The Lease Option
The Risks of Leasing a Home with an Option to Purchase
In today’s economy, many people are looking to rent a home or an apartment instead of purchasing a home due to financial hardship. Renting is an excellent alternative for anyone not able to afford a home today and needs to get their lives settled before taking the leap to home ownership once again.
Today, when searching for rentals, many have found themselves coming across the term “lease-option.” Before considering entering into a lease with option to purchase, one must do two things first: 1.) research it heavily to make sure it’s the right choice for you, and 2.) consult a real estate attorney.
The initial information below is a good place to start in realizing some general risks involved with a lease-option. This is strictly informational purposes only, not legal advise. You are strongly urged to seek legal counsel if you have any legal or financial questions with regards to lease-options.
What Is a Lease Option?
A lease-option agreement is an alternative to purchasing a home where the home is leased to a household that may not be able to qualify for a mortgage. A right to purchase the home may be exercised after a certain amount of time. The lease-option may lock in a sales price and preserve the property until the Buyer obtains a mortgage. The Buyer can receive credit towards the purchase price for the rentals the Buyer pays to the Seller. If the Buyer decides not to purchase the property, the Buyer can walk way without exercising the option to purchase.
Disadvantages of a Lease Option
LEASE PAYMENTS ARE HIGHER: In a lease-option, the monthly payments are typically higher than the current going market rent rate. This is normally to compensate the Seller in return for locking the home in a lease instead of being able to offer the property for sale to the public. The difference between the going rate and actual lease payment rate can go toward the future down payment if the option is exercised, depending on the contractual terms of the lease-option.
FORFEITURE OF PAYMENTS: In a lease-option, the Buyer forfeits everything paid to the Seller if the Seller cancels the lease due to things such as late payments and canceled insurance. The Buyer will also forfeit all payments that have been made if Buyer does not complete the purchase. The “option” as well (lump sum paid at the execution of the agreement) is normally forfeited (per contractual lease-agreement terms).
CURRENT MORTGAGE MAY PROHIBIT SUCH A TRANSACTION: If there is an existing mortgage on the property, the current mortgage may prohibit the owner from entering into a lease-option agreement. The lender may have the right to demand the entire amount of the loan if the owner sells or enters into a long-term lease. Your rights may be cut off by the lender unless you or the seller has the ability to immediately pay off the underlying loan.
NO PROTECTION FROM ACTS OF SELLER:
- Judgments Against Seller - The Seller may not be able to deliver a clear title when the right to purchase is exercised. Judgments obtained against the seller may attach to the property if a notice of option right is not recorded. If an option is recorded, however, the lender may elect to enforce the due on sale clause and demand immediate payment of the note. Unless the buyer or the seller can pay off the underlying mortgage loan balance, all rights may be cut off by the lender.
- Bankruptcy of the Seller - If the seller files bankruptcy, your rights may end. Even if you have paid on the lease-purchase for several years, you may find yourself with no rights and no legal recourse against the seller.
- Death of Seller - If the Seller dies before Buyer obtains legal title, the Buyer may not be able to get clear title unless the Seller's estate is probated. If estate has little or no money there may be little incentive to probate the estate.
- Unscrupulous Seller - An unscrupulous Seller may transfer title to another Buyer or borrow money against the house creating an additional mortgage. Since a lease-purchase typically not recorded, another buyer would have no notice of your property interest. The new buyer may take title to the property, free and clear,cutting off the original Buyers' rights. The only way for Buyers to protect themselves against claims against their title is to record the lease purchase agreement at the courthouse. ..... Sellers usually do not want Buyers to record lease-option agreement, because recording may trigger a due-on-sale clause. Recording a lease-purchase agreement may also put a cloud on the title of the Seller, limiting what they can do with the property.
HOMEOWNERS INSURANCE POLICY: the Seller usually requires the Buyer to pay for insurance and taxes on the property. If the Seller carries a standard homeowner’s insurance policy, the lease-option agreement may terminate the coverage of the policy. ... If the policy is changed to permit the lease, the insurance company will send a new copy of the insurance policy to the lender, potentially violating the due-on-sale clause. If the policy is not changed, the Buyer and Seller runs the risks that there is not a valid insurance policy covering the property and that the mortgage will be violated since there is no a valid insurance policy on the property. ....If something were to happen to the property, and the property is insured properly, the Seller will collect proceeds. The amount the Buyer pays the Seller for the house will not be reduced.
IMPROVEMENTS MADE BECOME THE PROPERTY OF THE SELLER: Until the Buyer pays for the property in full, any improvements to the property (e.g. new kitchen cabinets) by the Buyer will be the Seller's property. The Seller does not have to reimburse the Buyer for costs associated with improvements even if the Seller evicts the Buyer.
Ways to Protect Yourself from Lease Option Risks
- Examine the options available to you before you decide to enter into any type of agreement.
- Have an attorney review your agreement.
- Buyers should have a professional home inspector inspect the property, especially if agreement states the property is in "as is" condition.
- Take photos and video tape the entire property for current condition upon taking possession.
- Make sure the initial lease-option inspection/walk thru paperwork is signed by both yourself, and the Seller/Landlord.
