Lease-Options in Texas

Introduction

Lease-options and lease-purchases have always been favorite tools of Texas real estate investors—among the Big Three alongside contracts for deed—all of which have been employed as devices to get under-qualified buyers into a home without qualifying for traditional institutional financing.

There arose a challenge to the use of these creative tools in 2005. The Property Code was revised to define certain sales arrangements as executory contracts subject to strict regulation and penalties if not done exactly right. Specific requirements must be observed if executory contracts are to be valid and the burden is entirely on the seller to comply. Violation incurs not only Property Code penalties but potential liability under the Deceptive Trade Practices Act, which can involve treble damages plus attorney’s fees.

This article will discuss the law applicable to lease-options and lease-purchases including the overlap with the law of executory contracts.

Preferential rights such as rights of first refusal (ROFRs), rights of first negotiation (ROFNs), and rights of first offer (ROFOs) are closely-related and will also be addressed.

LEASE-OPTIONS

Lease with Option to Purchase

A lease with an option to purchase (lease-option) is a sub-category of options generally. In real estate, an option consists of a contractual right granted to a potential buyer that may be exercised in writing (at a time of the buyer’s choosing, if at all, and without the requirement of a triggering event) to purchase property at a pre-determined price. A lease-option may apply to any kind of real property—residential or commercial, improved or unimproved.

A defining feature of a lease-option is that it fixes a specific sales price. Brooks v. Acosta, 581 S.W.3d 485 (Tex.App.—Austin 2019, no pet.).

Options connected to a residential lease that last for longer than 180 days are defined by the Property Code as executory contracts. They are therefore subject to extensive pre and post-closing rules contained in Property Code Section 5.061 et seq.

What’s in a name?

Can one circumvent the executory contract rules by calling a lease-option by a different name? No. The Brooks case is a good example of how courts look to substance over form in interpreting documents, including a willingness to look beyond the way a document is titled. A judge will actually read a document to see if it is what it purports to be.

Details of the Option

It is not sufficient to say “Tenant has the option to purchase 123 Oak Street for $250,000” and let it go at that. (This is true whether or not the option is connected to a lease.) Many other details need to be considered. How long does the option last—what is the option term, in other words? Is it a one-time right or a continuing right? Is the option assignable? Just as important, what are the terms of the prospective purchase—cash, third-party financed, or seller-financed? How long will the buyer have to close after notice of the exercise of the option is given? Failure to specify these and other features of the option invites litigation.

A well-written lease-option agreement will contain all key points and material terms that are found in an earnest money contract—so beware the one-liner option that raises more questions than it answers. Keeping it brief is not a virtue when it comes to options.

Lease-Options and Executory Contracts

Executory contracts in real estate include any transaction that defers some material action by either party (usually delivery of the deed by seller to buyer) into the future. A case from the Texarkana court of appeals provides a good definition of an executory contract: “In a typical real estate contract, the seller and purchaser mutually agree to complete payment and title transfer on a date certain, the closing date, at which time [the contract is executed and] the purchaser generally obtains both title and possession. By contrast, in an executory [unfinished] contract the purchaser is usually given immediate possession, but is required to satisfy numerous obligations over an extended period of time before the seller has an obligation to transfer actual title.” Bryant v. Cady, 445 S.W.3d 815, 822-23, (Tex.App.—Texarkana 2014, no pet.).

So why do residential lease-options fall within this definition? Because the Property Code expressly says so:

Prop. Code Sec. 5.062(a). This subchapter applies only to a transaction involving an executory contract for conveyance of real property used or to be used as the purchaser’s residence or as the residence of a person related to the purchaser within the second degree by consanguinity. . . . (1) a lot measuring one acre or less is presumed to be residential property; and (2) an option to purchase real property that includes or is combined or executed concurrently with a residential lease agreement, together with the lease, is considered an executory contract for conveyance of real property.

Prop. Code Sec. 5.062(c). This subchapter does not apply to an executory contract that provides for the delivery of a deed from the seller to the purchaser within 180 days of the date of the final execution of the executory contract. . . .

The exception for residential lease-options of 180 days or less accommodates the short-term leases often used by real estate brokers and agents.

Note that the executory contract rules apply to an unimproved residential lot as well properties improved with a dwelling. They do not apply to commercial lease-options.

