Key Terms in Option-to-Purchase Agreements

Make sure your lease-option agreement is clear on important details, such as how and when the purchase price of the house is determined.

An option- to-purchase agreement is an arrangement in which, for a fee, a tenant or investor acquires the right to purchase real property sometime in the future. While option contracts are used in both commercial and residential real property transactions, this article focuses on option to purchase contracts in residential real estate transactions.

In the residential context, an option to purchase is usually a part of a rent-to-own agreement, also called a lease-option. This involves a tenant entering into a standard lease or rental agreement, in addition to acquiring the option to purchase the rental property in the future. In this arrangement, a portion of the tenant's monthly rent payments is applied toward the principle of the house. For more details, see the Nolo article, The Basics of Rent-To-Own Agreements.

What to Include in an Option to Purchase

An option to purchase can appear as a series of clauses in a lease or rental agreement or as a separate document. No matter the format, an option to purchase must: 1) state the option fee, 2) set the duration of the option period, 3) outline the price for which the tenant will purchase the property in the future, and 4) comply with local and state laws.

The Option Fee

In order to be contractually enforceable, the option to purchase must be given in exchange for consideration, or value. While the value of an option contract cannot be nominal, there is no special floor or ceiling; it's a matter of negotiation between landlord and tenant. Depending on factors such as the price of the home, the option fee can range from several hundreds to several thousands of dollars.

Option fees are typically nonrefundable. In other words, if the tenant decides not to exercise his or her option to purchase the house within the agreed-upon time frame, the tenant forfeits the option money. The option fee is also usually forfeited if the tenant defaults on the lease by failing to make timely and exact rent payments or by breaking a term of the lease (such as housing pets when pets are prohibited). Upon the purchase of the home, the landlord deducts the option fee from the principle of the house and the sale price is therefore deducted by the option fee.

The Duration of the Option Period

An option-to-purchase contract must conspicuously state the duration of the option period. There is no correct or preferred unit of time and option periods can range from months to years. Typically, however, in the residential context, option periods range from one-to-five years.

Depending on the terms of the contract, the tenant may exercise the option to buy the house at any time during the set option period or at a date specified in the option-to-purchase agreement. If the tenant lets the period pass, the option expires and becomes null and void. In that situation, the tenant forfeits the option fee.

Purchase Price of the House

An option to purchase must address the price for which the tenant will buy the rental property in the future. Sometimes, the purchase price is a set price that is determined based on the current appraisal value of the house. This approach does not always make sense, however—the longer the option period, the higher the likelihood of fluctuating home values. So, when longer option periods are contracted for, landlords and tenants usually agree to re-evaluate the purchase price of the home periodically. Alternatively, the landlord and tenant may agree to determine the actual value of the house by appraising the house at the time the option is exercised. Ultimately, as long as both parties are in agreement as to how the value of the house is to be determined, the option contract is enforceable.

For general advice on determining the value of a house, see the Nolo article Home List Price: What Is a House Worth?

No matter how the value of the property is determined, it is likely going to be decreased by a percentage of monthly rent payments. This is so because in an option contract, an agreed-upon percentage of the monthly rent is typically placed in an escrow account. The landlord then either reserves the escrow funds and refunds the tenant upon purchase of the home, or simply applies a percentage of the rent payments toward the principle of the house. In this manner, the tenant builds equity in the house throughout the duration of the lease agreement. The tenant forfeits these payments if he or she does not purchase the property within the option period.

Adherence to State and Local Laws

Some state laws specifically protect tenants from entering contracts they do not understand—for example, by requiring option contracts to contain conspicuous wording in specified font size, to inform tenants of the possibility of forfeiting the option fee. To be valid and enforceable, an option to purchase must comply with the nuances of state (and any local) laws that govern the transaction. Check with your state department of real estate to find any applicable laws that may apply to your option to purchase contract.

Do You Need a Lawyer to Draft an Option-to-Purchase Agreement?

Typically, yes, it's important to work with an experienced real estate lawyer. A lot is at stake financially for both landlord and tenant, and state and local laws (such as property disclosures), often come into play as with house purchase agreements. Some states require option contracts to be recorded in the courthouse in the manner of a deed transfer; the rationale behind this is to encumber the property and ensure that the landlord is unable to sell the rental property to a third party.

Nolo's Lawyer Directory is a good place to start your search for an experienced real estate lawyer who can help a landlord draft a lease-option or option-to purchase agreement, or review one from the tenant's point of view. Also, see the Nolo article Real Estate Attorneys and Home Purchases for advice on hiring and working with a real estate attorney.

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