January 1, 2010
The lease option offers two benefits to real estate investors: a way to control property for little or no money and to rent out or sell a property that might not otherwise be rentable or saleable.
An option is an option to buy. A buyer makes an agreement with the owner of a property to buy that property within a specified length of time for a specified amount of money at specified terms; in return he pays the seller of the property an option fee. The option fee is compensation of the seller for keeping the property off the market for the period of time of the option agreement.
The steps in an 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 (the contract). They write it up just as if the property were being sold now; but instead of the actual sale and closing dates, those are either blank or the space contains 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. Whether or not the option fee is applied to the sale price is negotiable.
Things 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. The agreement would then have to specify what happens if the monthly payment does not arrive on time.
Important: Nowhere in the option agreement should it allow the buyer to live in the property, only to buy it at the terms and conditions agreed upon. Options are used every day by corporations wanting to tie up properties in case those properties meet 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.
With 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 his 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. As long as the terms of the option are met, he can be forced to abide by the contract in the courts.
To avoid bank-account-draining problems, lease options consist of two separate agreements, the lease and the option. They do not have to both be present. Obviously someone can lease a property without having an option to buy it. That happens daily with rental property. And obviously someone can buy a property without an option. That happens every day, too.
Accordingly, when an investor goes about buying a property with an option and wants to take control of it to rent it out, he needs to write both an option agreement and a lease agreement. It is important that they are separate. For the seller, it is also essential that in the option agreement contain clause such as: “nothing in this agreement permits the optionee the right to occupy the property.” Without that provision in the agreement, trying to evict someone with an option from the property for nonpayment of rent or some other offense could be problematic. A judge could allow the optionee to stay because he has “equitable title” to the property and thus as much right to occupy it as the seller. The seller could be forced to foreclose.
Likewise, the lease should not mention the fact that there is an option on the property. It should be a standard lease agreement that may well coincide with the beginning and ending dates of the option, but doesn’t have to.
The use for the lease option arrangement for buying or selling property is to allow a sale or purchase essentially using owner financing without triggering the “due on sale” clause in the mortgage. Since the property has not actually been “sold” or “bought,” most mortgages don’t consider the use of an option to buy as something that give the lender the right to call the loan. In fact, the lender probably won’t even be aware of the option. Rather it is an agreement that gives someone the right to buy the property at a future date.
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 advise you if you have any questions, regardless how trivial. The most seemingly trivial incongruity can turn into the biggest headache.