Lease-option transactions pose many risks, but an experienced lawyer and advice from tax advisors and other experts can minimize them.

Landlord/Seller Risk is Lower, but Multi-Faceted

In the typical transaction, the landlord/seller retains ownership of the property and receives monthly lease income until the option is exercised, so the landlord/seller generally has a much lower risk in a lease-option arrangement. However, the lawyer representing the landlord/seller must be mindful of potential pitfalls.

Market Value Change. The home value could appreciate above the agreed-upon purchase price, such that the seller could have made more money by renting the property for that period and then selling it. To mitigate this risk, landlord/sellers can often demand a purchase price above market.

Tax Issue. If the option payment is too large relative to the value of the home, the taxing authorities may re-characterize the lease-option as an installment sale and assess penalties and interest against the landlord/seller for unpaid back taxes. Thus, be mindful of the option fee amount and possibly consult a tax advisor during the transaction.

Nature of Occupancy. If the total of the option fee plus the option money from the monthly rent premium is too high such that ownership is deemed constructively transferred, the landlord/seller may be forced to go through foreclosure proceedings rather than using the standard eviction process if the buyer/tenant defaults.

Seller Mortgage Terms. The option agreement may trigger the mortgage loan’s due-on-sale clause. Review all mortgage notes encumbering the property and advise the client accordingly.

Maintaining Rental Income. In lease-options, the parties will often have identical lease and option termination dates. However, if the tenant/buyer were to not exercise the option, the tenant/buyer would presumably vacate the property upon expiration of the lease and option terms. This would create a vacancy without giving the client an opportunity to market the property until the option expires. Consider creating a lease term that is a few months longer than the option term. That way, should the option expire unexercised, the client could market the property without losing rent due to vacancy.

Tenant/Buyer’s Lack of Sophistication and Need for Capital Create Higher Risk

The tenant/buyer is at a disadvantage in lease-option arrangements for a number of reasons. Sophistication is often the primary issue of concern. The owner may be a seasoned developer or landlord who has the experience, and the legal counsel, to understand that seemingly benign provisions may be disastrous to the tenant/buyer over the agreement term. Conversely, tenant/buyers may have significantly weaker bargaining power because they cannot secure traditional mortgage financing, they may be desperate to buy a home, or they may have been recently foreclosed upon. Thus, a lawyer representing the tenant/buyer should consider and address several different issues in addition to ensuring the deal terms are clearly stated in the lease-option documents.

Financing the Purchase and Protecting the Client’s Investment. The most common reason a tenant/buyer fails to exercise an option is the tenant/buyer cannot qualify for a loan within the option period. As a result, counsel should recommend that the tenant/buyer meet with a lending agent or loan broker to reasonably estimate the tenant/buyer’s chances for qualifying for the loan to complete the purchase. Relatedly, a lender may not allow all the money that the landlord/seller is willing to credit towards the tenant/buyer’s down payment. In that case, counsel could negotiate a provision that would require the landlord/seller to contribute a corresponding amount of cash to escrow.

Counsel should also strive for the longest lease and option term the landlord/seller will allow. Lenders like to see stability for over two years, and a client who has been living in the same house, making payments on it, and working at the same place for that long may qualify for better loan rates. A longer lease can also help the client build equity in the home if property values are increasing.

After the lease-option documents are signed, give the client instructions or a “roadmap” for the remaining term. Encourage the client to keep records of payments and expenditures, which should help the client qualify for a loan. Additionally, good recordkeeping will protect the client against unscrupulous landlord/sellers. When the client is ready to exercise the option, recommend that the client begin the application process at least 45-60 days before the option period terminates because it is essential to have a loan ready to close by the date specified in the lease-option contract.

Because of the significant investment a tenant/buyer will be making during the life of the option, the tenant/buyer’s lawyer should ensure the option and purchase agreements are assignable so that if it becomes apparent the tenant/buyer could not exercise the option, she could sell the option right and recoup some or all the option money that would otherwise be forfeited to the landlord/seller. Counsel can also explore whether the landlord/seller will finance the purchase of the home so the tenant/buyer can avoid having to qualify for the purchase loan.

Saving for the Down Payment. The other common reason a tenant/buyer fails to exercise an option is the tenant/buyer cannot save the down payment amount within the option period. Again, counsel should encourage the tenant/buyer to review her budget, current and future financial status and income, and be realistic about her prospects for marshaling the funds required to purchase the property. To protect your client, as mentioned above, ensure the option and purchase agreements are assignable if the buyer cannot make the down payment.

The tenant/buyer must also be realistic about the lease payments, which typically exceed the monthly fair market value rate for that property. The tenant/buyer’s lawyer should recommend the client include this larger amount in her budget, both for purposes of being able to pay rent throughout the lease term and being able to save adequately for the down payment.

Finally, inform the client of the costs of home ownership, which are often underestimated. Factor in not only the mortgage payments, but also property taxes, insurance, and maintenance costs, all of which a tenant often has never previously had to pay.

Risks Relating to the Dwelling & Housing Market. The tenant/buyer’s counsel should ensure the tenant/buyer performs adequate due diligence before entering into the lease-option agreement. The client should get an independent professional home inspector to do a full inspection even if the client has resided in property. The landlord/seller is required to provide property disclosures that list the landlord/seller’s knowledge about the property’s condition and the buyer/tenant should review those disclosures carefully. If there are problems, discuss with the lender whether they will prevent the client from getting a loan, and specify in the contract who is responsible for making repairs. The client should also obtain a title report for the property.

Counsel should also confirm the tenant/buyer is a named insured on the landlord/seller’s homeowner’s insurance policy in the case the property is severely damaged or destroyed. Because the tenant/buyer now has an interest in the home, he/she may require additional insurance to protect the home and cover the increased liability exposure. Encourage the client to contact her insurance agent to determine what coverage would be needed.

Finally, any real estate transaction is subject to the ups and downs of the market. In the case of the lease-option, the home value could depreciate below the agreed-upon purchase price, such that it would be unwise to exercise the option. There is little the lawyer can do about this, other than to warn the client ahead of time of this possibility.

Conclusion

A lease-option is an excellent opportunity for a tenant/buyer to own a house when it might not otherwise be possible through traditional purchase channels. However, there are risks and pitfalls for both sides that the lawyer must navigate carefully. If negotiated and documented properly, the lease-option arrangement could benefit both parties.