One of our loyal visitors asks: “When is a
lease option valid…?” The answer is both simple and informative:
a lease option is valid when it is done correctly and both parties have
performed all the terms and conditions leading to and including the exercise of
the option. Let’s explore a bit further to get to the informative
things.
Three types of options are generally associated with leases. The first
type is the option to lease. In this scenario a potential lessee contracts
to lease a certain premises on specific terms at a future time. This
option covers a situation in which a desirable location is not ready for rent at
present, or the lessee is just not ready to take possession yet, but wants to
make sure the unit will be available for a planned future move. It is a
freestanding contract separate from the lease that may ultimately be entered
into. It is very rarely used, and only when the lease inception is
contemplated so far in the future that the potential lessee wants the
opportunity not to enter into the lease if circumstances change or, for that
matter, if they do not, otherwise, a future occupancy date simply would be
specified in the lease itself. The second type is a lease with an option
to renew. In this scenario, the lessee leases a property for a fixed term,
e.g., three years, and takes an option for a further three years on terms set
out in the option portion of the original three-year lease. This option
assures the lessee he can remain on the premises if he wishes to do so after the
first term of the lease expires, but gives him the option of moving on if he
believes that is in his best interest. The third type is a lease with an
option to purchase. A variant is a lease with a right of first refusal.
In this scenario the lessee obtains, in addition to his leasehold interest, an
option to buy the property by exercising an option to do so by a specific date
and on specific terms. The right of first refusal gives the lessee the
option to match any offer the landlord might receive on the property during a
specified time frame.
Options
such as those described above are most often in commercial leases, but there is
no reason why they could not be used in a residential lease, and, in fact, the
third type, lease with a purchase option, is often used in residential settings,
mostly when the lessee is strapped for cash and the option money, paid in
installments over the term of the lease, is used as the down payment when the
lessee exercises his option (see more about this below). It is a device to
permit a potential buyer to pay his down payment in installments while living on
the premises, with the contingency that he loses his option money if, for any
reason other than breach by the lessor, he fails to buy.
If you decide to enter into a lease agreement containing an option there are
certain things you should be aware of.
Options are supported by their own consideration, which is usually separate from
the consideration for the lease. In the case of the option to lease and
the lease with an option to purchase, the contract should specify that the
option money does not constitute rent, and is consideration for the option only.
This is especially critical in leases with a purchase option. The last
thing you want is to have the tenant contend that the option money he is paying
in monthly installments should be credited to his rent, or is some kind of
installment down payment on the purchase of the property, if it is not, and
should be refunded if he does not follow through with the purchase. This
is not the case for an option to renew. The consideration for an option to
renew in a fixed term lease is usually the act of entering into the original
lease.
You should always ensure that an option terminates either on a date certain or
at the termination of the lease, whichever comes sooner. If, for example,
you lease a home to someone with an option to purchase and you evict him for
nonpayment of rent, the option continues to exist even though you have
terminated his lease. By ensuring that his option to purchase dies when
his lease does, you will avoid a potentially costly cloud on your title if the
deal falls apart.
Whenever an option, either to purchase or to renew, is entered into in
connection with a lease, it is the best practice to ensure that the option
specifies that there be no outstanding defaults under the lease agreement at the
time the option is exercised. Thus, if the lessee is behind in the payment
of rent, he cannot exercise his option to renew the lease until he makes the
rent good. If he is trying to buy the property, he cannot exercise his
option to purchase unless his rent is current. This can be a powerful
incentive for faithful performance of the lease.
All of the important terms of the option should be specified in advance and in
writing. In the case of options to renew, describe the property subject to
the option, the date the option must be exercised, the new rent or a formula for
the ready calculation of the new rent (such as a CPI adjustment or percentage
increase), and any terms of the new lease that will vary from the old one.
In the case of an option to purchase, specify the date the option must be
exercised, the price of the property, the description of the property,
contingencies such as qualification for financing, whether the seller will
assist in financing, whether the option money is to be applied against the
purchase price, whether the option is transferable, and anything else that is
important to you. Be especially careful to lay out in detail what happens
if the lease is forfeited due to a breach or consensual termination, or if the
lessee misses an option payment if the option money is to be paid in
installments, which is a common arrangement in residential settings. It is
critical that all essential terms of the option transaction be specified and not
left to future negotiation or agreement, otherwise your option will only be an
agreement to agree, which is unenforceable.