- Obtain title insurance. The title company can insure that there are no existing judgments or liens against the property when the lease-option is entered into. It will not protect the Buyer against any judgments filed against the Seller after the date the lease-option is entered into.
- Record a Memorandum of Option. This gives notice that an option to purchase the property exists and may protect the buyer against judgments filed against the Seller after the date the lease-option is entered into. WARNING: The recording of a Memorandum of Option may trigger a due-on-sale clause.
Please visit these resources for more information on lease-options, the current trends, scams and risks involved:
Risk of Lease Option - High Failure Rate
Risk of Lease Option - Losing Your Option
Risk of Lease Option - Can Turn into Disaster
Lease Option - Q&A
THE LEASE OPTION - General Information
A lease option is the abbreviated form of the appropriate term “Lease With the Option to Purchase.” It is a type of contract used in both residential and commercial real estate. Commercial real estate can get pretty complex so we are going to stick with residential.
The contract is typically between two parties: the tenant (also called the lessee), and the landlord (lessor), who owns or has the right to lease or dispose of the property.
As the name lease with an option to purchase says there are two events and one is not mandatory. In order to have a valid option the tenant/buyer must provide valuable consideration for the option. In other words buy the right to purchase at a later date at an agreed amount of money.
The lease option only binds the seller to sell, it does not bind the buyer to buy. That is why consideration is important. Valuable consideration is approximately 1-3% but there is no rule.
The basic elements are
1. Buyer purchases the option, the parties agree to what the cost of the option is.
2. The parties agree to a purchase price. It can be decided that the price will be appraised value at the time the option is exercised.
3. The length in residential real estate is typically 1-3 years and may start to get longer because of the current credit conditions (spring 2010)
4. How much the monthly lease payment is, whether any of the lease payment is to be credited towards the purchase price reducing the purchase amount.
5. Whether the tenant/buyer will occupy the property or whether the tenant/buyer has the right to sub lease or the right to sell the option.
6. An investor may acquire a distressed property with a lease option and make improvements to the property. Then the investor can sell the option to a buyer that is willing to pay the new market value for a profit. It is a common financing technique with investors.
6.a An example of this. Seller has a property that needs considerable amount of work.Retail buyers typically cannot get financing or have too much to choose from to bother with physically distressed properties. Investor enters into a lease option agreement for let’s say $100,000, rehabs the property with about $20,000 and now the market value is approximately $135,000 the investor can sell the right to purchase for $35,000 and the new buyer would close with the original seller for $100,000
6.b Another example of this would be a buyer buys the same property and uses their own money to rehab and may use their rehab money towards the down payment. This allows the buyer to NOT have to come with a large down payment and rehab money.
Everything functions like a lease except there is a schedule when the buyer can decide to purchase the property.
The terms of the lease have to be negotiated also. The responsibilities of maintenance, utilities, taxes, pets, how many occupants, what type of insurance...
During the term of the lease option, the tenant makes lease payments to the landlord for the use of the property with the terms mutually agreed. At the end of the contract, the tenant has the option to purchase the property outright; the tenant would typically obtain the money to do this using a mortgage.
Excess credit may also be applied towards the eventual purchase of the property, or towards the down payment for a mortgage (CAUTION, the buyer and seller can agree to whatever they want, but when the buyer goes to get permanent financing the bank has guidelines to what can be applied towards the down payment or the purchase. Typically a banks only allow an amount that is above and beyond market rent to be considered for a down payment) In that case, the lease option works as an automatic savings plan for the tenant. This down payment is applied as part of the "option consideration fee"; in the arena of lease option purchasing this is a fee charged for the right to purchase the property.
Reasons for using a lease option
1. Buyer is relocating and may need to sell a property in another area before the buyer can qualify to purchase the new home.
2. Buyer may have had some credit issues that have since been resolved and can afford the payment but needs to time to get permanent financing.
3. Buyer may have started a new business and otherwise qualifies and can afford the payments.
The lease option may carry less risk for the landlord than a mortgage would for the lender. In the event of non-payment, it may be possible to remove the tenants through eviction, which is likely to be cheaper than foreclosure on a mortgaged property. The lease option may also require less money up front, while a mortgage might require a substantial down payment from the tenant.
If the tenant does not exercise the option to purchase the property by the end of the lease, then any up front option money along with any monies that the tenant paid in addition to the market rental rate for this option may be retained by the owner depending on the agreement. This might occur if the tenant no longer wishes to purchase the property, or if the tenant wishes to purchase the property but is unable to obtain the financing required to do so.
Advantages to the seller. Allow the seller to sell a property that they may not have otherwise been able to sell. Most cases a seller can net more money when offering terms to a buyer.
There is an expression, “Price or Terms, Pick One” Usually you get one over the other. So for a seller to get a better price they can offer terms that favor the buyer and the opposite is true. For the buyer to get a favorable price the terms usually have to favor the seller.
Default if the buyer defaults and the contracts are drafted properly then there is an automatic tenant landlord relationship. All valuable considerations are typically surrendered and then it would be an eviction.
Some forms of lease option have been criticized as predatory, if a lease option is sold to a tenant who cannot realistically expect to ever exercise the option. These types are usually but not always advertised as “rent to own”. Owner Carry, Seller Financing, Owner will Carry, Owner Carryback are all terms that can be used for Lease Option purchases.