Brokering Lease-Purchase and Lease-Option Transactions

Note: In 2009 the author wrote an article for the May/June issue of Insight magazine entitled “Brokering Lease-Purchase Transactions; Are They More Than You Bargained For?” The following year, the North Carolina General Assembly enacted new legislation codified as Chapters 47G (“Option to Purchase Contracts Executed With Lease Agreements”) and Chapter 47H (“Contracts for Deed”) of the North Carolina General Statutes. Each of these new Acts applies to one-to-four family residential properties intended to be occupied by the purchaser as a primary residence. These new laws could substantially affect how a lease-purchase or leaseoption transaction must be handled. As such, the author has updated the previous article to address the impact of the new legislation on lease-option and lease-purchase transactions and to provide some practice pointers for how best to handle them when acting as either a listing or a selling agent.

In times of tight credit and soft real estate markets, many would-be sellers have to con sider the possibility of some kind of leasing arrange ment to facilitate a future sale. The two most common arrangements are a lease with option to purchase (leaseoption) and a lease-purchase agreement. In a leaseoption, the tenant/buyer is granted a discretionary right to purchase the subject property for a stated price within a stated option term. In a lease-purchase agreement, the tenant/buyer has a definite obligation, and not merely an option, to purchase the property during or immediately following a lease term. This article will explore some of the inherent risks and potential complications of leaseoption and lease-purchase transactions that may confront both the tenant/buyer and the seller and also compel the consulting and drafting services of legal counsel.

Lease-Option Agreements

A seller/lessor who enters into a lease-option assumes many risks. While the specified rent provides a source of funds to service a mortgage and to reduce both vandalism and insurance risks from lack of occupancy, there is no real assurance that the buyer will ever proceed with the purchase. If a prospective tenant/buyer cannot presently qualify for a mortgage, there is obviously substantial risk that this tenant/ buyer would not qualify at the end of the lease period. Even worse, the tenant/buyer could assume possession, default on rent payments, and then declare bankruptcy before eviction. The seller/lessor would then need to hire counsel to obtain an order for relief from the bankruptcy court’s stay of collection or eviction efforts. This process can take months, which in the interim, could force a struggling seller/lessor into insolvency and potential foreclosure.

The status of the lease-option as a “leaseplus” may also deprive the seller/lessor of the expedited remedy of summary ejectment in Small Claims Court, forcing the seller/lessor to pursue a far slower and more expensive eviction action in civil District or Superior Court.

The tenant/buyer may also fail to adequately care for the premises and cause the property to depreciate from the tenant’s neglect or abuse. Such damages could far exceed the typical onemonth deposit charged in residential tenancies and could delay the seller’s ability to prepare the premises for re-showing or re-letting. Finally, as an inherent risk of any tenancy, the tenant/buyer’s failure to pay utility accounts could also result in substantial liabilities that the seller/lessor must satisfy to obtain continued service.

Given these risks, the seller/lessor should require both a credit application and also the tenant/ buyer’s authorization to obtain a credit report as conditions to considering any lease arrangement. A criminal record check on each potential tenant/buyer is also suggested.

Chapter 47G

A prospective lessor/seller entering into a lease-option transaction could face substantially heightened burdens if the transaction falls under the jurisdiction of Chapter 47G of the North Carolina General Statutes. Chapter 47G applies to residential lease contracts containing an option to purchase the leased property, or options to purchase residential property that are executed concurrently with leases for the property, if the property is intended to be or become the tenant/buyer’s primary residence. If Chapter 47G applies, the burdens it imposes upon the lessor/option-seller include: w A tenant-option holder’s three-day right to cancel the option contract w The obligation to include numerous disclosures in the contract documents and to record the contract within five days following its execution w The one-time right of the tenant/buyer to cure a default within thirty days from receipt of notice to-purchase upon the tenant/buyer’s period of satisfactory performance. In this manner, the seller could seek to avoid the lease becoming a “lease-plus,” which might prevent the seller from eligibility to evict the tenant using summary ejectment or expedited eviction.

There is also the obligation to terminate the agreement through either a mutually-executed termination or a final court judgment. It could take many months to obtain either, therefore clouding title to the property and preventing re-sale in the interim to a replacement purchaser. In addition, the lessor/option-seller faces potential liability for unfair and deceptive trade practices for any violation of Chapter 47G.

Even if a seller/lessor were comfortable with merely renting the property and not relying upon any likelihood that the tenant/buyer would exercise his or her option to purchase, the substantial burdens from having to comply with Chapter 47F should discourage the seller/lessor from accepting any lease arrangement falling under this statute’s jurisdiction. Instead, if the tenant/buyer insists upon receiving some defined option to purchase as a condition to leasing the property, and if the seller/lessor still wants to lease to the prospective buyer, it is recommended that the tenant must first comply with all terms and conditions of the lease for a probationary period of several months before the seller would be obligated to grant the tenant an option to purchase under defined terms. The resulting time separation between lease commencement and option contract execution would remove the transaction from the jurisdiction of Chapter 47F.

