1. Document everything in writing
Keep a written record of everything that is agreed on, and be careful to use the right terms in the agreement.
“Refrain from using the words ‘credit,’ ‘seller’ and ‘buyer’ in your agreements. Instead, use the words ‘non-refundable option,’ ‘landlord’ and ‘tenant,'” Bill Bronchick, a nationally-known attorney, author, entrepreneur, speaker and CEO of Legalwiz Publications, wrote in his article “Lease Option Tips & Strategies” on REIClub.com.
Written documentation helps the tenant/buyer to prove the lease option’s validity in applying for a mortgage at the end of the agreement, William J. Archambault, Jr. of The Real Estate Institute said.
A record also protects the lease option claim on the title against other claims and liens, Archambault said.
Documenting the fair market rent up front is useful because “it’s a very difficult thing to go back and recreate what the fair market rent was a year or two years or three years ago,” Archambault said.
2. Consult an attorney
Have an attorney draft a legal document specifically for this situation. “Use a legal document that is drafted specifically for your situation. Don’t use a form document that you’ve downloaded from the internet or purchased at a drugstore,” Craig Blackmon, a Seattle attorney who specializes in assisting people with the purchase or sale of a home, said.
“Those forms may or may not satisfy the requirements for the investor’s particular state. And those forms may or may not specifically address the investor’s particular concerns in any one transaction,” he said.
Investors involved in lease options need to consult an attorney, Blackmon said. Property is a significant asset, and representation can be had for a fairly reasonable fee, he said.
3. Use separate agreements
Write up separate agreements for the lease and the option, making certain that the lease doesn’t refer to the option, Bronchick said.
“It’s the option to purchase that really makes courts hesitant. It’s not the leasing,” Diana Bartolotta, a real estate investment attorney from Connecticut, said. A lease contract could state that after a certain period of on-time rental payments, an option contract will be negotiated. “If you delay that option contract, split it up more, I think that could protect the investor a little bit.”
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4. Keep the term short
Set the lease option term for a maximum of one year; if the tenant wants multiple years, give a one-year term with two rights to renew, Bronchick wrote. “Draw up a brand new lease and option agreement each time.”
The longer the term, the more likely courts might view it as a mortgage instead of a lease. Most residential leases are set for a maximum of one year and are then renegotiated or renewed. By following that structure, the transaction looks less like a sale.
5. Take a security deposit
A security deposit helps to maintain the landlord/tenant relationships. “Sellers don’t take security deposits, landlords do,” Bronchick wrote. “Make it look like a landlord/tenant relationship, even if the security deposit is small.”
If the tenant hesitates at paying a security deposit and an option fee, reduce the option and put that money toward the security deposit. That way, if the tenant doesn’t exercise the option, there will still be an incentive to keep the property up. This also helps preserve the lease nature of the contract.
6. Pay like an owner
Pay the taxes, insurance and homeowners dues. “Do not let the tenant pay the taxes and insurance. This makes it look like a sale,” Bronchick wrote.
The tenant may pay water and sewer, but the investor should at least get duplicate copies of those bills because they are lienable on the property and could ultimately become the responsibility of the seller, along with penalties and interest.
7. Factor in repair costs
Don’t put the tenant in charge of all maintenance. This shifts too many burdens over to the tenant and could make a tenant’s claim to equitable title much stronger. Investors should factor maintenance costs into the rent, Bartolotta said.
Lack of funding capacity or homeownership experience mean that many tenants won’t keep the property up anyway, and it will cost the seller more in the long run if the tenant neglects the property and walks away from the option. Most tenants don’t exercise the option, so it’s a good idea to be ready for that possibility.
One strategy for a landlord could be to establish relationships with trusted repair companies so that the tenant could be responsible for arranging repairs. The repair company would ultimately report to and collect payment from the landlord to avoid abuses. This would offer a lower time burden to the landlord while ensuring that repairs are completed as needed. This also helps teach the tenant about how to maintain a home.
If the landlord does place the burden of maintenance completely upon the tenant, regular inspections can help to ensure that the property is being properly maintained.
8. Don’t give large rent credits
“The more ‘equity’ the tenant has, the more likely a judge will favor an equitable mortgage,” Bronchick wrote.
This is why preforeclosure situations can face complications with equitable title; many of the original homeowners—now tenants—have substantial equity in the home and have a stronger claim to ownership than typical tenants.
Rather than offer rent credits, which can be viewed by courts as built up equity, reduce the monthly rent. The lower rent will most likely produce a better quality tenant much faster. In addition, the closer the monthly rent is to market rates, the better case landlords have if tenants try to push the equitable interest envelope.
If you absolutely must offer a rent credit, keep it small.
9. Give the tenant a fair chance
Give the tenant a fair chance of being able to exercise the option at a reasonable price. If you ultimately don’t want to sell the property, don’t do a lease option. Investors who set up lease options on properties they don’t really want to sell are using an unethical strategy.
Ethical investors will analyze the lease option and go through with it only if the numbers make sense in the event that the tenant exercises the option.
“If the people are not now qualified to buy a home and get a mortgage, don’t do a lease option with them unless there’s some explicit concrete reason to believe that in the future, they will be qualified,” John T. Reed, a publisher of real estate investment books and former real estate investor, said.
10. Give full disclosure
Make sure the tenant has read and fully understands the ramifications of the deal. This may mean reviewing the contract with an attorney who has lease option experience and can provide sophisticated advice. Investors who frequently participate in lease options may create a lease option pamphlet and require that tenants sign off on it.
“The best way for an investor to protect himself if he’s setting himself up for a lease option is full disclosure. You want the client to be aware of exactly how you’re making your money,” Bartolotta said. “Make sure that the person…knows what you’re doing, why you’re doing it and why it benefits them.”
One of the biggest court problems for lease option landlords is that tenants claim they didn’t understand the contract or that the landlord took advantage of them. Proactive investors can help avoid this problem through full disclosure and taking measures to ensure the tenant understands the agreement.