“Lease options are like guns. You either love them or hate them,” William J. Archambault, Jr. of The Real Estate Institute said. “You either see them as a great tool for good, or a great tool for evil.”
Controversy about lease options has developed as the strategy has increased in popularity with real estate investors in recent years. The strategy has grown popular in the last 15 years or so, John T. Reed, a publisher of real estate investment books and former real estate investor, said.
In a lease option, the property owner leases the property to a tenant with an option to purchase at or before a set date. The purchase price is usually set up front, and the tenant often makes an up front payment as a sort of down payment.
A rental rate is typically set at least a few hundred dollars higher than the fair market rent, and the excess amount is often credited toward the down payment if the tenant exercises the option to purchase.
Tenants are willing to pay higher rents “as consideration for the option to purchase,” Diana Bartolotta, a real estate investment attorney from Connecticut, said.
Recently, lease options have received negative press as a tool for greedy investors to defraud unsophisticated tenants of their money and, in some preforeclosure or foreclosure scenarios, property. Some of these cases are going to court and could result in new legislation governing lease options.
Lease option evolution
Lease options originated as a tool to help homeowners move property they had difficulty selling. This opened up the buyer pool to renters who were not quite ready to buy.
“It allows a little bit more flexibility for…a property that [a seller] couldn’t flip, or is staying on the market too long,” Bartolotta said. “This will generate cash flow during the process of selling it.”
“The best reason for a seller to get involved with a lease option is that he’s got a prepayment penalty and he needs to wait…to get rid of the prepayment penalty,” Archambault said.
Real estate investors soon saw the benefits of selling through lease options, which allowed them to get above average rent, sell at or above market prices and avoid commissions.
Some investors began to lease option property from homeowners who needed to sell quickly. The investor could then re-lease option the property to another party for a profit.
Gurus quickly began selling seminars and educational materials to teach investors to profit from lease options. Many programs were designed to find the “greater fool”—someone who knows less about the value of their asset than the investor.
Preforeclosure programs are a recent development; investors identify distressed homeowners, purchase the property and lease the property back to the original homeowner with an option to purchase.
Pick-your-own-home programs have also arisen recently. Tenants identify the home they wish to purchase, and then the program matches them with an investor, who purchases the home and lease options it to the tenant for a marked-up price.
Lease options have become a mainstream investment tool, but legislation to protect tenants/buyers from landlords/sellers may dramatically change their function.
Allure for investors
Lease options are relatively easy and inexpensive to set up, and they usually generate a more desirable tenant than a typical rental. “You can put somebody in there who takes pride in ownership,” Archambault said.
Sellers often ask for a large payment up front, so they make an immediate profit. “Typically when you structure the deal, you have to give a big wad of front money—maybe five, 10 grand—and that counts toward the purchase price typically if you exercise,” Reed said.
Lease option tenants usually pay $200 or $300 extra above the market rent, and that excess rent counts toward the purchase price, Reed said.
“That extra money above fair market value will go towards the down payment, which is why the lease option is attractive for a tenant, somebody who…can’t qualify for a mortgage, can’t put that money aside to save up every month for that down payment, they know that part of their rent is going towards that down payment,” Bartolotta said.
“One important reality about lease options is that more often than not, the tenants never execute the option to purchase,” Bartolotta said. If the tenant doesn’t execute the option, “the investor walks away with that money” paid up front and in excess rent, she said.
After a failed lease option, the investor can sell the property or lease option it to another tenant and repeat the process.
Sellers who use a lease option strategy make certain sacrifices. “There is certainly a practical benefit to just cashing out of a property and moving on to another investment. With a lease option you are not in a position to do that,” Craig Blackmon, a Seattle attorney who specializes in assisting people with the purchase or sale of a home, said.
The seller takes on the responsibilities of a landlord, including property maintenance; by law, a landlord is required to keep the home habitable. Many sellers structure the contract to make the tenant responsible for maintenance, but this can make the transaction look more like a sale than a lease option. A court would be more likely to say the tenant has rights to the property if maintenance responsibility lies with the tenant.
Although lease options are not difficult to set up, many people don’t understand how to properly structure them. Sellers often transfer too many benefits and burdens of the property to the tenant, making it more likely for a court to view the tenant as equitable title holder.
If a court grants a tenant/buyer equitable title interest, the seller is not allowed to evict the tenant. Instead, a complex and lengthy foreclosure process is required for the seller to regain possession of the property. Foreclosure gives tenants more rights to stay the process and redeem.
