This article is part of a larger collection of articles that has been combined into an e-Book. Click here for the full e-Book on Lease-Options & Land Contracts in Indiana.
Why Landlords Need to Know the History of Lease-Options
Over the past several years, there have been many changes in the use and the courts’ treatment of lease-options. Even state and local legislative bodies have begun to regulate lease-options. In Cincinnati, for example, there is now a “predatory leasing” ordinance that regulates lease-option contracts. Georgia, as another example, has regulated lease-options by state law, and more states are critically viewing leases with options as a form of needed consumer protection. And, the rate of changes in the use and regulation of lease-options is accelerating. But why? What’s happening to lease-options?
In short, real estate guru’s taught investors to over-use and abuse lease-options. Back in the late 1990’s, residential landlords rarely used lease-options. It was a different breed of real estate investor who used lease-options. Lease-options were more common in commercial real estate deals and farmland than they were in residential deals. However, more and more national and regional real estate investment speakers began advocating lease-options for residential properties. Books and tapes and CD-ROMs full of lease-option forms proliferated in number, and investors become very aggressive about how to structure lease-options. Largely based on bad advice from these national and regional speakers, real estate investors started taking very large “down payments” from renters. Investors went to “boot camps” and seminars, and were taught that large “down payments,” coupled with regular turnover of tenants, equated to a source of steady income of “option money,” much like monthly rent payments themselves. Eviction rates did not fall. To the contrary, landlords were encouraged to evict tenants after collecting those large option fees. And so, tenants who were not qualified to be buyers paid big bucks and signed “rent-to-own” contracts, on the promise of home ownership in the future. Later, those tenants were evicted, and new tenants took their places, signed new lease-options, and paid more option fees. And, landlords laughed all the way to the bank.
Not everyone and not every landlord are laughing today. Some of those tenants, who eventually lost their “down payments,” filed lawsuits and have found sympathetic judges. Others found their state legislators. And, so the regulation of lease-options began. Slowly over the past many years, it has become more difficult and precarious to offer a tenant a legitimate and fair lease-option. Too often, because lease-options are now being abused and misused on a frequent basis, landlords cannot evict tenants under the lease, merely because there is also an option agreement between the landlord and tenant.
The problem is that the many courts and some state legislatures are now treating lease-options as if they were land contracts. And, in most states, land contracts are treated as notes and mortgages, which require enforcement of the state’s foreclosure statute, rather than the landlord seeking the quicker and less expensive eviction or forfeiture remedies. The question has become: Does this lease-option really constitute a land contract, and thus note and mortgage?
Land Contracts Contrasted
Under a land contract, the buyer has possession and control of your property, and it is often expensive to regain that possession and control. Again, to repeat the point, under an old Indiana appellate decision, land contracts are treated as notes and mortgages, which require the prosecution of a foreclosure action and a foreclosure sale. Forfeiture, which is similar to an ejectment or eviction of a tenant, may not be an available remedy against the defaulting land contract buyer. Foreclosures, as opposed to forfeitures, are slow and expensive. And, just before you get your property back at the sheriff’s sale, the buyer might file bankruptcy, which automatically stays the foreclosure sale. In bankruptcy, a forfeited land contract receives far less favorable treatment than do a note and mortgage.
In theory, our courts require foreclosure, rather than permit forfeiture, as a means of protecting a buyer who has substantial equity in the subject real estate. The reality is usually very different. Usually, the buyer does not have substantial equity in the property. He only thinks he does. And, the buyer has stopped paying the seller by the time a lawsuit is filed, which further reduces the buyer’s illusionary “equity cushion.” Add attorneys’ fees, court costs and sheriff’s costs to the equation, and the seller usually will be eligible to seek a deficiency judgment, even after getting the property back after the sheriff’s sale.
Years ago, one solution to the forfeiture-foreclosure problem was to sell property using a lease and an option to purchase. Back in the 1990’s, there was a clear distinction between lease-options and land contracts. A true lease-option is actually two documents representing two separate transactions: (1) a lease with (2) a separate option to purchase. A land contract is one, single transaction.
Lease-Options Offer a Win-Win Scenario
In general, lease-options enable a landlord to sell a property at a price on the high end of fair market value to a buyer who presently does not qualify for third-party financing, but who is likely to qualify for financing at the end of the lease term (usually 12 to 24 months). The landlord can also collect an option fee at the time the lease is signed and additional option fees during the life of the option. The option fees compensate the landlord for keeping the property off the market during the option term and improve cash flow. The tenant gains access to a property worth purchasing, re-establishes his credit, and pre-pays, essentially, a part of the down payment. This gives the tenant a good reason to remain current on the lease and close on the purchase.
Because investors are abusing lease-options, there is a definitely a trend for judges to re-write lease-options by treating them like land contracts, requiring foreclosure and not permitting an eviction. It is hard to imagine having to file and prosecute a foreclosure lawsuit in order to evict a deadbeat tenant, but that has become a reality, as some judges decide to change the law and your lease-option agreements.
One solution to this problem is to elect judges who do not aspire to be legislators and who are willing to honor agreements as written by the parties. That is not a very practical solution. A more practical solution is to avoid giving a judge good reason to re-characterize your lease-option as land contract. How? Here are some suggestions.