Be absolutely positive that this is what you want to do. An option will
tie up your property for a substantial period of time. You are conferring
on the other party a right to do something in connection with your property,
essentially losing control of it for as long as the option exists. This is
not a trivial step. Options are as enforceable as contracts of sale, and
can create as many problems if the deal turns sour.
Know the optionor, that is, the person to whom you are giving the option.
It does not matter how well you or your lawyer or realtor draft the option
agreement if you do not trust that the other party can and will follow through.
Screen such a lessee as you would screen any other potential tenant, but with
special care. A well crafted option will give you a winning legal cause of
action against a defaulting optionor, but you are not bargaining for a cause of
action, you are bargaining for a potentially profitable sale or lease.
If you are not experienced in drafting documents of legal significance you would
be well advised to obtain the help of one who is. In the case of an option
to purchase, it would not be out of line to budget a small part of the option
money you are going to receive to get a lawyer to draw it up for you. You
will want an attorney who has experience in conveyancing in your state. Do
not ask your real estate broker unless he also has legal experience. The
reason the drafting is so important is that all of these agreements must be in
writing under the Statute of Frauds. Everything necessary to describe the
agreement between the parties must be written down because while a few notes
scribbled on the back of an envelope might make your option enforceable under
the Statute of Frauds, the result might be to drag you into a contract the
ultimate details of which you never intended and which are decidedly unfavorable
to you.
A lease with an option agreement can have many benefits. The option for
renewal can attract a stable tenant for a long period of time. A lease
with a purchase option can help you move an otherwise difficult to sell property
in a down market. In any case, however, proceed with caution and have the
foresight to head off problems before they occur.
Questions
and Answers:
My tenant and I entered into a
lease of a single family home for two years with an option to purchase at the
conclusion of the lease term. All the lease said was that he could buy the
property at the “then fair market value.” We are in a hot market and
he is talking about a price far below what I could get if I offered the property
to the public. Can he enforce this agreement?
The real problem here is not whether the option can be enforced, but what you
are likely to go through as your optionor attempts to enforce it. It
sounds as if he has a mind to do so if the exercise of the option will give him
instant equity by acquiring the property while appraised values lag behind a hot
market. This will be especially true if he has paid option money.
Expect a suit for specific performance of the agreement.
The price term of the option you describe is extremely vague and could well be
held by a judge to be insufficient to satisfy the requirement that all essential
terms of the option contract be specified. However, the key word here is
“could.” A court could as easily hold that the signed written
agreement is sufficient to satisfy the Statute of Frauds and accept parol
evidence, evidence outside the terms of the contract itself, and consider your
dealings, conversations, and other communications with the optionor to clarify
and flesh out its other terms, such as how “fair market value” is to be
determined. A judge would be strongly inclined to do so, if possible, if
option money were paid. Issues as to how “fair market value” is to be
determined would be totally out of your control. Most judges are in love
with appraisers because an appraiser, clothed with the aura of an expert, can in
effect relieve the judge of the obligation to make an independent determination
of value, overlooking the fact that an appraisers opinion is just that, an
opinion, and may not reflect the true value on the date it is made, lagging
behind the hot market. In any event, litigation is certain, and will be
costly.
The lesson to be learned here is never to enter an option agreement that has
jokers in it. If you are not willing to specify the terms, then you are
not ready to enter into an option. If you are going to leave valuation of
the property to a future determination, then you must – MUST – describe with
certainty how that determination is to be made and what happens if there is a
dispute. This is one reason why these agreements need to be supervised by
a lawyer who is an experienced conveyancer.
I
entered into a lease with a purchase option when my tenant executed his two-year
lease. Over the two years he paid $4800 in option money, $200 per month,
which is to be applied to the purchase price if the option is exercised.
The agreed price of the property is $145,000, which looked reasonable at the
time, but comparable houses are now going for $160,000. He has sent me a
certified letter exercising his option to purchase and has engaged a real estate
broker to handle the transaction. What happens if I ignore the option and
try to sell the property on the open market for a higher price?
