The Lease Option

LEASE-OPTION TRANSACTIONS

JAMES ROBERT DEAL, J.D.

425-774-6611 x 1

James@JamesDeal.com

MATTHEW PARKER, J.D.

MatthewParker@JamesDeal.com

425-774-6611 x 2

More Seller Financing Information

Read overview of wrap-around, seller-financed deed of trust.

Read an overview of Dodd Frank..

Read an overview of How to Beat the Due-on-Sale Clause.

What Is A Lease Option?

A lease-option transaction is a form of seller financing. It differs from the wrap-around deed of trust transaction in that the lease-option is generally not recorded while the wrap-around deed of trust transaction is recorded. A memorandum of lease or lease-option could be recorded, but that would be unwise in a due-on-sale situation since it would give potential notice to the lender that a violation of the due-on-sale clause had occurred.

The aim is not so much to hide the transaction from the lender. The aim is not to change the transaction, for example, by changing the insurance policy, which would force the servicer to pull the file and review it. Most loans get capitalized, and servicers want to leave them alone.

With the unrecorded lease-option deal, title stays in the seller until the buyer refinances or resells or otherwise pays off the seller. The advantage of a recorded wrap-around deal is that actual title is transferred to the buyer. Having title is valuable. It can be very tricky to refinance out of from a lease-option into a new loan. If you are a lease-option buyer, you should pass all your payments through a collection service so you can prove to your new lender someday when you are refinancing that you paid all payments and paid them on time. This includes the down payment.

Generally, sellers want to be paid in full at closing and not muddle around with seller financing. However, if they are open to seller financing for some reason, they are more likely to consider seller financing if the buyer pays a significant down payment, generally enough to cover all closing costs, including commissions and to leave the seller with significant money in hand.

Generally, sellers are less likely to consider a recorded wrap-around recorded deal if the buyer has only a small down payment. But sellers might still consider a lease-option deal. A good example of this is the renter who says, oh, by the way, I would like to have the option to buy this house.

An unrecorded lease-option deal is not as good for a buyer as a recorded wrap-around deal, but it can still be good for a buyer. It may be the only way the buyer can even get close to becoming an owner.

Why would a seller give the renter a lease-option?

An advantage to the seller: A landlord can generally charge a higher sale price and higher rent to a lease-option buyer than to a regular tenant. There is a larger pool of potential buyers. Surprisingly, there are many lease-option buyers who have a significant down payment and good income but who cannot qualify for a new loan to cash out the seller. They probably have dented credit.

Another advantage to the seller: With a lease-option, the seller can sometimes require that the renter be responsible for all repairs and maintenance, taxes, and insurance. The renter intends to become the owner down the road and so the renter should start taking responsibility.

Another advantage to the seller: The seller will be able to increase the sale price every year or so. The SAFE Act and Dodd Frank require that payments and interest rate on a recorded wrap-around deed of trust deal be fixed for the first five years before they can be increased later. With a lease-option, a seller will generally want a relatively short option period, say two years, so that the seller can adjust the price upwards if the market value of the property increases. The law presumably does not require that lease-options last a minimum of five years with fixed rent, although some authorities say otherwise.

The lease-option buyer should negotiate for the parties to sign and notarize a deed and wrap-around deed of trust and deposit them into true escrow so that these documents can recorded when the lease-option buyer is approved for financing and ready to close. This provision crease would involve complex drafting and a seller would want enough money paid to pay the costs of this extra transaction.

The buyer will ask that part of each monthly payment apply to the purchase price, whereas the seller generally will want none of the rent to apply to the purchase price. This is always negotiable.

Lease-option buyers often negotiate for a two-year lease-option term. However, bear in mind that whatever is wrong with a buyer’s credit that prevents the buyer from being able to get financing in two years may take more than two years to fix.

Technically, a lease-option deal triggers a due-on-sale clause. However, because generally the lease-option agreement is not recorded, there is no way the lender will learn of the sale unless one of the parties to the transaction tells the lender or if the buyer is added to the seller’s insurance policy. A lender will almost certainly not call the loan due as long as title and insurance have not been changed.

Another issue pertains to eviction.

The lease-option contract should say that only a simple eviction would be necessary to terminate the lease and option. However, landlord tenant laws are different from state to state and from city to city. A quiet title action might be necessary to terminate the option.

Regarding insurance, it is best to keep two policies in place. The lease-option buyer should obtain the buyer’s own homeowner insurance policy. When the buyer is added to the seller’s policy, a lender might pull out the file and review it.

A lease-option situation might arise in the case of a listed property. A buyer is located. The buyer does not qualify for financing. But suppose the buyer has a substantial down payment, enough to pay commissions and a substantial payment to the seller. Brokers like to get paid, and if the option money is great enough to cover the commission, the commission might be paid at the start of the lease-option agreement.

On the other hand, If the option money is smaller, the broker might have to wait until the buyer cashes the seller out. If the option money is enough to pay part of the commission, then part of the commission might be payable when the lease-option begins and the rest when the buyer cashes the seller out.

Lease Option Summary

Most lease-option deals do not involve a real estate broker. Brokers need to be paid and there is no good way under a lease-option deal for a seller to give security to the broker that the commission will be paid some years down the road.

Sincerely,

James Robert Deal
Real Estate Attorney & Real Estate Managing Broker
James@JamesDeal.com
PO Box 2276 Lynnwood WA 98036
Law Office Line: 425-771-1110
Broker Line: 425-774-6611
Cell & Text Line: 425-670-1405 (better to send email)
KW Everett Office Line: 425-212-2007
Fax: 425-776-8081

WashingtonAttorneyBroker.com/Helping-Brokers
WashingtonAttorneyBroker.com/Helping-Buyers
WashingtonAttorneyBroker.com/Helping-Sellers
WashingtonAttorneyBroker.com/Seller-Financing
WashingtonAttorneyBroker.com/Wrap-Around-Deed-of-Trust
WashingtonAttorneyBroker.com/Escrow-Attorney

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