Executory Contract Rules

The executory contract rules are tough. One can still do an executory contract (such as a long-term lease-option) but there are extensive requirements: the landlord-seller must provide the buyer with a recent survey or a current plat; copies of liens, restrictive covenants, and easements; a statutory disclosure; a disclosure for non-subdivision properties stating utilities may not be available until the subdivision is recorded; tax certificates; a copy of the insurance policy showing the name of the insurer and insured along with a description of the insured property and the policy amount; a seven-day notice letter; and an annual accounting that includes amounts paid, amounts owed, payments remaining, taxes paid, and the amount paid for insurance premiums plus an accounting for any insurance proceeds. All of this must be done before the contract is signed (Prop. Code Sec. 5.069 et seq.).

Additionally, sales advertisements for the property must disclose the availability of water, sewer, and electric service. The seller must provide a thorough disclosure of the financial terms of the transaction including the interest rate, amount of interest charged for the term of the contract, the total amount of principal and interest to be paid, and the non-existence of a prepayment penalty. Annual accounting statements must be given to the buyer. Excessive late fees and prepayment penalties are banned.

Even if all the foregoing statutory requirements are met, the buyer may still cancel an executory contract for any reason within 14 days of signing (Prop. Code Sec. 5.074).

Clearly, the benefits of engaging in a long-term lease option must be carefully weighed against the regulatory burden and penalty risk. Short-term lease options are another matter.

The Short-Term Lease-Option

Lease-options that have a term of 180 days or less are a more feasible approach. (The regulatory burden is also less if the property is paid for, meaning a lender’s consent will not be needed). A real estate investor should not avoid utilizing a short-term lease-option if it is appropriate under the circumstances, particularly if there is a good possibility that the option will be exercised during that period.

A good recommendation is to use a 179-day option term in order to avoid any doubt as to whether or not there was statutory compliance.

Option Combined with a Month-to-Month Lease

What if a lease-option is combined with a month-to-month lease? Do the requirements and penalties of Property Code Sections 5.062 et seq. apply? The answer is likely yes so long as the term of the option fails to be expressly limited to 180 days or less. If the lease can extend for longer than 180 days then the option can as well—so a court would probably find this arrangement to be an executory contract.

Stacking Short-Term Options

What about the possibility of stacking short-term option contracts—i.e., allowing the option to expire in less than 180 days and then renewing it again and again? This would appear to be a loophole, making stacking a possible way for an aggressive investor to do a lengthy lease-option without complying with the executory contract rules. There is risk, however. If the option is challenged by the tenant-buyer, a judge may examine the totality of the circumstances including the intent of the parties and declare that the arrangement is a de facto executory contract.

It all comes down to whether or not the tenant-buyer becomes disgruntled and decides to (1) challenge the transaction with a lawsuit or (2) resist an eviction based on an executory contract defense. No challenge, no issue. There are no executory contract police. Having said that, lease-options that endure for longer than 180 days are potentially perilous. The legislature clearly intended to discourage their use in residential transactions and deliberately imposed significant liability on landlord-sellers for doing them improperly.

LEASE-PURCHASES

Lease-Purchases Versus Lease-Options

A lease-purchase is conceptually different from a lease-option. In a lease-purchase (or rent-to-own) a portion of each monthly rent payment is set aside and credited toward the tenant-buyer’s down payment. Are lease-purchases executory contracts? Yes, since fulfillment of a material term (delivery of a deed to the buyer) is deferred into the future.

It is common for a lease-purchase to provide that after a certain amount is paid in, the tenant-buyer is able either (1) to convert the transaction from a lease to an owner-financed sales transaction in which the tenant gets a warranty deed (now instead of later) and gives back a note and deed of trust to the seller; or (2) the seller agrees that the tenant-buyer may show the accumulated down payment on a loan application to a third-party lender and thereby assist the tenant in qualifying for traditional financing.

Note that pursuant to the executory contract rules a buyer has an absolute right “at any time and without paying penalties or charges of any kind” to convert any executory contract to “recorded, legal title” (i.e., a deed) whether the contract says so or not (Prop. Code Sec. 5.081).

Lease-Purchase-Option Hybrids

Lease-purchases may provide that once a sufficient down payment is paid, the tenant-buyer will have an option to purchase the property at a certain price. Result? The lease-purchase becomes tangled up with a lease-option. It becomes a hybrid lease-purchase-option. What if the lease-purchase provides that payments will continue over a number of years until the property is paid for? Such a contract may not be a lease-purchase at all but an old-fashioned contract for deed.