Ignoring the option is not a good idea at all. In all likelihood, if you
fail to follow through, your optionor will retain an attorney to sue you for
specific performance of the option agreement. Specific performance is a
form of relief in which the court forces you to follow through on an agreement
you have made. This sort of relief is extraordinary and only granted in a
few kinds of cases, most real estate transactions, unfortunately from your point
of view, being one kind. What is more, you will be in trouble even before
the court makes its determination. Your optionor’s lawyer will record,
at the time he files the petition for specific performance, a Notice of Lis
Pendens. Such a notice, known by various names in various jurisdictions,
is recorded with the Recorder’s office in your chain of title. It puts
any purchaser of the property constructively on notice that there is a lawsuit
pending that affects title and makes his interest, if he buys the property or
lends money against it, subject to the court’s ruling. Even if you were
to find a purchaser willing to risk taking title subject to the Notice, no title
insurer would insure title without excluding the Lis Pendens, and no lender
would lend against the property. You must remember that an option is a
binding contract that you must perform, even if it hurts. Attractive as
the option, and the option money, may appear when you enter the option, you have
to consider what will happen when the option is exercised. Otherwise you
may be stuck.
My tenant and I made a lease for a commercial space for three years with an
option to renew for three years. The lease says that in order to exercise
his renewal option, there must be no uncured defaults outstanding. Over
the years this tenant has paid rent late numerous times. He always refused
to pay the late charges and now owes several thousand dollars. I really
don’t want him around anymore but he has sent his 90-day notice to renew.
My lawyer told me I could never evict him for the late charges alone so I simply
accrued them and sent him a notice of the outstanding amount each month.
Do I have to allow him to renew?
When the option says it can only be exercised if there are no uncured defaults,
it means any default, not just in payment of rent. This could include
non-payment of late charges or CAM charges or taxes, unauthorized use of the
property, or anything else that constitutes a breach of the lease. You
should be able to remove the tenant by rejecting his notice of exercise of his
option to renew, and taking the position that his lease has expired at the end
of the original term, requiring him to vacate. Go back to your attorney so
that he can send appropriate notice and prepare to get around any waiver or
course of dealing issues that might potentially arise.
My tenant entered into a lease with an option to purchase at a price of
$175,000. On the open market, the property will only bring about $160,000,
so I can make money if I can force him to buy. Is he obligated to buy the
property if he has it under option?
No. “Option” means that your optionor can buy the property or not, at
his pleasure, and you cannot force him to do so. That is what the option
money is for. The option money is consideration paid to you to keep the
property off the market for the time specified in the option, making sure it is
available to your optionor if he decides to buy. If he does not exercise
his option you keep the money and he moves on, with neither of you under any
further obligation.
Can I enter into an option with my tenant that obligates him to buy the
property at the end of his lease?
Yes, you can, but in that case it would not be an option. The essence of
an option is that the optionor can exercise his option or not at the appropriate
time, and that he pays you money for the privilege. If you have an
agreement obligating him to buy at a specified time, then you have a contract of
sale, which is beyond the scope of this article. There is no legal reason
why a contract of sale could not be preceded by a lease. In fact, this is
sometimes done when the buyer wants to move in right away and it is anticipated
that the closing will be delayed, and is nearly always the case when a sale
under contract of sale is used as a creative financing device. Whether or
not it is a good idea is another question. Even more than an option, a
pending contract of sale will hugely complicate the landlord-tenant relationship
and attempts to enforce it if things do not go as planned.
I have
granted an option to buy my home to the tenant who now occupies it and he has
another year to run on his lease till he must exercise it. Cash is tight
and I need to sell. He says he is not ready to exercise his option yet.
Can I sell the property to someone else? If I do, what happens and what is
my potential liability?
Technically you can sell the property, but you should be aware of a few things
before you try. Sale of the property during an option period to someone
other than the optionor is not a breach of the option agreement on your part.
An option is not a conveyance; it is a mere encumbrance. That being so,
the purchaser of the property would take subject to the option, and anyone
financing the sale would insist that the option be subordinated to his mortgage.
Still, there is no reason why the sale could not be made, though the reasons it
should not be made are numerous.
