Lease Options - How to get above market rents and good long term tenants for your investment properties

Lease Option Agreement

Before reading this article, please make sure you have a lease option agreement to hand or use the one we supply - http://www.property-system.com/index.php?pageid=investing

 

With ever-rising house prices ‘Lease Options’ are rapidly becoming a new approach for individuals to purchase their dream properties and provide investors with an alternative property investment strategy other than ‘buy to let’.

Given that over 1 in 4 people are being refused normal mortgages at affordable rates, divorce rates are on the rise and most people today are unable to raise even a 5% deposit on a house, the Lease Option provides a flexible way for people to own their dream homes.

As the name suggests a lease option combines the benefits of both a normal lease (an AST) and an option to purchase.

The investor will own the property and then let it out to the tenant with the view that in a prescribed period of time the tenant will then have the option to purchase the property at a pre agreed price.

Benefits to the tenant are that they will eventually be able to purchase their ‘dream home’ which they might not be able to afford now. For the investor he gets the chance to charge a premium on the rent and purchase price and have a tenant who will look after the house as if it was their own.

In reality the Lease Option is two separate agreements; an AST lease and an option agreement. Let’s briefly review each component. Please note where it says ‘investor’ it is meant the person who has purchased the property and has granted the option. The ‘tenant’ is the person who will live in the property under the tenancy agreement and who has the right to purchase under the option.

Lease

The lease to be used is simply an AST. The investor will own the property throughout the period of the tenancy and the tenant will only have the normal tenant rights. Given that it is the ultimate intention of the parties that the tenant will purchase the property, the tenant should be allowed to treat the property like ‘home’. He can decorate and perhaps materially refurbish the property, all with the investor’s consent of course. Also the tenant will be expected to put and keep the property in a good state of repair as it is intended that it will be his home.

The Option

The option grants the tenant the RIGHT but not the OBLIGATION to purchase the property within a set time period at a set price. Remember that the tenant does not HAVE to purchase the property; he just has the RIGHT to purchase the property. If however the tenant chooses to exercise his option then, subject to the tenant complying with all the terms of the lease option agreement the investor must sell the property at the agreed price and on the agreed terms of sale as set out in the Option Agreement.

When both these concepts are combined you have your lease option. Typically you would expect the property to have been purchased by the investor at below market value.

The purchase price set out in the option will be the market value of what the property is worth today. Of course as owner of the property you can set what ever price you would like for the purchase price. The rent charged also is typically at a premium to reflect the fact that you will be selling the house in, say 2007 at 2004 prices.

This Lease Option Agreement also provides for an Option Sum to be paid on signing of the Lease Option Agreement. This would be like a small deposit of perhaps 1-2% of the Purchase Price which is usually not refundable. The investor has the option of whether to deduct this Option Sum from the monies due to him when he sells the property to the tenant.

This Lease Option Agreement is straight forward to understand and the wizard will take you through the agreement step by step. However, I would like to draw your attention to the following clauses:

Clause 1

1.2 The Completion date will need to be settled. Your solicitor can best advise you as to the best day.

1.3 The contract rate has been defined by reference to Barclays Bank base rate. Any other interest rate calculation or bank could be used here.

1.6 This is the period during which the Tenant can exercise the option to purchase the property. 2 years is considered in commercial circles to be the normal maximum time period but you can make it as long or as short as you wish. Notwithstanding the time period you enter here the option period will end automatically on the date when the tenancy agreement is terminated. Obviously the investor would not want to be restricted as to what he can do with the property if the tenant has vacated and is not paying rent.

1.8 Your solicitor will know your registered title number or you can find this information by speaking to the Land Registry.

1.9 The most important clause! Insert the purchase price for the property. Please note that a mechanism has not been included for the investor to increase the purchase price to be in line with inflation etc. Of course such a mechanism could be added if you so wish.

1.12 The investor will need to provide the tenancy agreement he expects the tenant to sign and attach it to the back of the signed agreement at schedule 4.

Clause 2

2.1.1 Insert the Option Sum you wish to charge and delete the acknowledgment of payment wording if in fact the Option Sum has not been paid!

2.2 You will need to decide whether the Option Sum will form part of the purchase price or not. The wizard will prompt you as to what wording should be inserted.

Clause 3

3 The Option can only be validly exercised if the Tenancy Agreement has not been breached and the deposit has been paid. Therefore if rent is due under the tenancy agreement then the Option cannot be exercised.

Clause 4

4 This clause provides for the tenant to provide a 10% deposit on exercise of the option. This is to show good faith on the part of the tenant that he wants to go through with the purchase. However please note that the investor cannot keep this money if contracts are not formally exchanged on the purchase. He must return it!! Once contracts are exchanged then the deposit can be kept if the tenant withdraws. You can manually change this figure as you wish.

Clause 6, 7 and 8

6,7,8 You MUST have your solicitor review these clauses to ensure you are selling with full title guarantee and that you have correctly set out how title will be deduced. This agreement has not been drafted with any particular property in mind and so these clauses will not be suitable for you.

Clause 9 and 10

9 You must have your solicitor review these clauses and complete them for you to ensure proper title is passed.

Clause 12

12 Your solicitor must review this clause. If no amendments are to be made to the standard General Conditions of Sale then delete the wording in brackets.

