Lease Options Can Work Well for Those Waiting to Buy

When real estate markets slow down, and especially when mortgage financing becomes more difficult to obtain, many buyers and sellers turn to lease/purchace options as a way to achieve their short term goals while waiting for situations to become more conducive to engaging in a straightforward purchase or sale.

In its simplest form, a lease/purchase option occurs when a tenant has an option to purchase a property that he is occupying or using according to the terms of the lease. Lease options may offer advantages for both parties.

Buyer-tenants may be able to occupy a property that they would like to purchase but currently don’t have sufficient down-payment and/or borrowing ability.

Seller-landlords are given a way to have their costs of owning the property covered, allowing them to move on somewhere else, and they usually get good tenants who are motivated to keep up the property and remain current with the payments.

There are lots of things for both parties to think about when entering into a lease option. First and foremost is the fact that they are committing to three distinct, though related, transactions: 1) a lease, 2) on option to purchase, and 3) a sale agreement.

These three different agreements might be spelled out in three separate agreements, with cross references, or in one fairly complex one.

The lease part would typically be fairly standard. Certainly, it ought to have the normal rights and protections that accompany a regular lease.

The lease term may be the same as the option period, but it need not be. One might, for example, have a three year lease, but only a two year option period. That way, should the option not be exercised, the landlord would be able to market the property while he or she still had a tenant in it.

The option agreement will spell out how much is being paid for the option, which is usually not refundable if the option is not exercised. It will specify the length of time the option period lasts, the manner in which the option is to be exercised (usually some form of written notice) and also the consequences of non-exercise.

The big item, of course, is the price. This might be specified in the option agreement, or, better, it could be designated in a purchase agreement that is referenced by the option agreement.

“A purchase agreement?” some might wonder. “Why should there be a purchase agreement?”

Specifying the price alone is just not enough. Suppose you give me an option to buy your property for $500,000, and that, later, I say, “OK, I want to exercise the option. I’ll give you $5,000 down, and I’ll pay you $5,000 a year until it’s paid off.”

Well, of course that won’t work for you. But that’s why you want a complete purchase agreement complete with all the terms spelled out at the time you give the option – not just the price.

Note, though, that it is not necessary for a specific price be agreed upon at the outset, as long as there will be a clear unambiguous method for determining the price, e.g. by referencing the consumer price index, the average of three appraisals, or some other agreed upon valuation method.

An option to purchase is, or can be, an enforceable document. But if its terms are too vague or ambiguous, it can’t be enforced. Both parties should want a purchase agreement to accompany the option agreement.

Any credits that are to be given to the buyer towards down payment can also be spelled out in the purchase agreement.

Typically, though not necessarily, the option money and all or part of the rent may be credited towards down payment.

Among the other things to think about: It is a very good idea to record the option agreement, or a memorandum thereof. This protects the potential buyer. All should recognize that a lender may not “allow” all the money that the seller is willing to credit towards the buyer’s down payment.

State law will determine whether disclosure requirements are triggered at the outset, rather than at purchase time. Finally, both parties should be aware that many mortgages provide for acceleration of the note (calling to due) if a lease option occurs.

Adapted from an article by Bob Hunt, a director of the California Association of Realtors.