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Lease Options are Back: Proceed Carefully

Written by on Monday, 24 October 2011 7:00 pm
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When real estate markets slow down, and especially when mortgage financing becomes difficult to obtain, many buyers and sellers turn to lease options as a way to achieve their short-term real estate goals, while waiting for situations to become more conducive to engaging in a straightforward purchase or sale.

In its simplest form, a lease option occurs when a tenant has an option to purchase property that he is occupying or using according to the terms of a 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 to 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: a lease, an option to purchase, and a sale agreement. These three different agreements might be spelled out in three separate documents, with cross-references, or in one fairly complex one.

The lease part would typically be fairly standard. Certainly, it ought to have the normal provisions for a security deposit and late fees (items that are liable to be overlooked when everyone is happy, and thinking that there eventually will be a purchase). Each party should 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 not just the price, but also, the terms, spelled out in a purchase agreement at the time you give the option. 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 method for determining the price, e.g. by referencing the consumer price index, or some real estate 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 document. 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 it due) if a lease option occurs.

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  About the author, Bob Hunt

Individual news stories are based upon the opinions of the writer and does not reflect the opinion of Realty Times.