Tenant/Buyer Considerations

If a tenant/buyer wants to negotiate a lease-option, he or she should consider disclosing any circumstances that would prevent qualification for mortgage financing which many sellers could understand and accept. Examples could include: w A recently initiated self-employment opportunity or other career change (Conventional lenders generally require self-employed individuals to provide tax returns from two years of work to qualify them for mortgage financing.) w A recent move to a new town or city w A recent business failure suffered by someone who has a long history of good credit and is demonstrating a likelihood of returning to financial stability

w A deflating market

In consultation with an attorney, the tenant/buyer should also try to gain some of the protections provided by Chapter 47G (whether or not the act actually applies) by insisting that the option be recorded, that the seller/lessor disclose any mortgage or similar default, and, if possible, that the option fee be held in escrow rather than paid at time of contract to the seller.

In order to further protect the seller, consider creating an agreement separate from the lease to grant a future option- (continued on page 10)

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Lease-Purchase Agreements

Those who prefer simply to sell, but are willing to rent temporarily, are far better served by a lease-purchase agreement. Under this arrangement, a tenant who fails to proceed to purchase by a defined date is in breach of contract and liable for damages, unless protected by the failure of a condition to the tenant’s purchase obligation. For protection, the seller should require that the tenant/buyer post a deposit, separate from the security deposit, to secure the obligation to purchase. The deposit, or down payment, would be credited to the buyer at closing, but would be non-refundable should the buyer fail to close. It would also be important for the lease-purchase contract to provide no more than four installment payments to the purchase price, (beyond the deposit/down payment) whether those installments were part of or separate from the rent. Providing for five or more such installment payments could render the lease-purchase agreement a “Contract for Deed” subject to the requirements of Chapter 47H of the General Statutes.

Chapter 47H

Similar burdens, as discussed above in Chapter 47G, apply to the seller/lessor through Chapter 47H. Attorneys have advised both seller and buyer clients for years to stay away from contracts for deed, as they present a full list of potential perils for either party. While Chapter 47H has increased protections for tenant/purchasers whose agreements fall within the jurisdiction of the statute, these contracts remain fraught with trouble for seller/lessors. In addition, as the inherent risks of renting property (including the worst-case default and bankruptcy scenario outlined above in the lease-option review) are also present with any lease-purchase transaction, it is essential to obtain as much information as possible about the tenant/buyer’s credit-worthiness prior to entering into a lease-purchase.

Insurance Considerations

Any residential property owner considering becoming a lessor needs to understand that the North Carolina homeowner’s insurance policy is generally not intended to cover leased property. This may result in inadequate, or even denial, of coverage should a claim be filed during the leasehold, especially if the insured owner-lessor fails to disclose the leased status of the property to the insurance carrier. Appropriate coverage for leased property should include benefits for loss of rental income. Not surprisingly, obtaining coverage on rental property is more expensive than on owner-occupied premises. Before committing to any lease arrangement, the property owner should discuss the coverage issues with both his or her attorney and an experienced insurance professional.

Tenant/Buyer Risks

Tenant/buyers also assume risk with lease-option and leasepurchase arrangements. Tenant/buyers who pay significant purchase deposits may lose them should the seller suffer foreclosure or prove unable to convey clear title. Tenants whose rent is to be partially credited to purchase under the terms of contract, may discover that the underwriter reviewing their subsequent loan application may refuse to credit these incremental payments as equity contributions, regardless of the language of the contract. They may instead reduce the effective purchase price by the total of such payments, thereby imperiling the buyer’s ability to receive adequate funding. Tenants who project an ability to receive financing at the end of the lease term may find that underwriting standards have tightened or that anticipated improvement in their financial condition has failed to occur.

Use of Legal Counsel

Given the potential applicability of Chapters 47G and 47H to lease-purchase and lease-option transactions, it is imperative that any potential tenant-purchaser or lessorseller receive thorough advice and assistance from an experienced North Carolina real estate attorney. Although brokers may complete standard form rental contracts and Offers to Purchase and Contract, creation of proper lease-purchase or lease-option agreements should be left solely to the drafting expertise of competent counsel. An attorney’s involvement ensures that the client receives appropriate legal advice, with a clear understanding of potential risks and benefits, before entering into a complex transaction.

As the economy and real estate market continue to slowly improve, the prevalence of lease-option and leasepurchase transactions may decline, but there will always be sellers desperate to cover mortgage debts on vacated homes, and buyers unable to obtain immediate institutional financing, for whom such transactions will appear attractive. The hope for this article is to provide a least a general orientation for approaching such transactions should the need arise. v

John A. Turner is President and Shareholder of Turner Law Office, PA in Boone, N.C.; a Past Member of the Real Property Council of the North Carolina Bar Association; and a Past Chairperson of the NCBA-NCAR Joint Task Force on Residential Forms.

By ADAIR COLLINS DIRECTOR OF POLITICAL COMMuNICATIONS