How to Protect Yourself as the Tenant in a Lease Option?

Great! After searching high and low, you’ve finally found an owner willing to offer a lease option for the home you desire. However, your dream of homeownership can still be derailed if you’re not careful. Now that the hardest part is over, it’s time for some due diligence to determine whether the rent-to-own agreement is worth signing. Due diligence is essential as it significantly reduces the probability of getting scammed or ending up with an agreement that works against you.

This article discusses due diligence for various rent-to-own home agreements, such as lease options and lease purchases. The term “lease option” will be used throughout the article because it is more common and better for tenants, giving them the flexibility to decide whether to buy the home or not. Additionally, the current title holder of the home who is offering the lease option is referred to as “owner” or “seller”.

Potential Problem with Lease Options

Before delving into how to conduct due diligence on lease options, it is essential to be aware of  potential problems that can complicate these types of agreement. In 2005, Texas passed statutes governing rent to own to address some of the problems that are described below. Understanding these issues will help you stay vigilant and protect your interests.

Owner Losses the Property

This situation often arises when the owner faces financial troubles or has negative equity, meaning they owe more on the property than it’s worth. Instead of using the rent money to pay the mortgage or property taxes, the owner uses it for other expenses, leading the property to fall into foreclosure. If this happens, the tenant’s option to purchase the property becomes invalid, and they could lose the option credit, and potentially face eviction from the lender.

Owner Sells the Property to Someone Else

In some cases, the owner may decide to sell the property to another buyer for various reasons. Once the property’s title transfers to the new owner, the tenant has limited options. While the tenant can sue to recover damages, this process can be expensive and time-consuming. In such situations, the owner is essentially breaking the law and committing fraud. Suing the owner is an option, but requires time and money.

Owner Forces Eviction of Tenant

Unscrupulous owners might find flimsy excuses to evict the tenant and quickly initiate eviction proceedings. Some landlords may even misrepresent information in court to obtain a favorable ruling, especially in states that favor landlords. The purpose of evicting the tenant is to keep the option fee and avoid selling the property. These dishonest owners then find a new tenant to repeat the process.

Owner Encumbers Property with More Loans

As the seller retains the property title until the option is exercised, they have the right to refinance their mortgage or take a home equity loan. However, this becomes problematic when the refinanced amount exceeds the purchase price agreed upon in the lease option. This situation makes it challenging or nearly impossible for the tenant to purchase the property. For instance, if the owner refinances the home for $250,000, but the lease option’s purchase price is $200,000. Either the owner or buyer needs to pay off the difference to the lender. If not, the lender will most likely prevent the sale from going through and foreclose on the property.

Owner Decides Not to Sell the Home

During the rental period, the home’s value may significantly increase, surpassing the agreed-upon purchase price. The owner may want to capitalize on this appreciation and may stall the sale of the property or ask the tenant to renegotiate the terms, such as agreeing to a higher purchase price. In this scenario, the lease option has a purchase price of $250,000, but the property’s value rose to $300,000 within three years of signing the lease. Even with a signed contract, the tenant would need to hire a lawyer and go to court to resolve the matter, which can be time-consuming and costly, with uncertain outcomes.

How to Minimize Risk with Lease Options

If you’re considering a lease option, it’s crucial to be proactive in minimizing potential risks. The problems listed earlier often stem from issues with the owner/seller, so ensuring their trustworthiness is essential.

Know the Person You Are Renting/Buying From.

Take some time to research the owner/seller to gauge their credibility. A simple Google search with the owner’s name and keywords like “fraud,” “crime,” or “lawsuit” can reveal any potential red flags. Additionally, conducting a background check on the owner, even if the Google search seems fine, can offer additional information that is not available from a Google search like legal judgements.

In addition, pulling a credit report on the seller can provide insight on the owner’s financial health. Obtaining a credit report requires the owner’s permission, but it’s worth discussing it with them to ensure you’re entering into an agreement with someone trustworthy. To address privacy concerns, consider using an intermediary for this purpose.

If dealing with a company, do an online search for the company name, the state you are in, and keywords such as “lawsuit”, “sued”, “complaints”, “reviews”, etc. Check with the Better Business Bureau for any complaints and how it was resolved. Ask the company for references that you can contact.

Verify the Seller Owns the Property and Any Outstanding Loans On it.

Conduct a title search to confirm that the property’s owner matches the one you’re dealing with. If the property is owned by a company, check the Secretary of State’s website (for the state that the home is located in) to find out who owns the company. If the owner can’t provide proof of ownership, it’s a major red flag, and you should avoid signing any agreement. The title search will also reveal if there are any liens or foreclosures on the property, indicating potential claims by lenders. If there are no liens on the home or the owner owes a small loan amount then it is a good signal that the owner is in good financial standing.

Record a Memorandum of Lease-Option

Placing a memorandum on the home’s title will alert lenders and others about the possible claim on the property through the lease option agreement. In some states, third parties are allowed to record a memorandum on a title, while in other states only the title owner is allowed to do so.

Thoroughly Review and Understand the Lease Option Agreement

Carefully go through the lease option agreement to fully grasp its terms. Most agreements consist of a lease and a separate option agreement, while some may be combined into a single document. Regardless, make sure you understand what the option agreement entails. At the very least, it should include details about the purchase price, option duration (including if renewable or extendable), option fees, option credit, refund policies, termination conditions, and maintenance responsibilities. To minimize the chance of the owner not selling the home if the home value appreciates significantly is to have a clause that adjusts the purchase price up reasonably in such situations.

Use ChatGPT to translate the legal language in the agreement into simpler terms. While, ChatGPT can help clarify, it cannot provide legal advice or ensure compliance with local statutes. For legal expertise, consult an attorney who can review the agreement and identify any potential red flags. If cost is an issue, consider seeking help from legal aid services in your area for assistance in reviewing the lease option agreement.

Lease Option Consideration for Tenants

Conducting due diligence is essential for minimizing risks with lease options, but it doesn’t guarantee a trouble-free experience. As a tenant, you must fulfill your obligations under the agreement.

Lease options provide the advantage of trying out a home before committing to buying it in the future, especially if the property’s value is expected to appreciate. However, it’s crucial to be aware that lease options come with additional expenses and responsibilities compared to standard rental. The rent is often higher because a portion of it is set aside as the option credit, which will be used for the future purchase of the home.

Before deciding on a lease option, evaluate whether the extra time gained before exercising the option will genuinely improve your financial situation and if it is financially feasible to pay more than market rent. If not, consider opting for a regular lease and focus on saving up for a down payment. While, just renting approach may mean missing out on potential property appreciation, paying market rent and saving can also be a wise decision in the long run.