Should Your Seller Do a Lease/Option – Lease/Purchase?

Disclaimer:  I am not an attorney and the ideas expressed here are those of an educated layman (me).  Rules and law governing property transactions including those mentioned here are State specific and vary from location to location.  Please do not consider this post to be ‘advice;’  and before proceeding with any property transaction seek the counsel of a qualified, local, real estate attorney.

Situation:  Your Seller has very good, even excellent credit.  He/She has never been late on their mortgage or anything else.  This is very important to them:  they’ve worked very hard over the years to budget, live within their means and meet their financial obligations.  Unfortunately they are now upside down on their house:  current market value is $225,000 and the mortgage is $250,000.  They paid $300,000 seven years ago.

Even though Short Selling has become an acceptable option for most sellers, in fact a wise choice for many, this seller just can’t go there.  But he/she wants to take advantage of the great mortgage rates and excellent deals in the marketplace right now and upgrade to a bigger house in a nicer neighborhood.  This might be a good situation for a lease/option or lease/purchase.

A Lease/Option is two things:  an Option to purchase the property on or before some date in the future, and a Lease agreement giving the Option holder possession of the property during the interim period.  The Option is usually accompanied by non-refundable Option money, which can be substantial.  The eventual purchase price for the property is either locked in at the time the Option agreement is reached OR can be ‘Market Value’ at the time the sale is eventually consummated.  In the latter case, ‘Market Value’ must be carefully defined:  is it the opinion of one appraiser?  Two?  Do we average three? or take the middle figure of the three?  And, oh, by the way:  who’s going to pay for all of these appraisals?  During the Lease period, part of the rent paid can be credited against the eventual purchase price.  The Option money, however, is only there to secure the Option:  it would be rare for any of it to apply toward purchase price.  In a Lease/Option, the purchaser is not obligated to buy the property.  If, at the end of the Option period, the buyer does not want to complete the purchase, he can either renegotiate a lease (or new sale) with the seller or move.

A Lease/Purchase is similar:  there is an agreement to purchase at a later date that is secured with cash, there is a Lease agreement governing the interim period and part of the rent may be applied toward the eventual purchase price.  But there are some differences.  First, this is not an Option situation.  The buyer is paying the seller a non-refundable fee upfront for the privilege of purchasing the property at a later date.  The purchase is not optional:  the buyer is obligated to buy or face consequences like specific performance.  Usually, in this kind of transaction, the eventual purchase price is locked down at the time the purchase agreement is ratified.  Often, the price is current market value PLUS an increment over and above.

Back in the late 70s and early ’80s we experimented with these kinds of transactions.  Back then, interest rates were spiking well into double digits.  Often the lease periods were very long and it was clear what everyone was trying to accomplish was a way around the due-on-sale clause in most mortgages.  The courts were not pleased and some sellers, buyers and agents paid dearly.  That’s another reason to get competent legal advice before proceeding here.  It was that crazy interest rate period that gave birth the first adjustable mortgages any of us had seen.  We learned to think of them as temporary financing to bridge the gap until sanity returned to the market and a refi could be done.

So, back to our Seller – the one with excellent credit and an upside down home.  You just helped a family navigate a short sale.  They are good people, no doubt, but were WAY upside down:  the home was work about 50% of what they owed!  They aren’t able to get a mortgage today but unless financial disaster strikes, will probably be in good shape in a couple of years.  They love the seller’s house and offer an Option to purchase on or before this date three years hence, secured by $10,000 (non-refundable). The eventual purchase price will be $250,000.  They’ll pay monthly rent of $2,100 on the property during the lease period and $500 of each month’s rent will apply toward the eventual purchase price (If the rental period runs the full three years, that will be $18,000 in ‘credit’ from the Seller to the Buyer).

This is attractive to the Buyer because he gets to get back into a home he loves immediately.  The $250,000 purchase price is higher than the property is worth today but he is optimistic about the economy and thinks it’s likely the property will be worth that much or more at the end of three years.  The $10,000 cash for the Option in theory will be more than offset by the credit coming back at closing.  And, if it just doesn’t work out, he doesn’t have to purchase the property.

The Seller is intrigued but cautious.  This looks like a way to preserve their good credit and make a move as well.  The $10,000 Option money will help supplement the down payment they’ll need on the new home,  And the monthly rent is $500 more than their current mortgage payment.  The biggest concern is the Option:  what if the buyer rents for 3 years and decides NOT to buy the home.  What if the buyer gets into the home and stops making rent payments?  And so on.

The first thing you would do – and you’d probably have done it long before this situation got this far – would be to put the parties in touch with a good real estate attorney.  But having said that:  what do you think the Seller should do?  What would YOU do (as James Quinones might ask)??  Do you think this kind of strategy would appeal to some of your sellers?

Oh, by the way – there is something that I forgot t mention.  It has to do with the real estate fee.  Sometimes it is due and paid at the time the Option is agreed upon and funded.  Sometimes it is not payable until the property eventually closes. It’s a negotiation.   In our hypothetical example, the Broker’s fee will be paid by the seller at Closing.  Now:  what do you think?