Landlord tips: Is a lease option right for you?
October 1, 2010
The lease option can work one of two ways. First, it works to buy property without putting a lot of cash into it at first, because a buyer can control property for little or no money. Second it offers a solution for a property that won’t sell and offers a way for a landlord to rent it out or sell it. We will look at three things in this article. We will look at what an option is and some important considerations to examine when thinking about doing one. Further, we will examine what must be in the lease agreement and the option agreement to protect you. And, in the process, we will look at some scenarios in a lease option and what we would need to think about.
What is an option?
A real estate option is an option to buy. In the case of a buyer, he, she or it 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. For that he, she or it 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.
Options are how major corporations tie up a piece of property where they might want to put a new building or where there is already an existing building that might work for their needs. Just as major corporations use them, so can smaller investors. They gain the ability to buy a property sometime in the future but are protected against having it sold before they decide if the property will work for them.
Regular home buyers can use options to purchase a home under the same conditions. They may not have a down payment yet. They could be saving money for it, waiting for a bonus from work, have a tax refund coming, be counting on an inheritance in the near future, or a combination of two or more of those situations.
For the Buyer
Options come with risks for a buyer who is using an option. The option agreement has a time limit. That means the buyer has a set length of time to go through with the purchase or to lose the option money paid. For example, if an investor finds a fourplex that he or she believes would be an excellent investment, that investor could see if the seller would accept an option to buy from the investor.
If the seller would be amenable to an option, the seller and investor work would out the purchase price, the option amount and the length of time the investor has to actually go through with the purchase. At that point, the investor would pay the seller the option money and agree to complete the purchase of the property on or before the time when the option expires.
This is not a perfect solution. Three things can happen, two of them bad for the buyer. The good thing that can happen is that the investor comes up with the down payment required to buy the property and goes through with the purchase before the option expires and that the value of the property even appreciates while the option is in place allowing him to buy at a price below market.
The two bad things that can happen are one, the investor can’t come up with the down payment before the option expires and loses his option money; and two, the value of the property goes down below the agreed upon sale price, thus putting the investor in the position of having to either forfeit his option money by refusing to buy the property or to buy the property at a price above market.
Here’s an example. Joe investor finds a four-plex that will generate cash flow of $18,000 a year that is in good repair and in a good part of town. The owner doesn’t have it on the market, but the investor calls the owner and asks if he had thought about selling. As it happens, the owner had been having some problems with tenants lately and was in the mood to dump the place. The investor explains that he doesn’t have the cash right now for a down payment but is willing to pay the owner an option fee and buy the property outright in 18 months or less. You see, the investor is in the process of selling another property and will need to move the proceeds in a 1031 Exchange or get hammered by the IRS with capital gains taxes.
An option is not a purchase. The purchase doesn’t take place until title is transferred. So with the option, the investor has time to get his other property sold and fall within the 45-day identification time frame and the 180-day closing time frame.
The numbers look good to the investor, too. The seller is willing to let the property go for $200,000. At 5.5% interest, that is a monthly payment of $1135 and some change. Add property taxes and insurance, and the investor will have around $500 a month positive cash flow to play with. The investor agrees to pay the seller $200 a month as option payment as long as he can have control of the property and be the new landlord.
The seller agrees, the two sign all the papers, and Joe takes over the property. But I have left out a step. Nothing in an option agreement allows the buyer to occupy the property. Occupation of the property is covered by a lease. The difference is vital to understand.
I repeat, all the option agreement does is provide the buyer with the right to buy the property at the option price as long as he meets the conditions set forth in the option.
For the Seller
The seller has risks, too. Mostly his risk comes in the form of an increase in property value that puts the option price significantly below the market price. In that case, if the buyer/optionee meets all the option conditions, the seller has no choice but to sell the property at the option price. Therefore, it behooves a seller to be sure the option price is high enough to ensure that he won’t lose his shirt in the sale.
But there’s another huge risk to a seller that can result in a bad tenant being allowed to stay in a property he or she is buying with a lease-option. An improperly drawn lease option agreement must be in two separate parts.
