The Lease Option Agreement: Pros, Cons, and a Creative Approach to Real Estate
A lease option agreement can be an advantageous arrangement for both the landlord and tenant. However, there are pitfalls that you as a landlord need to be mindful of so that the agreement can be drawn to work to your benefit.
The simplest definition of a lease option agreement, according to Frank Uzzi, private practice real estate attorney and licensed real estate broker, is the right for a tenant to purchase your property at a future time. It is also sometimes called a rent-to-own agreement.
One of the important features of this type of agreement is that it is usually drawn up so that the option is exclusive to the tenant. Legally, options are assignable, meaning that the tenant can sell or give their option to buy to someone else if there is no specific wording in the agreement that prohibits this. Another feature is that this agreement doesn’t obligate the tenant to buy the property. It is merely the right to exercise the option if they choose to do so.
The option can be designed so that it begins at a certain time during the life of the lease, and expires at a certain time. It can also be drawn so that it expires when the lease expires. The pricing structure can be different at certain times when the option is exercised. Frank gave the following example, “The agreement can be structured so that the purchase price within the first 12 months of the lease is $100,000. If the tenant decides to purchase in year two of the lease, the price is $105,000.” The other alternative to naming a set price is to have a custom market analysis performed at the time the tenant wants to exercise the option to determine fair market value.
The way the agreement works, according to Frank, is that the tenant usually pays rent that is higher than market value. A portion of that rent goes toward the purchase price. Frank added that in some cases, the entire rent could go toward the purchase price. If the tenant fails to exercise the option, the extra money they paid the landlord isn’t refundable.
Frank noted that this type of arrangement has become slightly more popular in the current real estate climate. There are two major reasons for this. The first is the declining housing market. Prices have fallen, and landlords know they can’t get fair market value for their property. So they try to “beef up” rents instead by offering tenants the option to buy.
The second reason the lease option agreement is gaining in popularity is the credit crunch. Working men and women who in the past would have been suitable candidates for financing now find themselves unable to qualify for a mortgage. Because credit is so tight, they are actively looking for lease option agreements.
There are some significant advantages for landlords to enter into this type of agreement. Even though a tenant may start out assuming they will be able to purchase the property down the road, a lot of them may not be able to obtain financing to complete the purchase. The money paid toward the purchase price remains with the landlord.
The other distinct advantage is the difference in attitude between a tenant who simply rents and one who intends to eventually own. Here’s how Frank explains it, “The landlord-tenant relationship is usually a push-pull in terms of getting the tenant to take care of the property. The tenant that wants to purchase will typically take better care of the place, pay rent on time, and even make improvements.”
But in spite of these obvious incentives for a landlord to consider a lease option agreement, you can’t overlook the drawbacks. If a landlord needs to sell the property, but the tenant turns out not to have substantial enough credit to go through with the sale, the property remains unsold.
Frank said that landlords also need to keep in mind that tenants are agreeing to purchase in the future. This is a volatile market both in terms of price and interest rates. What seems like an affordable price now, may seem unfair two years from now, resulting in the tenant either asking to renegotiate, or deciding to renege on the option.
If you’re thinking about entering into a lease option agreement, a consult with an attorney may prove to be beneficial. They will be able to take certain steps to ensure that you maintain ownership. Frank explained that some lease option agreements have been interpreted by the court to be sale contracts, not lease option arrangements because of the way they were written. You certainly don’t want to find yourself in the position of having to turn over your property to a tenant because the agreement you signed was subject to misinterpretation.