Lease Purchase Options
In a tough market, where short sales abound, lease purchase options arise. There is both good and bad. The best way of protecting yourself from harm is to understand them.
What you pay for a home isn't nearly as important as when you have to pay for it!
If I offered you my home today for $500,000 and it's worth about $450,000 I'll bet you won't buy it. But, if I offered to let you buy the house for $500,000 in ten years, I'll bet you might.
So, what if I offered to let you rent it for the next two years at market rate rents AND you could purchase the property for $500,000 in two years? What if I made the same deal for five years? Ten? Would you be interested? Would you be interested if I also offered to accept slightly higher rent payment in exchange for crediting something towards your purchase price, building your future down into the deal? That might solve a short sale problem, right?
When is an LPO appropriate?
I love your house, but I cannot buy it today because:
- I have really crumby credit that I'm in the process of cleaning up
- I am self employed and cannot yet prove my income on my IRS 1040, but I'm going to make a million bucks this year
- I sold my home in North Carolina and won't have the cash in hand to buy your home for another two months
- I won the lottery, but haven't yet received my second annual installment
- Your property is over-priced, and you cannot afford to sell it for less because you owe more than it is worth
- You need to sell your home quickly as it is about to foreclose, and I can't get a loan quick enough to do that
- You need to make a deal quickly because you are moving to Tucomcari next week and I can't close that fast
If I have a choice of either renting or selling on lease-purchase, legitimate lease-purchase optionees take better care of a place than renters. The property will eventually be theirs. Keeping it in good condition is in their best interest. Renters will move on regardless of the condtion of the property.
What is a Good Lease Purchase Option?
- You and I agree on a future price for your property.
- I give you non-refundable good funds option money that protects you from full risk and rewards you today for making a lease-purchase deal, often equal to six month's rent, but could be somewhat less, depending on circumstance.
- There is no security deposit. The non-refundable option money is all there is. Last month's rent can, but does not have to be included.
- I pay you market rent or more for the property and become a tenant until I exercise my option to purchase.
- Maybe some of my rent goes toward the purchase price, maybe not, depending on what you and I have agreed to.
- You get to treat the house as a rental and deduct normal rental expenses, including depreciation, until I buy. You will declare my rent as income, but can take all interest, property taxes and expenses paid by you as a deduction.
- Depending on what we agree, either you or I can pay HOA, property taxes and/or insurance. Whoever pays usually gets to deduct.
- Either you or I agree to maintain the property, yard, pool, spa, etc., depending on what we agree.
- You and I sign a residential purchase agreement, a lease, and an option to purchase agreement.
- A neutral third party should receive my monthly payment and make the underlying loan payments.
- I may not sublease or rent any part or whole without your prior written consent.
- I must keep the property in good condition.
- I get to make improvements to the property, with your consent.
- Our respective REALTORSŪ get paid a lease commission based on the length of the option period and only as rent is paid. If I don't make the rent payments, they get nothing. They get a sale commission only when I exercise the option and close the purchase.
- I give you thirty days notice of my intent to exercise the option, or not, prior to the end of the option period.
- If I don't make payments, or I elect not to exercise, the contract is kaput, you get to keep the money and house, and the deal is dead.
- All of the above is in the contracts.
The Good, the Bad, and the Ugly of LPO's
Let's talk about the Good, the Bad, and the Ugly. We'll start with the Bad as that can be the most harmful.
The Bad
If you find yourself in a short sale or standard sale and are approached by a company or individual proposing to purchase under a lease purchase option PROCEED WITH CAUTION. Ditto Land purchase or land trusts.
If they are offering NO or little upfront option money, or just barely enough to get you out of the house, expect that your payments will not be made, the house will be rented out and the home will eventually, and fairly quickly, be foreclosed.
If they put a tenant in, that tenant has all the eviction rights of any other California tenant, and their rights are extensive. Once in, it will be tough to get tenants out.
On the other hand, if you are going to lose the home anyway and the paltry hundreds of dollars they are likely to offer helps, what the heck? Just be wary of the hype and false promises that everything will be okay. In most cases the property will end up in foreclosure, particularly in a tough market, and your credit will bear the brunt of the foreclosure.
The Ugly
For the Optionor (Seller, landlord)
The lease-purchase optionee (the person contracting with you) also has tenant's rights. Unless they leave voluntarily, they can be a thorn to remove. If rent payments stop and eviction begins, the underlying loan payment must still be made. The eviction process can take 90-180 days.
Before considering becoming a landlord. Rent the movie "Pacific Heights", starring Michael Keaton. Great flick. Keaton plays a memorable bad guy. Landlord issues in the movie are quite accurate as they relate to California law. A bad tenant can do real harm in more ways than one.
The optionee (occupant, buyer, tenant) can tear the place up, steal all the fixtures, soil the carpet, move in cats, dogs, horses and cows all without your permission and still be protected by California tenant law. They can throw wild parties, do drugs, wake the neighbors and violate all manner of HOA rules and you, the property owner, are powerless to stop them.
Yes, if they are breaking the law, you can call the cops. Unless they are standing on the front steps, with cocaine powdering their nose and a needle in their arm, a Fender amp blasting the neighborhood, the police have limited authority to do much.
If you run a credit check on them before granting possession (always a good idea whether just renting or lease-optioning) review the credit check closely. Don't rely on score alone. Have they been evicted before? While foreclosure may indicate bad luck, eviction usually means bad faith. If they've had a tough time once and can explain it (health, job loss, etc.) and you buy the story, okay, but be skeptical. Good cons usually have good stories.
The last ugly is that after giving you $10,000 or so for option money they could take a hike, leaving the property back to you. On the other hand, it was $10,000 you probably wouldn't have had in the first place, and maybe it bought you some time.
The Good
LPO's don't require a lender's approval, repairs, good credit, extensive buyer and seller disclosure (although if exercised all of these things will apply) and no escrow. They can happen with the stroke of a pen which is what also makes them dangerous. Before embarking on the seas of optioning, ask your agent if they have done this before and if not, do they have someone in the office that can help the two of you through it.
Many options to purchase work out well for both parties. The option gets exercised, the optionee gets a loan, you get whatever money you have coming and get off the liability for that property.
In good times LPO's can be used to get property sold to existing tenants and can have escalation clauses built in for future increases in value. For example, the price could be $225,000 the first year of the option, $250,000 the second year, and $275,000 the third, encouraging the purchase earlier (and therefore your money earlier).
Short term LPO's can solve the gap issue between selling one and closing the other. You may have a very good buyer who just cannot close their sold home quickly enough, but it is going to close, and they may be willing to pay more under a an LPO than any other buyer. LPO's are a great way to close the gap.
DANGER . . . DANGER WILL ROBINSON! (Lost in Space for those of you who are not familiar with the movie or TV series). Any deal that looks to good to be true generally is. Do your homework. Don't be so anxious to make the deal that you get into trouble.
Solicit the advice of an attorney or someone whose been down this road before. Either use them as your REALTORŪ or offer to pay for their review. The documentation is difficult and time consuming to go over and most good agents will not be willing to advise you for free. There is liability in doing so. When agents get paid for providing a service, their insurance covers their mistakes, when free, perhaps not. Whether you know it or not, their insurance helps cover you as well.