Let’s look at this scenario.
Jim Landlord owns a single-family home that he has been trying to sell for several months but with no luck. So Jim advertises the property as a rent-to-own, or lease option. Wanting to save some money (lawyers are just a bunch of thieves, after all), Jim finds a free lease-option agreement on the internet. It’s a great form, Jim thinks, because the paperwork is simple. The whole agreement is on one sheet of paper, both the lease and the option.
Jim gets calls right away. Lots of people, it turns out, want to own a home but can’t get financing for one reason or another. Jim takes the first applicant who shows up. They seem like nice people. In fact, both husband and wife have real jobs that pay real money every two weeks. That’s better than the applicants he had been getting just to rent the place. The tenant-buyer and Jim sign the agreement that includes part of the rent going toward the down payment.
Everything is fine until four months later the tenants forget about paying rent. After all, they figure, they are homeowners. Jim files an eviction. The tenants show up in court with the lease-option agreement in hand to show the judge. The judge takes one look at the “free” lease-option agreement and rules that the tenants have “equitable title” to the property and thus Jim must go through a foreclosure process to get them out.
Equitable Title means “A title to property in which a party has a beneficial interest and will eventually acquire legal title.” Beneficial Interest means “The right to benefit from a trust, contract, or other form of agreement.” (Business.yourdictionary.com)
Of course, foreclosing is a huge problem since there is no actual sale of the property. Was the judge wrong? Maybe. Jim would have to appeal the court’s decision to find out.
But Jim would have avoided all those problems if he had made two separate agreements.
The Lease Part
Lease options are 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; we do that all the time with rental property.
So when someone is buying a property with an option, and wants to take control of it to rent it out, he has to write both an option agreement and a lease agreement. It is important that they are written separately. For the seller, it is also important that in the option agreement he or she places a clause such as: “nothing in this agreement permits the optionee the right to occupy the property.” Without that provision in the agreement, when the seller tries to evict someone with an option from the property for nonpayment of rent or some other offense, as pointed out above, a judge could allow the optionee to stay because they have “equitable title” to the property and so as much right to occupy it as the seller.
By the same token the lease should make no mention of the fact that there is an option on the property. It should be a straight lease agreement that coincides with the beginning and ending dates of the option.
The Real Advantage
A use for the lease-option arrangement for buying or selling property is to allow someone to sell or buy essentially on contract, using owner financing, or with conventional financing without triggering the “due on sale” clause in the mortgage. Since the seller has not actually “sold” and the buyer has not actually “bought” the property, most mortgages don’t consider the use of an option to buy as something that means the lender has to call the loan. Rather it is an agreement that gives someone the right to buy the property at a future date. Without title changing hands, as far as the lender is concerned, the current mortgagee owns the property.
Here’s one final example. Suppose Tom Landlord wants to sell his four-plex for $360,000 and a Mr. Jones has agreed in principle to buy it for $90,000 down. The problem is the current $270,000 loan Tom has on the property has a clause that says that if he sells 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 Tom will have to lower his price or find another buyer.
Tom and Jones consider several different alternatives, but finally solve the problem with a lease-option arrangement.
Jones has $90,000 cash available. Tom will take $76,500 of that as a security deposit for a 20-year lease on the four-plex. Under the lease, Jones will make monthly rental payments to Tom equal or slightly larger than the payments on your $270,000 loan. (One reason for making them larger is that Tom would be compensated for his trouble in the matter. It would still work if Jones just made lease payments equal to the debt service.)
At the same time Tom gives 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 the existing 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 for the down payment.
Jones, per the agreement, also has to pay all property taxes and other expenses. The entire agreement is filed with the county recorder. Tom is free of all expenses connected with the property and essentially in the same position as if he had sold it. In fact, he is better off in one way. He can still take the tax deductions for depreciation because he still legally owns the property.
After Jones’ payments reduce the balance on the 17-year loan to zero, the dueon-sale clause is a moot question. At that point, Jones pays Tom 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.