Lease-to-Own Contracts

Written by Jared Weinman, UCLA School of Law Class of 2012

I recently was using Craigslist.org to search for a new apartment in Los Angeles. Scattered amongst the West LA listings were a number of three and four bedroom homes listed for prices well below comparable rentals in their neighborhoods. These listings were made even more enticing by their pictures of large kitchens with well-apportioned hardwood floors and granite countertops. Each listing had either a 1-800 or a local number to call with a reference number to be given to an agent with some generic first name. In addition, there were no specific addresses for the homes, just cross-streets or neighborhoods.

I was admittedly a little bit desperate in my search and allowed curiosity to get the best of me. I called and after getting a grainy connection was asked abruptly for a reference number. No hello, no this is XYZ Financial, no how may I help you, and no name. After giving the reference number he reread the listing to me. I began to ask about the property and exactly how the lease-to-own process works. I have read about lease-to-own arrangements before, but have always been skeptical because they are so untraditional.  I asked a number of questions about the legitimacy of the transaction. Each was answered quickly and surely, seemingly to allay any concerns. It appeared from my conversation with this unknown mystery man that the entire transaction was legitimate, transparent and a no-brainer. He explained that I would be making rent payments directly to the bank on behalf of the current owners, who would remain responsible for the loan. Despite my skepticism, I wanted to know more, and to get my hands on the a sample lease document, so I asked if I could view a more official listing. The mystery man told me that I could see this particular listing as well as hundreds of others if I sign up for $175.  This confirmed my suspicions regarding the whole thing and I said my goodbyes and hung up.

Lease-to-own purchases can be a legitimate way for a purchaser to buy a home, particularly if the purchaser’s credit is not yet good enough to obtain a mortgage. Legally, the lease-to-own arrangement is broken into two distinct contracts: the option contract and the lease contract. The purchaser/lessee has an option period lasting a number of years with which to exercise the option to buy the home outright. Often, the purchaser will also have a portion of the monthly rent applied towards the down payment. Both the option and the accumulated down payments require a premium be paid on the monthly rent on top of a market rate rent payment. Many agreements require a nonrefundable deposit to buy the option, the amount of which is then applied to the down payment. By establishing a potential purchase price up front, the lessee transfers any risk or benefit of market fluctuations over the period of the option to the current owner, and has the advantage of trying a home before buying one. The lessee however runs the risk of not becoming eligible for a mortgage. If that were the case, the lessee would not have the funds to buy the home and would lose their premium as well. The lessee also must maintain the home as if they owned the property, even though they do not hold all the rights of ownership. The current owner also retains the title and thus the tax advantages of the property. Since the down payment and option premiums are surrendered if the option is not exercised, the owners also enjoys the benefit of increased monthly rent and an initial option deposit with the potential of keeping both the premium and the home. In fact, the nature of the agreement means that it is in the owners’ interest for a default to occur. In addition, the terms of the agreements may be particularly restrictive on tenants in the hopes that a breach of contract occurs.

The buyer/lessee is at a significant disadvantage in these arrangements for a number of reasons. Sophistication is the primary issue of concern. The owner may be a seasoned developer or landlord who not only has the experience, but also the legal counsel, to fully understand that seemingly benign provisions may be disastrous over the course of the contract. The seller may also be a troubled homeowner who has not sought professional advice. Another issue is that buyers may have significantly weaker bargaining power because they currently cannot secure traditional mortgage financing. They may be desperate to “buy” a home, even if they are not eligible for a mortgage, or may have been recently foreclosed upon. Without sufficient bargaining power, the buyer may be forced to sign a contract purely on the owner’s terms. Lawyers call these “contracts of adhesion,” and they are often predatory. This lack of sophistication and bargaining power in a lease-to-own arrangement is similar to the market position of homebuyers who obtained subprime financing that lead to the most recent housing crisis.

While the legal structure and implications of a lease-to-own agreement may be significantly more complicated and confusing that I’ve stated, there is enough of an understanding to know that the craigslist posting I saw were either outright scams, were laden with hidden costs or had hidden terms disadvantageous to a renter. The rents advertised were approximately 40 percent below the market rate for a nearby comparable, if not more. Knowing that lease-to-own properties should typically be more expensive than a similar rental, the listings were either phishing attempts to get the $175 service fee, did not disclose a required upfront deposit, or the pictures of the homes were not accurate. These potential problems would be in addition to the lack of rights a renter has in a legitimate lease-to-own arrangement. It is also possible that my rent payments wouldn’t actually go directly to the bank, as the man on the phone said, but rather, went to the owners. If that happened there is the risk that the owners could foreclose, and then I would not only lose my option deposit, but would be homeless.

While I was never in danger of forking over $175, I can imagine that it would enticing to some potential homebuyers looking for a deal. Even if  I legitimately got access to hundreds of lease-to-own listings with inexpensive monthly rents, I would have been confronted with the complexity of the contracts, the potential of an upfront option fee, and potential restrictive terms that required me to upkeep the home. These are clearly not the terms I would want as a student planning to live there for only a year, or in any circumstance. However, lease-to-own can be a legitimate way to buy a home, but buyers should expect to pay a premium price, not receive a significant discount on monthly rent. Craigslist is a great resource for many informal purchases, but it is knowingly filled with controversial scams, and it appears that the numerous lease-to-own postings were either outright scams or misleading. Like many untraditional real estate transactions, lease-to-own deals should be made only when specific circumstances make them a reasonable alternative to the traditional process.

Click here for more information on lease-to-own contracts generally.
Click here for more information on the pitfalls of lease-to-own.

 

Comments

[Hendri Prastio Kurniawan]

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