Home buyers face an uphill battle in today’s housing market: high prices, increased interest rates and a low supply of homes on the market. What is a home buyer to do?
This NerdWallet article, How people bought homes in the 1980s when mortgage rates were 18%, compares today’s housing market to 40 years ago, and explains that in the early 1980s, buyers and sellers embraced “creative” alternatives, such as leases with purchase options, in order to grease the wheels and keep sales moving in an era of sky-high interest rates. Will we see an increase in lease purchase options in 2023?
While a lease purchase option is an attractive alternative to the traditional path of home ownership, it is not without risk. In fact, our office has seen a number of litigation matters regarding the interpretation and mechanics of purchase options.
A purchase option in a lease is a unilateral contract under which the optionor (the landlord) gives to the optionee (the tenant) an irrevocable offer to purchase the property within a set period of time. This provides the tenant the ability to (a) rent a property (whether commercial or a residential home) and (b) within a designated time, purchase the property from the landlord pursuant to the terms of the purchase option.
To be enforceable, the purchase option must identify the parties (buyer/seller), the property to be purchased and the purchase price (or a clear method to establish the purchase price), the term of the option and the time within which it must be exercised by the tenant. If the option is not exercised by the tenant within the time required, it expires.
A purchase option is an irrevocable offer as to the landlord. The option does not bind the tenant, however. Instead, the tenant has the choice of whether or not to exercise the option and if the tenant decides not to exercise it, the landlord cannot enforce it.
It has long been the law in California that, from the moment a purchase option is properly and timely exercised, the lease agreement ceases to exist, and a binding contract for purchase and sale comes into existence, and the parties have the relationship of buyer-seller (and no longer landlord-tenant). So clear is this bright line between landlord-tenant and buyer-seller, that once the option is properly and timely exercised, and the lease ceases to exist, the obligation to pay rent also ends – unless there is an express provision in the lease that requires continued rent payments after exercise. (Petrolink, Inc. v. Lantel Enterprises (2018) 21 Cal.App.5th 375, 384.)
Disputes regarding purchase options can arise over whether the option was properly exercised. Some purchase options require that the tenant provide notice to the landlord in order to properly exercise the option (within the specified time period) while other purchase options might require the tenant to provide notice and tender performance (e.g., payment of the purchase price) concurrently in order to exercise the option. However, if the option does not specify that payment of the purchase price must be made at the same time as providing notice, the tenant has a reasonable time after providing notice to pay the purchase price. When the option provides the tenant exercises the option by simply giving notice, such exercise must conform strictly to the terms of the option agreement.
When the option requires tender of performance and not simply giving notice, the landlord must timely notify the tenant of any purported defect(s) in the tender so that the tenant can correct it. Otherwise, any defects in the tender that could have been corrected are waived by the landlord. However, in order for a tender of performance to be effective, the tenant must be willing and able to fully perform unconditionally at the time of the tender. Therefore, a landlord who fails to object to a tender on grounds that the tenant does not have the ability to perform (pay the required amount) does not waive that requirement. As a result, the parties may dispute whether the tenant has the actual ability to unconditionally pay the amount required by the purchase option when tenant exercised the option.
Cases involving purchase options can also arise where the tenant seeks to exercise the option, only for the landlord to discover that the tenant has been in breach of the terms of the lease. This can be not only a breach in payment of rent, but also breaches of nonmonetary provisions in the lease, such as a prohibition against assignment or subletting absent landlord consent, or impermissible use of the premises, or failure to comply with applicable laws (depending on the events of default set forth in the lease). As a result, a dispute can arise as to whether the landlord may declare a breach after tenant exercises the option or whether the landlord is prevented from claiming a breach under theories of waiver and estoppel.
These are just some of the issues our office has seen arise with lease purchase options. As in the ‘80’s, we are living in a material world and in today’s market, it might take some creativity in order to get that home. While a purchase option arrangement can be beneficial to both landlord and tenant, both parties should be aware of the risks and issues such creative financing brings along with the potential benefits.