The option is a contract, and your contractual obligation is to convey title at
the time the option is fully exercised, that is, when your tenant has performed
all the terms of the option agreement by him to be performed. At that
point, if you do not convey, you are in breach. Your tenant then could
enforce the agreement through specific performance, both against you and the
then current owner. In this regard, all of the rules about recordation,
priority of encumbrances, constructive and actual notice, and bona fide
purchasers apply. He could also sue for damages. Your sale of the
property, in any event, does not extinguish your personal obligation to perform
the option when exercised.
I am occupying a home under a lease option agreement. My landlord seems to
be having money problems and I am afraid he may end up in foreclosure.
What will happen to my option?
What happens to your option will depend on what is foreclosed. Your option
is an encumbrance, and like all other encumbrances, a foreclosure will wipe it
out if the lien being foreclosed is senior to your option. In most states,
if your option is not recorded practically everything is senior to it except
judgment liens. If it is recorded, then the order of recordation would
control, and if your option is senior to the thing being foreclosed, then your
option would survive and the purchaser at the sale would take subject to it, not
likely if it is a mortgage extended by an institution as they will always insist
on subordination of any encumbrance senior to them except, say, a purchase money
mortgage, before funding a loan. If you are junior to a mortgage or other
encumbrance you would have a right to redeem as any other encumbrancer would
have, but you would not usually have a right to notice if your option is not
recorded unless you have recorded a Request for Notice of Default in the chain
of title. Whether or not you choose to exercise this right is a mixed
legal and economic decision to be made after consultation with counsel. Of
course, you would still have a right to sue for breach of contract if you decide
to exercise the option and the person who sold it to you fails to perform.
Do you have a form I can use to set up a lease option with my next tenant?
I need something with all that legalese I don’t understand.
Options, though potentially beneficial, are like most creative legal devices in
that they are complicated and need to be done right. A form has blanks
that need to be filled in. It is a real time saver but not a substitute
for understanding. If you don’t understand “all that legalese” then
you don’t understand options and might just as well dynamite your house as
option it. Not only will you not know what to put in the blanks, but also
you will not even know the import of the contract you are signing. If you
think you need a form then you need a lawyer more. Lawyers experienced in
conveyancing have both the knowledge and experience to help you avert disaster.
Your real choices are to gain the knowledge yourself or employ the services of
someone who already has it, usually a much less expensive, less time consuming,
and less disaster prone process.
How does an option to purchase differ from a right of first refusal?
An option to purchase grants the optionor the right to buy the property at a
fixed or easily determinable price on or before a certain date in the future.
A right of first refusal gives the holder the right to match any offer made on
the property before the owner can accept it. For example, suppose the
owner receives an offer of $125,000 for a home and he intends to accept it.
Before he can accept the offer, however, he must go to the holder of the right
of first refusal and give him the opportunity to buy the property for at least
that price. If the offer is matched, the owner must sell to the holder of
the right. If it is not, then the owner is free to sell to the third party
offeror. Of course, the owner is under no duty to accept any offer.
If he simply rejects the $125,000 offer at the outset then the holder of the
right of first refusal has nothing to say about it. Also, the holder of
the right of first refusal has no control over when he may have to exercise his
right. The holder must match all terms of the offer from the third party,
including details such as closing date, all contingencies or the lack of them,
terms of financing and down payment, and so on. A right of first refusal
is also limited in time although a certain date may not be specified.
Partnership situations are an example, where a partner may reserve a right of
first refusal on a piece of partnership property during his lifetime.
Since no one knows exactly when the partner will die, no one knows when the
right of first refusal will expire, but since it is certain he will die, it is
certain to expire. Before attempting to enter into such agreements consult
a lawyer about the Rule Against Perpetuities in your state.
My tenant has a two-year lease on a freestanding home. He pays rent of
$800 per month and is paying his option money of $4800 in installments of $200
per month. He has missed his last two option payments but is current on
his rent. Can I evict him?
You cannot evict him for non-payment of the option money unless you have
explicitly made a default in option payments a breach of the lease, which is
possible if you say so in the lease. Otherwise, your remedy is to
terminate his option and sell the property to someone else if you want to do so.
Remember that the option and the tenancy are two separate things, even if they
are created by the same document.
lease_options.htm
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