Lease/purchase and Lease/option Agreements

Posted on March 27, 2012 by Christopher Combs and Michelle Lind

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There are many reasons why a client may want to enter into a lease/purchase or lease/option agreement. Most commonly, the buyer wants to enter into a lease/purchase or lease/option agreement because the buyer is unable to obtain financing for some period of time. A seller may consider a lease/purchase or lease/option agreement if the seller has been marketing the property for some period of time without success. This article answers some of the most common questions asked about these agreements.

Lease/Purchase Agreements

A lease/purchase agreement is an agreement in which the buyer and seller enter into both a lease agreement and a purchase contract at the same time. The buyer will lease the property, for example, for one year, and at the end of the one-year period the buyer is obligated to purchase the property by closing escrow.

Should the parties execute both a lease agreement and a purchase contract?

Answer: Yes. In a lease/purchase agreement, the parties should enter into a lease agreement for the specified period of time. The AAR Residential Lease Agreement should be used for this purpose. The parties should also enter into an AAR Residential Resale Real Estate Purchase Contract. The lease agreement should reference the purchase contract and vice versa. Additionally, the lease agreement and purchase contract should have cross default clauses; in other words, a breach of one agreement constitutes a breach of both.

During the term of the lease in the lease/purchase agreement, prior to close of escrow, is the relationship between the parties governed by the Arizona Residential Landlord and Tenant Act (“Landlord/ Tenant Act”)?

Answer: Yes. The Landlord/Tenant Act applies during the lease period of a lease/purchase agreement. Although the Landlord/Tenant Act at A.R.S. §33-1308(2) excludes “[o]ccupancy under a contract of sale of a dwelling unit or the property of which it is a part, if the occupant is the purchaser or person who succeeds to his interest,” this provision should be construed to exclude occupancy under an “agreement for sale” (also known as contract for deed, land contract, or installment contract), not a lease/purchase. Thus, the Landlord/Tenant Act should govern the rights of the parties in a lease/purchase agreement prior to close of escrow.

What are the landlord/seller’s rights if the tenant/buyer fails to make the rental payments as required under the lease/purchase agreement?

Answer: If the tenant/buyer fails to make the rental payments as required, such a breach of the lease agreement should also constitute a breach of the purchase contract, if the lease/purchase agreement contains a cross default clause. Therefore, if the tenant fails to pay the rental payments as required, the landlord/seller may institute a special entry and detainer action pursuant to A.R.S. §33-1368(A) to evict the tenant and terminate the purchase contract as a result of the breach.

Lease/Option Agreements

A lease/option agreement differs from a lease/purchase agreement. In a lease/option agreement, the buyer and seller enter into a lease agreement containing a clause that gives the tenant/buyer the right, but not the obligation, to purchase the property under specified conditions. The lease/option should be drafted to provide that a default in the lease agreement results in the termination of the tenant/buyer’s option to purchase.

Should a lease/option require the tenant/buyer to purchase at a fixed price agreed upon at the time the lease/option is entered into?

Answer: An option to purchase may be at a fixed price, based on fair market value established by an appraisal at the time the option is exercised, or the option may be drafted as a “first right of refusal” in which the tenant/buyer has an option to purchase the property on the same terms as an offer from a bona fide third party. There are benefits and risks associated with each method.

What are some other considerations in drafting a lease/option?

Answer: A lease/option should be carefully drawn to document the understanding of the buyer and seller. Since you cannot predict future events or economic conditions, the option should be limited in time and the price should be based on the anticipated fair market value of the property at the time the option is exercised. Additionally, the tenant/buyer should be required to take title to the property in the condition of the property at the time the option is exercised, rather than the condition that existed when the lease/option was executed. The lease/ option should also provide that the option terminates with the expiration of the lease and can only be exercised if the tenant/buyer is not in default.

How should the lease/option agreement provide that the option be exercised?

Answer: The lease/option agreement should set forth (1) the period during which the option can be exercised: i.e., 90 days prior to the expiration of the lease; (2) the manner in which it can be exercised: i.e., written notice; (3) to whom notice must be given, normally the seller; (4) how soon after the option is exercised the closing must occur; and (5) the manner of determining the purchase price: i.e., appraisal or fixed price.

What are some additional considerations if the option is a “first right of refusal”?

Answer: When writing an option as a “first right of refusal,” the agreement should provide that the tenant/buyer must be given written notice of the proposed offer or a copy of the offer, all terms of the proposed sale, and the specific time period and manner in which to respond.

Conclusion

A lease/purchase or lease/option agreement can be complex, and if the parties are entering into such an agreement because of a potential buyer’s inability to obtain financing, the chance for a default or breach of the agreement is increased. However, a carefully drafted agreement in which the rights and obligations of the parties are clearly stated can prevent unnecessary disputes.


Note: This article is of a general nature and may not be updated or revised for accuracy as statutory or case law changes following the date of first publication. Further, this article reflects only the opinion of the author, is not intended as definitive legal advice and you should not act upon it without seeking independent legal counsel.

Christopher A. Combs

Bio:

Christopher A. Combs, Phoenix attorney, is a partner with the firm of Combs Law Group, P.C., and is on the AAR Legal Hotline team. Find out how brokers can access the Legal Hotline. Note: The above is for informational purposes only and is not intended as definitive legal or tax advice. You should not act upon this information without seeking independent legal counsel. If you desire legal, tax or other professional advice, please contact your attorney, tax advisor or other professional consultant. Q&As are not “black and white,” so experienced attorneys and brokers may disagree. Agents are advised to talk to their brokers/managers when they have questions.

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