Structuring a lease with purchase option for single family homes

In today’s economy with tighter lending standards, real estate investors with a growing inventory of single family homes are becoming more creative to move the homes into the hands of buyers.  Some investors are turning to leases with a purchase option that gives the tenant the ability to build equity over time to help make the later purchase a reality.

Lease-option agreements are structured to provide for a percentage of the rent to be applied towards the purchase price if and when the tenant exercises the purchase option.  After a period of time the tenant may exercise the option, having accumulated sufficient credit towards the purchase price to meet the down payment required by a lender.  Freddie Mac created its own program in 2002.

The option must have separate consideration to be enforceable, so the rent payment is typically higher than fair market with the excess amount being applied to the option. Some lease-option agreements might also require a small upfront payment as additional consideration for the option, which payment may also be applied to the purchase price.

When structuring a lease-option agreement, consider the following:

  • Take care the agreement does not look too much like a land installment contract.  While land installment contracts must strictly follow the Ohio statute for such agreements, courts have been known to hold that a lease with purchase option is really a land installment contract if the facts of the case and intent of the parties warrant that interpretation. If the landlord wants to evict the tenant, and the lease-option agreement is found by a court to be a land installment contract in disguise, then the landlord will be forced to file a more costly and lengthy foreclosure procedure to remove the tenant.  
    • Any agreement should make clear the parties are in a landlord-tenant relationship until the option is exercised.
    • Take care on how responsibilities such repairs, maintenance and taxes are allocated. The more a tenant acts like the owner, the more a court may see the tenant as one.
    • Consider limited the period of years in which the option may be exercised. Land installment contracts typically provide for a 15+ year terms. Option periods under the lease should be for a shorter period of time.
    • The percentage of rent credited towards equity if tenant exercises the option should be less an 100% to avoid resembling a land installment contract.
  • Clarify in the lease-option agreement whether the extension of the lease term also extends the purchase option or not. A lack of clarity in the drafting on this issue has resulted in more than one lawsuit over the years.
  • Keep the terms reasonable.  Parties in a lease-option agreement often have unequal bargaining power. If the landlord has significant leverage over the tenant in negotiating the lease and a court holds the terms to be unconscionable, it will not go well for the landlord.
  • Consider including a separate form of purchase agreement as an exhibit to the lease so that prior to signing the lease, the tenant can understand the terms of the purchase agreement that will apply upon exercise of the option.
  • Finally, the lease, option and any purchase agreement should be written in plain English with limited or no legalese, and special attention being drawn to important sections. It’s important that the tenant fully understand the terms of the agreements and the risks involved prior to entering into the lease.

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