Lease/Options Are Useful, But Can Be Tricky

A recently-revised memorandum (Option Contracts and Leases with Option to Purchase) has been released by the Legal Department of the California Association of REALTORS®(CAR). That is a good thing. A Lease with Option to Purchase (Lease/Option) is a useful tool in an agent’s box, regardless of general market conditions. While lease/options more often are instruments of choice when financing is hard to come by, it seems there will always be some parties whose situation is well-suited for this method of acquisition.

A good lease/option agreement consists of three components: the option agreement, a purchase agreement, and a lease agreement. While terms are always negotiable between the parties, a typical scenario would be as follows:

Option agreement: The optionor (seller) grants the optionee (buyer) the right to buy the property within a certain amount of time. I might grant you an option to buy my property within the next twelve months. You could exercise the option — buy the property — in the third month or any other month right up until the end date specified in the option. Typically, the option is paid for at the outset and is not refundable. It is between the parties whether or not the option money will be credited toward the purchase price.

It is important that the option agreement specify the purchase price or a clear method of determining it. We might agree today what the price will be, but we could also agree that it would be determined by an appraisal, or an average of appraisals, or by an increase/decrease of the Dow Jones average, etc. at the time the option is exercised.

Purchase Agreement: It is also important to agree at the outset on the terms of the purchase. If I have an option to purchase your property for $500,000 — but no terms are specified — you won’t be happy if next year I exercise the option saying, “OK, I’ll give you $5,000 down and I will pay off the $495,000 balance at $5,000 per year.”

Moreover, if a sample purchase agreement is spelled out, the optionor/seller may have the opportunity to confirm the buyer’s financing plans.

Lease Agreement: The option agreement and a proposed purchase agreement are essential for any option to purchase. If the optionee is to have possession of the property, then a lease agreement is also needed. In general, a conventional lease is sufficient, but some special considerations might apply. Often the parties may agree to apply some portion of the rent to the downpayment. It is certainly OK to do this, but if there is going to be conventional third-party financing, it is a good idea to determine how the lender will treat the matter. Suppose, for example, that the parties agree that the total rent amount will be credited to the downpayment. Many lenders might not agree to this, arguing that you had to pay rent anyway, so you really can’t count that as also accumulating a downpayment. Here, it is more plausible (from the lender’s point of view) that you pay higher than a market rental rate, and let the overage be credited to the downpayment.

Also, many lease/option agreements automatically terminate if the tenant does not comply with the terms of the rental agreement. This matter should be clearly addressed at the outset.

Finally, both parties will benefit from having all disclosures and inspections performed at the beginning of the lease/option period. Surprises at the end can take all the fun out of it.

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