants are never able to exercise the option due to poor credit or lack of funds. If they wish to renew the lease-option, they would be required to pay another option fee.
- The tenant-buyer tends to pay higher monthly payments than regular lease payments because in some contracts, a portion of the payment goes toward the eventual purchase.
- Some lease-options require the tenant-buyer take care of repairs and maintenance, as if it were their own home.
- If the tenant-buyer is able to exercise the option and purchase the property, the sales fees would be lower as a buyer and sales contract is already in place.
Risks of Lease Options to Landlords
- The same risks exist on lease-options as with regular leases. A tenant-buyer could be late on payment due to job loss, illness, divorce or any other personal or professional reason. This could result in eviction costs, turn-over costs and vacancy.
- As I mentioned already, some states consider a lease-option to be a contract for sale and legal transfer of title – even if the tenant-buyer is not on title. In the case of default, the landlord may have to foreclose rather than evict. In judicial states, this can be a very lengthy and difficult process.
- Market fluctuations could increase the value of the property beyond the option price. That’s why it’s always better to offer a higher option price. If values drop, the tenant-buyer can always negotiate a lower price at the time of purchase.
- Some states have very strict lease-option laws or don’t allow them at all. For example, the state of Texas has implemented many rules protecting tenants. Make sure you work with an attorney who understand the local state laws.
Since a tenant is likely paying a non-refundable fee rather than a refundable deposit, and making higher monthly payments than a normal lease, what’s in it for them?
Benefits of a Lease Option for a Tenant
If a tenant wants to own a home but can’t currently qualify for a loan, they can lock in an option price while cleaning up their credit, saving for a down payment, paying off debt or establishing a 2 year work history. In some cases, they may know they have a chunk of money coming but just don’t have access yet.
Lease payments can be credited towards the purchase price, reducing the purchase amount. For example, if fair market rent is $1,000, the seller might charge $1,100 with $200 being credited toward the purchase price. This is helpful for tenants who have difficulty saving money.
They can also lease option the property, fix it up, and then resell it for a profit before the lease option expires. This is a common practice among real estate investors and is precisely how RealWealth acquired a commercial building in Dublin, CA. We lease-optioned the property for $10M and paid a non-refundable option fee of $1.2M. We then re-entitled the land for residential lots and sold the property for $20M to a national builder, paying off the $10M option price. (Our investors got a nice return on that one!)
Of course, on single family homes, the numbers are much smaller. Someone might lease option a home for $100,000 with only a $3000 option fee. They could fix up the property and then resell it for more than the option price.
While this sounds pretty exciting, what are the risks?
Risks of Lease Option for Tenants
- If the tenant can’t exercise their option, they will have paid a nonrefundable option fee and higher lease payments for nothing. If they made repairs to the property, they would not be reimbursed.
- In the event that a landlord defaults on their mortgage, the property may go to foreclosure and the tenant could lose their position (this scenario is more prevalent during housing downturns).
- Sometimes the contracts are created by individuals rather than attorneys, or worse, there’s only a handshake agreement that won’t hold up in court. For example, if there is not a clear agreement that some of the lease payments are going toward the purchase price, an attorney could argue that the use of the property was compensation enough – if the terms are not clearly spelled out in the contract.
- The tenant-buyer often is expecting that the property will appreciate in value, but depending on the market cycle, the property could be worth less at the time of purchase. If they were looking for conventional financing and the property didn’t appraise, they would have to pay the difference. They could try to renegotiate the purchase price, but there’s no guarantee the owner will agree.
The terms of a lease-option vary. Here are some of the details that need to be negotiated in advance and written up in the contract clarifying who pays for:
- taxes and insurance
- pet fees
- number of occupants
- primary residence or investment
How to Avoid Consumer Protection Scrutiny
Some forms of lease-option agreements have been criticized as predatory. Here are some ways to protect yourself:
- Screen your tenant thoroughly as if they are qualifying for a Qualified Mortgage. This will help you avoid scrutiny for offering a lease-option to someone who could never realistically expect to exercise the option to purchase.
- Offer at least 1-3 year terms. 6 month terms could be considered predatory because the tenant-buyer would have little chance to repair his/her credit, save money for a down payment, or address whatever other problems exist.
- Keep the option price within 5% of market value or an attorney could accuse you of breaking consumer protection laws.
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