Addendum
Lease With Option To Purchase (Rent to Own)

Since creation of the Buying & Selling Income Property e-Course, LandlordAmerica has received a number of questions on the member-only Support Forum regarding the Lease With Option To Buy or Rent To Own way of buying and selling real estate.  Accordingly, we are providing a brief discussion in this lesson.

Definition
Option:  A right given a person to buy, sell, or lease property at a specific price within a specified period of time.  A valid option must name a valuable consideration.

Introduction

The lease option can be of value to both buyers and sellers and the issues of importance can be different depending on which seat one occupies.  There are a number of important issues to consider when an owner is giving an option to purchase the property to a tenant who is occupying it.  Failure to consider certain issues up front can result in serious problems along the way.

Unless both the lease agreement and the option agreement are properly written, serious problems can result. While there are many possible problem scenarios, consider the following question.  What would happen if the seller must evict the tenant having a lease option and the option to purchase survived the eviction?  Can you now rent the property to a new tenant?

From the point of view of an seller

Advantages can include the following:

1)      The seller can (at least theoretically) generate extra income because a lease option is usually written with an above market monthly rent with the excess usually applied to the option purchase price.

2)      Brokerage commissions and other marketing costs related to the sale are usually avoided.

3)      Because the tenant expects to end up owning the property, he will (in theory) take better care of the property.

4)      If the market declines, the seller may be able to sell at a higher-than-market price, if the tenant still wants the property.

5)      In most cases, the tenant will not exercise the option because they won't have saved the necessary cash for closing the sale or won't qualify for the necessary mortgage loan.  So, if you obtained premium rent and had good tenants and it was not important that you sell the property, you can be ahead of the game.

Disadvantages can include the following:

1)      The Lease Option is a unilateral contract unless and until the tenant elects to exercise his option.  That is, the seller must sell if the tenant decides to exercise the option, but the tenant need not buy.

2)      Unless both the lease agreement and the option agreement are properly written, serious problems can result.  While there are many possible problem scenarios, consider the following question.  What would happen if the seller must evict the tenant having a lease option and the option to purchase survived the eviction?  Can you now rent the property to a new tenant?

3)      If the market unexpectedly improves, the seller may end up locked into a lower-than-market price.

From the point of view of a buyer

Advantages can include the following:

1)      The Tenant can try out the property before committing to owning it.

2)      The Lease Option is a unilateral contract unless and until the tenant elects to exercise his option.  That is, the seller must sell if the tenant decides to exercise the option, but the tenant need not buy.

3)      If the market unexpectedly improves, the tenant/buyer will benefit from buying the property for under-market price.

4)      Brokerage commissions and other marketing costs related to the sale are usually avoided.

5)      Because the tenant expects to end up owning the property, he will (in theory) take better care of the property.

Disadvantages can include the following:

  1. The tenant/buyer will likely pay higher rent because a lease option is usually written with an above market monthly rent with the excess usually applied to the option purchase price.  However, the higher rent is not a problem if the excess is credited to the purchase price and the buyer.
     
  2. If the market declines, the seller may end up buying at a higher-than-market price, but the tenant needn't exercise the option.
     
  3. In most cases, the tenant will not exercise the option because they won't have saved the necessary cash for closing the sale or won't qualify for the necessary mortgage loan.  So, if you obtained premium rent and had good tenants and it was not important that you sell the property, you can be ahead of the game.

Items of Importance

There are a number of issues that must be considered when writing a lease option contract.  Included are the following:

  1. Obligations regarding inspection issues - Require that all inspections that are a contingency be performed prior to move-in.  However, since the tenant can fail to exercise the option for no reason, this doesn't guarantee that a inspection issue won't be the cause of no-sale, but it may reduce the probability.
     
  2. Maintenance obligations should always be defined in any lease agreement, but it is much more important that all details be covered when doing a lease option including who is responsible for major repairs during the term of the lease.  Be sure to cover such items as replacement of heating/cooling equipment and repair of major damage act-of-nature not covered by insurance.
     
  3. There are numerous issues to consider in determining the option price as well as a number of related issues including the rent premium, the portion of rent to be credited toward purchase price, and the length of the option. It's a matter of negotiating mutually acceptable terms.

A Purchase Option agreement should also contain clauses that cover at least the following issues:

  1. Time and Price:  Tenant is granted the option to purchase the Premises for the price of ____________ at any time during the period between execution of this agreement and ___________.
     
  2. Contingent on Performance:  The option agreement should state that the option is contingent on the tenant not being in default under the lease and that the option terminates upon termination of tenancy if before expiration of lease.
     
  3. Exercise of Option:  Tenant must exercise option by written notice to Landlord and shall designate a closing date not earlier than ____ days and not later than ____ days after the date of the notice.  Said notice shall be personally delivered to Landlord or mailed to Landlord by Certified Mail.
     
  4. Execution of Contract:  Upon tenant's exercise or the purchase option, Landlord and Tenant shall promptly enter into a contract of sale containing the provisions of this agreement and the customary provisions regarding sale of real estate in the County of ________________ and said contract shall be executed by all parties within ______ days.  Failure of Tenant to execute contract shall be a material default of this agreement.
     
  5. Payment of Purchase Price:  The purchase price shall be paid as follows: ___________________.
     
  6. At closing Landlord will convey the Premises by  _____________ deed, subject to _________________.
     
  7. Closing Costs and Adjustments:  transfer tax and/or other taxes payable for conveyance, real estate taxes, water and sewer charges, fuel and other utility charges, premium for any insurance policy being assumed, and any government charges or assessments with respect to the premises will be apportioned.
     
  8. Condition of the Premises:  Tenant acknowledges that he is familiar with the condition of the Premises, has performed or caused to be performed all inspection desired as to condition of the premises, and will accept the premises “as is” at the time of closing.

The bottom line is that one should seriously consider having a competent real estate attorney or a real estate broker with experience in lease options review the transaction documents.  However, you must also consider all the issues yourself as they relate to your particular property and other circumstances and utilize the professionals as a check rather than depend on them to worry about every possible issue that might become important.