When tenants challenge the eviction process and claim that they are the equitable title holder, courts will consider which party has more of the benefits and burdens of ownership, and if too many have transferred to the tenant, the lease option may be recharacterized as a sale, Reed said. “And that has enormous and numerous ramifications, almost all of which are horrible, if you thought you were in a lease option.”
This problem frequently arises in preforeclosure bailout situations. “If you’re buying the property back from somebody who has lived in the property for 10 years, you’re buying it from them and leasing it back to them, a court might say that this is actually a disguised mortgage,” Bartolotta said.
“And if it were a mortgage, then the person living in the property has a lot more rights than somebody who is just a tenant in terms of being able to redeem their mortgage…so you need to be careful about how you structure it in preforeclosure bailouts,” she said.
Finally, sellers face the risk that if the lease option ends and the tenant can’t afford to buy or the purchase price is above market, tenants may get angry and vandalize the property or steal “stuff that tenants would normally not even think of stealing,” Reed said.
The ethical debate
Investors generally have more knowledge about contracts and real estate than tenants, and some investors have taken advantage of tenants. “In the last decade or so, there’s a lot more abuse than there is practical use,” Archambault said.
Many lease option courses actually teach investors how to set tenants up to fail so that they won’t exercise the option and the profits will go directly into the investor’s pocket.
One way to do this is by selecting tenants who are unlikely to be able to buy at the end of the term. “One reason hardly anybody ever exercises the option in the lease option, [is] because their credit or income or net worth were unsatisfactory to the lenders at the outset, and they remain so throughout the duration of the option,” Reed said.
“They’re as screwed up at the end of the option as they were at the beginning, and the seller knew that was probably going to be the case,” he said.
Investors can also set tenants up to fail by setting an unrealistically high purchase price for the property, Reed said. Many gurus teach investors to add 10 percent appreciation to the purchase price each year—a hefty appreciation rate to maintain in any real estate market.
“Go out and screw the people” is the main program presented by real estate gurus, Archambault said. “The biggest idea seems to be…you can sell it taking a big option payment plus an inflated rent, and in a good year you can sell it twice and in a great year maybe three times. That line came from an apprentice of a well known guru,” he said.
Preforeclosure deals have even more complex and troubling ethical issues. A national concern has developed about investors taking advantage of distressed homeowners, Blackmon said.
“It puts [tenants] in a tough situation because they’re going to lose their house either way,” Bartolotta said. “If they sell…to an investor, and it’s leased back to them, they have the possibility of recouping their property, but also one of the realities is if the person was unable to afford the mortgage prior to the investor coming in, then they’re probably not going to be able to afford the mortgage at the end of this and be able to buy the property back at a higher price.”
“There are no laws currently governing this preforeclosure bailout world, and it’s really up to the investor in terms of how they want to handle the ethical dilemmas. And there are a lot of ethical dilemmas that come up,” Bartolotta said.
Courts tend to want to protect the weaker and more vulnerable parties, and with more attention being paid to the abuse of lease options, legislation to protect disadvantaged parties seems likely. “I see some laws changing that will protect [distressed preforeclosure] homeowners more,” Bartolotta said.
Many states have already begun to pass laws intended to protect tenants. Texas, for example, recently implemented heavy restrictions on lease options with a much larger burden on the seller/landlord to meet strict rules and deadlines, and other states with lease option abuse have been moving in a similar direction.
“I think the states with higher preforeclosures and foreclosures are going to be the first ones to regulate,” Bartolotta said.
Legislation will vary by state, and some states may outlaw lease options altogether. Lease options are “a powerful tool for those people…that actually need it, but it’s going to be gone because of the abuse,” Archambault said.
New legislation could generate a flurry of lawsuits, with lawyers actively pursuing tenant/victims as clients. Although tenants receive more sympathy, there are also times when tenants take advantage of investors, and investors will need to protect themselves against legislation that could put them at a disadvantage.
“As the laws change, obviously, the things that investors are going to have to do will change, but the one thing investors really can do is be proactive and ethical in their decisions of how they’re setting up their business investments, which will shape the ways the laws are written,” Bartolotta said.
“If investors are seen as bad guys and they’re going out and scamming people and stealing houses from people and lying to them, well then the laws are going to be written in a much tighter way than if investors were setting these up with a deal that they could show to their grandmother,” she said.
Investors who want to structure a deal fairly and ethically should make sure the tenant fully understands the contract and its ramifications. Unsophisticated tenants will need a counselor who understands lease options and their benefits and risks.
“Guns shouldn’t be touched by people with untrained hands, and real estate—particularly lease options—shouldn’t be [touched] by people without proper help,” Archambault said.