Many Californians rent because they don’t have adequate funds for a down payment and/or they can’t qualify for a loan to purchase a home through the traditional process. On the flip side, many rental property owners would like to “cash out” a sizeable asset on favorable terms. A lease-option (also called rent-to-own, lease-to-own, or rent-to-purchase), which is an arrangement whereby a tenant/buyer has a lease with a concurrent term within which to exercise an option to buy the home outright at an agreed-upon price, could solve these issues.

Documenting the Lease-Option

Lease-option agreement terms vary, but generally they can be considered three distinct, though related, transactions : a lease, an option to purchase, and a purchase and sale. These agreements can be three separate, cross-referenced, concurrently-executed documents or one complex document.

Lease. Each party should have the normal rights, obligations, and protections of a standard lease, including rent, late fees, security deposit, lease term, who pays for repairs and maintenance, and who is responsible for utilities. Additionally, in most lease-options the tenant/buyer pays above-market rent, with that rent premium credited toward the down payment if the tenant/buyer exercises the option to buy the property. However, if the tenant/buyer does not exercise the option, that rent premium is forfeited and kept by the landlord/seller.

Option Agreement. When the option agreement is executed, the tenant/buyer pays an option fee as consideration in exchange for the sole right (option) to purchase the property for a predetermined price within a defined term, which is usually between 1-3 years. The option fee is typically 1%-5% of the purchase price; the smaller the fee, the shorter the option period, and vice versa. This option fee usually is not refundable if the option is not exercised. The fee is typically credited, along with the aforementioned rent premium under the lease, to the tenant/buyer’s down payment when the tenant/buyer exercises the option. A landlord/seller must sell at the agreed-upon price if the purchase option is exercised.

Purchase Agreement. Both parties should execute a purchase agreement concurrently with the lease and option agreement. As with a standard residential real estate purchase agreement, this document would set forth not only the property’s purchase price, but all other terms of the purchase, including closing date, disclosures, inspections, title searches, appraisal, down payment and loan amounts, etc. It is not necessary for a specific price be agreed upon at the outset, but there must be a clear method for determining the price, e.g., by referencing CPI or by describing an alternate, but definite, valuation method.

Abstract of Optio. Concurrently with the execution of these documents, an abstract of option should be recorded to give notice of the buyer/tenant’s exclusive option to purchase the property.

Benefits of a Lease-Option

Lease-options can offer benefits for both parties, but especially for the landlord/seller there is little downside. The current owner retains the title, and thus the tax advantages of the property, during the option term. Even so, because the tenant/buyer’s goal is to own the property, the tenant/buyer generally maintains the house in better condition that a typical tenant/buyer otherwise would. In addition, there are significant economic upsides:

1. The landlord/seller often either receives an above-market sale price or leases out the house for the term and then collects a large option deposit if the tenant/buyer were to fail to execute on the purchase.

2. The lease income realized usually more than covers the landlord/seller’s ownership costs during the option period.

3. The landlord/seller could create an additional cash stream by financing the tenant/buyer’s purchase of the property, which has the benefit of deferring recognition of any capital gain for tax purposes.

4. The landlord/seller could save up to 5-6% of the sale price in commissions because many times real estate agents are not used in lease-option transactions.

The tenant/buyer carries more risk in a lease-option, but if the tenant/buyer can successfully exercise the option to purchase the home, arguably the tenant/buyer has more upside through the long-term benefits and financial leverage of home ownership when contrasted against continued renting.

As mentioned at the outset, the lease-option can help the tenant own a home sooner (and hopefully begin building equity) than he/she otherwise would have. In particular, the option period gives the tenant/buyer time to improve her credit necessary to qualify for a loan and/or overcome bad credit to purchase a home.

During this option period, the tenant also occupies and controls the desired home without the down payment and/or credit necessary to buy that home. In addition, because the agreement may fix a purchase price at today’s prices in a rising market, the tenant would benefit from any value increase in the home before the actual purchase.

In Part II, the risks and pitfalls of the lease-option transaction are discussed, with helpful tips for the lawyer representing a party to the transaction.