Option Agreements for Tenants

Option Contracts

In the broadest sense, an option is a contract between a potential buyer (Optionee) and a property owner (Optionor) which gives the Optionee the right to buy a property within a specific period of time and at a fixed price, if they so choose. An option, or memorandum of option, should be recorded in the city/county where the property is located. The option should identify the property, the consideration paid for the option, the time period of the option, how the option can be exercised, and other terms as agreed between the parties, such as a mechanism for extension of option period if desired.

A straight (also known as a “naked”) option is one that is not tied to a lease. The best practice is to create a single Option and Purchase and Sale Agreement that contains the terms of the option along with the terms of purchase should the option be exercised.  Including the purchase terms within the option agreement ensures that both parties are on the same page as to how the transaction will move forward should the option be executed. Leaving out the terms of a purchase is a recipe for argument, delay, and potentially litigation or a failed deal.

In a common lease-option structure, tenant and landlord sign a lease that also includes an option to purchase provision. The tenant pays higher than market rent, along with a large, non-refundable* option fee for the right to purchase the property during the lease term.  Often the agreement provides that the option fee will be used as a down payment towards the purchase price should the Tenant exercise the option. Sometimes these agreements call for part of the rent to go towards the purchase price should the tenant exercise the option.

From the tenant perspective, this structure can easily be predatory in the wrong hands. A landlord can collect thousands of dollars as a non-refundable option fee, offer only a short option period at a purchase price that is inflated above market, (with no appraisal or other contingencies). Tenant is unable to qualify for a loan so quickly (not to mention the appraisal issue) and they lose the option fee. This predatory practice is at least partially responsible for the Residential Executory Real Estate Contracts Act, which aims to mitigate this risk for tenant buyers.  That statute will be the subject of a future article.

The good news is that it is possible to craft a fair agreement, allowing for appraisal contingencies, and sufficient time for the tenant to qualify and apply for a loan.

From the Landlord perspective, a concern with Lease-Option agreements is that a court could view the tenant as being vested with equitable title. If the court finds that the tenant holds equitable title to the property, the landlord will be required to foreclose.  The combination of a large option fee along with higher than market rent (which sometimes directed by the Agreement to be partially credited to the price if the option is executed), leads to this result. It is not the option in and of itself that leads to a claim of equitable title.

To have a better shot at avoiding or defending against a claim of equitable title, the better practice is to create a lease and option separately.  Keep in mind, a court will look past the documents individually to gather the true nature of the transaction. If you collect a sizeable option fee, higher than market rent, and if your option references the lease, or any combination of these factors, you still run the risk of an equitable title argument. The court would likely peel back the layers and see if the option was really a disguise for a situation that more closely mirrors rent-to-own. The title of a document doesn’t control how a court interprets it.

Using a stand-alone Option and Purchase Agreement (and a separate lease charging only market rent that does not reference the option) will be the cleanest way to counteract an equitable title argument. The concern for a landlord with this structure is that a tenant whose lease has been terminated prior to the contemplated concurrent lease and option period will still hold an option to purchase the home. In the absence of a release of the option by the Tenant, landlord will have to honor that option during the specified time period. This means that landlord will be prevented from selling the property to a third party until the option period has expired. However, landlord was compensated for that option. If the tenant exercises the option, landlord gets the price and terms that were bargained for. Language tying the option to the lease period could be used solely within the option. However, this poses its own issues as to proving that the lease was terminated.  A specific time period of calendar dates is the most straightforward. As a general point, a former tenant who holds an option may be less likely to buy if they are not in possession and if the property is occupied by others.

What if the property value rises significantly higher than the fixed price given in the option? If your tenant does not exercise the option, there is no harm. But again, you are prevented from selling the property to anyone else during the option period unless the tenant agrees to sign a release. A balance should be struck between giving the tenant enough time to make a diligent effort to qualify for the home versus an option that is for such a long period that there is potential for significant appreciation.

Even with sufficient due diligence, it is still possible to miscalculate the future value of a property. Of course, if values go down, the tenant will likely not exercise the option. This is not a happy ending for the Tenant, but it is a risk that was taken (and hopefully an educated one – please always encourage your tenant to get legal advice before signing an option agreement). But what if the value unexpectedly skyrockets?  You don’t want to be stuck without an alternative except to wait out the option period and hope that the Tenant doesn’t exercise their option, which is now at a steep discount compared to market.

My suggestion to mitigate the risk of being locked into a fixed price option if property values soar is to couple the option with a right of first refusal. An option coupled with a right of first refusal can be called a dual option.

A right of first refusal gives the holder the right to match the terms of a bona fide third-party offer received by the seller, in this case the landlord. The landlord would be required to present the offer to the tenant, and the tenant must decide if they will buy the property on the same terms as the offer or waive their right.  The contract language must be very clear that the right of first refusal takes precedence over the fixed price option. The Virginia Supreme Court case on this point is Sheperd v. Davis, 265 Va. 108, 574 S.E.2nd 514 (2003) (hereinafter “Shepherd”). In Shepherd the court found that the language granting the right of first refusal was sufficient to indicate that, if the tenant/optionee was presented with a valid third-party contract/offer, its only choice was to exercise its right of first refusal.  Optionee no longer had the choice to exercise the fixed price option in place of its right of first refusal. This case came down to the specific language used in the clause granting the right of first refusal. Based on this ruling, coupling an option with a right of first refusal can protect landlords from the risk that property values rise significantly above the fixed price agreed on in the option.

I will note that the Shepard case dealt with an option and first refusal within a lease agreement and for commercial property. There is a possibility that a court interpreting these provisions within the context of a residential/primary residence transaction could reach a different result. The court would have to sufficiently distinguish the facts before it. In Shepherd, the court did not make mention of the commercial nature of the transaction or the type of tenant as part of its ruling. In general, courts will uphold the clear language of a contract. There are always gray areas, but using documents that are clear, straightforward, and concise gives investors the best argument in the worst-case scenario.

Regardless of your paperwork structure, equity and fairness in these types of transaction is paramount. Courts are on alert for unethical or fraudulent behavior and will be more likely to side with a tenant if you behaved in a way that was unfair or appeared predatory. Ethics can step in where contracts or laws fall short. Various statutes aimed at protecting tenants and consumers are already in place, and more new laws are being contemplated with the goal of preventing investors from taking advantage of tenants and homebuyers.  The value of sleeping peacefully at night also cannot be overstated! That option fee could very well represent years of savings for your tenant. Make good deals and be a good person. You’re reading this, so I already know you are doing both!

 *The Residential  Executory Real Estate Contracts Act, Virginia Code §55.1-3000 et. seq.  is a walking contradiction to established principles of contract law. It is well-settled that an option requires consideration, and the consideration paid is for the right to purchase the property IF the optionee so chooses.   This statute seemingly requires that the option fee be refunded if the Optionee does not exercise the option. More on this statute coming soon.