All about the lease option
October 1, 2008
The lease option does two things for you depending on which side of the transaction you fall. One, it offers a way for you to control property for little or no money; and two, it allows you to rent or sell a property you might not otherwise be able to rent or sell. But it also has huge traps that can result in a seller having to allow a buyer stay in a property paying you no money whatsoever. And as properties become more difficult to sell because of a tight credit and a glut of properties, the lease option will become more and more attractive to sellers.
First, what is an option? An option is an option to buy. A buyer makes an agreement with the owner of a property to buy a piece of property within a specified length of time for a specified amount of money at specified terms in return for which he pays the seller of the property an option fee. The option fee is compensation for the seller for keeping the property off the market for the period of time of the option agreement.
The steps for creating an option are as follows:
1. Buyer and seller agree on the price and terms under which the buyer will buy the property in the Agreement of Sale. Write it up just as if you were buying the property now, but leave the sale and closing dates either blank or write in the words “upon exercise of the attached option” in place of a date.
2. Buyer and seller attach an option agreement to the Agreement of Sale saying that the buyer has the right to go ahead with the purchase under the terms of the Agreement of Sale until the specified date.
3. If the buyer decides not to buy the property on or before the date the option expires, he usually forfeits his earnest money and the option fee.
4. If the buyer decides to go ahead with the purchase, he can buy the property under the terms and conditions set forth in the Agreement of Sale. It is negotiable whether or not the option fee is applied to the sale price.
Things you might want to add to an option agreement:
1. A provision that permits the extension of the option for an agreed upon amount of money.
2. A provision that allows the buyer to pay the option fee in monthly payments. You would then have to specify what happens if the monthly payment does not arrive on time.
Note: Nowhere in the option agreement does it say the buyer may live in the property, in fact it specifically mentions that the “optionee” does not have that right. The “optionee” only has the right to buy the property at the terms and conditions agreed upon. Options are used every day by companies that want to tie up properties to buy for their expansion or building plans. They might buy an option on anything from bare land to a 100 story skyscraper. They don’t want to do anything with the property just yet, just have it under their control until they decide if they really need and want it.
When you write an option on a piece of property both the buyer and seller take a chance: the market price of the property could drop below the option price, or it could rise far above the option price. If it drops far enough, the buyer could decide to forfeit his option money and not exercise the option, since buying the property at the option price would be a bad investment.
The seller, on the other hand, cannot decide not to sell at the option price no matter how high the market price of the property goes. He can be forced to abide by the contract in the courts.
The Lease Part
Lease options are actually two separate agreements, the lease and the option. They do not have to both be present. Obviously you can lease a property without having an option to buy it; you do that all the time with your rental property.
When you buy a property with an option, and want to take control of it to rent it out, you have to write both an option agreement and a lease agreement. It is important that you write them both separately. If you are the seller, it is also important that in the option agreement you place a clause such as: “Nothing in this agreement permits the “optionee” the right to occupy the property.” If you don’t put that provision in the agreement and you try to evict a tenant who also has an option for nonpayment of rent or some other offense, a judge could allow the “optionee” to stay because they have “equitable title” to the property and so have as much right to occupy it as the seller.
By the same token the lease should not mention the fact that there is an option on the property. It should be a straight lease agreement that probably coincides with the beginning and ending dates of the option. The option may extend beyond the lease period, though. You might lease a property for a year, but have the option run for two years. In that case, you would have the option of renewing the lease.
A use for the lease option arrangement for buying or selling property is to allow you to sell or buy essentially on contract or using owner financing without triggering the “due on sale” clause in the mortgage. Since you have not actually “sold” or “bought” the property, most mortgages don’t consider the use of an option to buy as a trigger for the lender to call the loan. Rather it is an agreement that gives someone the right to buy the property at a future date. Once the buyer exercises the option, that is when the buyer gets financing and takes title, the due on sale clause takes effect. When the option is in place it is not a sale, only the possibility of a sale. It is no different than when someone writes an offer on a property: it is just an offer, not a sale.
Here’s how it works
Suppose you want to sell your four-plex for $360,000 and Mr. Jones has agreed in principle to buy it for $90,000 down. The problem is the current $270,000 loan you have on the property has a clause that says that if you sell the property the entire balance is due on sale. There are 17 years left on the loan. Mr. Jones can’t do the deal because his debt load is too high to make a lender want to do business. So either you’ll have to lower your price or find another buyer.
You and Jones consider several different alternatives, but finally solve the problem with a lease-option arrangement.
Jones has $90,000 cash available. You will take $76,500 of that as a security deposit for a 20 year lease on the four-plex. Under the lease he’ll make monthly rental payments to you equal or slightly larger than the payments on your $270,000 loan. (One reason for making them larger is that you would be compensated for your trouble in the matter. It would still work if Jones just made lease payments to you equal to your debt service.)
At the same time you give Jones an option to buy the property at any time during the 20 year period of the lease. Under the terms of the option he can buy it for $13,500 cash plus whatever amount is then required to pay off your loan, with the understanding that he also forfeits his $76,500 “security deposit.” These two amounts total the $90,000 he has already agreed to pay you for the down payment.
Jones, per your agreement, also has to pay all property taxes and other expenses. The entire agreement is filed with the county recorder. You’re free of all expenses connected with the property and essentially in the same position as if you had sold it. In fact, you’re better off in one way. You can still take the tax deductions for depreciation because you still legally own the property.
After Jones’ payments to you reduce the balance on the 17-year loan to zero, the due-on-sale clause is a moot question. At that point Jones pays you the $13,500 option price, forfeits his security deposit and takes title.
The lease option sale process can be a complicated procedure, filled with traps for the unwary and inexperienced. Have an experienced real estate attorney draw up the documents and be ready to give advice if you have any questions, regardless how trivial. The most seemingly trivial incongruity can turn into the biggest headache.