LEASES WITH OPTIONS
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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.

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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.

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