Clause 14

14.2 The investor will be entitled to sell the property to another third party provided that the new purchaser takes over the existing position of the current investor. Schedule 2 sets out the deed the new purchaser would be expected to sign. This will give the tenant comfort that he will not lose his option to purchase. Indeed the investor would not want to sell the property prior to the expiry of the option period until he has found somebody to replace his position.

Clause 15

This clause does NOT have to be here. In fact as you read on I suggest you delete it before giving this to your lawyer to review.

The meaning and purpose behind this clause is subject to much legal debate which I will keep to a minimum. This clause benefits your tenant as it protects his option at the land registry and stops you from selling the house to another third party.

When that third party carries out their land registry searches they will see the tenant has an interest in the property and then they will make the relevant enquiries as not many people will buy a property which is subject to a formal notice on its title. The reason why I suggest delete the clause is two fold.

Firstly this is an issue of concern for the tenant only. You do not have to raise it out of the kindness of your heart.

Secondly there is a small chance that your mortgage company may find out about the notice and may not like this as most lenders typically request that they consent to any ‘disposition of the property interest’.

You will need to check your own individual mortgage deeds.

The question of whether the granting of an option is a disposition (or transfer) of the property is a much debated legal question. In my view (which is a majority view) the option merely grants your tenant the right to buy the property but not the obligation to do so.

Therefore there has been no transfer of any property. As a Landlord you would be entitled to sell the property to another person but would be obliged to pay damages to the tenant if you did not sell the property to him after he validly exercised the option.

However other more cautious lawyers (the types who say ‘you can’t do that here’) argue that the person with the benefit of the option is actually controlling the land and therefore an interest in the property has passed on the granting of the option as the Landlord cannot now sell the property.

This in my view is incorrect as the landlord could still sell property (subject to their being no notice) but then be in breach of the option as discussed above.....however who wants to argue abstract legal arguments with a mortgage lender!

Therefore my suggestions are that you do not raise the issue of registering the option to the tenant and delete clause 15. I have only included it in your draft for completeness sake. Let the tenant raise this point if he thinks or is advised about it.

Most will not and if they do raise the point resist the requirement to register by stating the option agreement is clear and may cause issues with your lender if they find out.

If the tenant insists then just add a clause 15 and the following sub clause at clause 20 (Contract Termination) which states:

“This Option shall immediately terminate in the event that the [name of Bank] request that the Option be terminated and if applicable, the Buyer hereby irrevocably and unconditionally grants to the Seller a power of attorney to do all such acts and sign all

necessary documents to remove any notices affecting the Property’s title registered at the Land Registry which the [name of Bank] request.”

Another issue which may arise (unlikely) is what happens to the tenants option if the property is repossessed from the landlord? This is unlikely to happen if the tenant is paying you premium rent, regularly and on time.

An easy way to resolve this if the tenant decides to ‘dig his heels in’ would be for the Tenant to pay the rent into an accountants/solicitor client account as escrow agent and make sure the accountant/solicitor pays the mortgage company directly and then remits the balance to you.

This will give the tenant the security his after that you will not pay the mortgage company. Again do not raise this point unless the tenant does so first. It is not your obligation to look after your tenants’ interests.

Also always remember that the term of the Tenancy agreement should not be more than six months and then let the agreement continue on a monthly tenancy after that. In any event always please consult with your solicitor.

Clause 18

18.1 The parties will need to agree whether the chattels (i.e. the contents) at the property will be included in the sale price or whether an additional payment is required over and above the Purchase Price and make the necessary deletions and changes to this clause.

Clause 19

19.1 This clause as currently drafted provides for the tenant to PUT and KEEP the property in a good state of repair. This means that if before the tenancy commences the property is in disrepair, then it is the obligation of the tenant to make the repairs to turn the property into a good state of repair. Given that it is the intention for the tenant to purchase the property, most tenants will in any event want to improve the house and make necessary building works and decorations. It also ensures that the tenant knows he is to be responsible for the maintenance of the house.

Clause 20

20.1 As currently drafted the Option Agreement can be terminated by the investor when the Tenancy Agreement is terminated. The rational behind this is that if the tenant is not prepared to live in the property as a tenant then he will not be entitled to retain his control over the investor to purchase it at the agreed price. However a tenant might be concerned that the investor can properly give notice to terminate (eg the tenancy is in a rolling notice period) for the sole reason of terminating the Option Agreement. In this case wording could be added to clause 20.1.2 stating that the Option Agreement may only be terminated in circumstances where (a) the Tenant gave notice to terminate the Tenancy Agreement; and (b) the Tenant had breached the terms of the Tenancy Agreement.

Just a brief word as to what happens if the tenant does not exercise his option to purchase within the required time frame. In that event nothing will happen! The investor will still own the house and will benefit from any alterations and improvements if carried out by the tenant. The tenant’s right to purchase the property will cease and the investor can then sell the house to whomever he wants.

As you can see the Lease Option is not a simple agreement. Remember the precedent here is just that; a precedent which can act as your guide to prepare a first draft to show to your solicitor so he will not charge you thousands of pounds for the further work required! This agreement should not be used without professional advice being sought. As with all things involving the sale of property, you will need to show it to a solicitor to ensure it adequately protects your position.

 

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