Two points are worth noting. The first is that lease-options and lease-purchases can, if only slightly modified, become hybridized with something else thus sinking the transaction deeper into the executory contract hole. The second point is that regardless of the form such hybrid contracts take, they remain executory contracts for purposes of the rules and penalties of Property Code Sections 5.061 et seq.

Setting a price can be key in determining whether a contract is a lease-purchase or a lease-option. “An option to purchase is a land contract by which the owner gives another the right to buy property at a fixed price within a certain time . . . [the contract in this case] specified that plaintiffs could purchase the home at ‘market value,’ without specifying how ‘market value’ might be determined. In the absence of a fixed price or other evidence that the parties had agreed on the meaning of ‘market value,’ [the court concluded] that the lease-to-purchase provision was not an option to purchase.” Brooks v. Acosta, 581 S.W.3d 485 (Tex.App.—Austin 2019, no pet.).

Lease-Purchases as a Business Model

Residential lease-purchases for longer than 180 days are a challenging strategy for real estate investors because of the multitude of requirements and the potential liability for doing them improperly. There is really no way to use a stacking technique to make them work. Add the fact that the Property Code declares open season on investor-sellers whenever a tenant-buyer becomes disgruntled and there may be more reasons to avoid long-term lease-purchases than there are to do them.

PREFERENTIAL RIGHTS (ROFRs, ROFNs and ROFOs)

Right of First Refusal (ROFR)

A right of first refusal (ROFR) is a preemptive right to purchase specific real property at some future time upon defined terms and conditions. “A right of first refusal is essentially a dormant option. It requires the owner, before selling the property to another, to offer it to the rightholder on the terms and conditions specified in the contract granting the right. . . . When the property owner expresses [an] intention to sell, the rightholder must elect to either purchase the property or decline to purchase it and allow the owner to sell it to another. . . . A purchaser from a lessor who has given a right of first refusal takes the property subject to that right. When a sale is made in breach of the right of first refusal, it therefore creates in the rightholder an enforceable option to acquire the property according to the terms of the sale. . . . However, the option is not perpetual and the rightholder must choose between exercising it or acquiescing in the transfer of property.” A.G.E., Inc. vs. Buford, 105 S.W.3d 667 (Tex.App.—Austin 2003, pet. denied).

ROFR Versus Option to Purchase

Certain characteristics are shared by ROFRs and options. Both are exercisable in the future. The validity of both can be limited to certain time periods or terms, i.e., either may expire before being exercised. They can occur in both residential and commercial situations. Also, both ROFRs and options grant the holder the power but not the obligation to act. There is no breach or liability for damages if the holder of an option chooses to do nothing.

However, a ROFR differs from an option in that it is conditional, not fixed, and does not specify a dollar price. An option to purchase, on the other hand, is a unilateral contract which gives the holder the right to compel sale of property at a certain price within a certain option term. When an owner gives notice of intent to sell, the ROFR matures or ripens and then becomes enforceable.

The terms of an option consist of the contractual provisions granting the option along with the terms and conditions of any third-party offer. Once the property owner has given the holder notice of his intent to sell, the terms of the option cannot be changed for as long as the option is binding on the owner. City of Brownsville v. Golden Spread Elec. Coop., Inc., 192 S.W.3d 876 (Tex.App.—Dallas 2006, pet. denied).

What if an investor-seller gets creative and deletes the word option from the document, substitutes ROFR language in its place, and then goes on to specify a price? Under the Brownsville case, once price is specified it is likely that the ROFR becomes an option and therefore an executory contract. As mentioned above, courts are likely to interpret a contract clause in light of what it actually is rather than what it pretends to be (the quacks like a duck rule). The result could be a finding that executory contract rules have been violated, or worse, that fraud has been committed.

Drafting ROFR Language

Drafting a ROFR is an interesting challenge. Critical considerations include:

(1) the duration of the right—is it a one-time right? Does it expire at some point or does it endure? What are the specific provisions for giving notice, whether that be notice of a pending offer or notice of exercise of the ROFR? What are the time limits for a reply?

(2) What is the geographical scope of the ROFR? Does it extend to a proposed sale of a portion of the subject tract or only to the tract in its entirety? In other words, does the ROFR contain within it an express or implied right to partition the property? If so, will a new survey be required to delineate the acreage covered by the ROFR?

(3) How exactly is the ROFR triggered? If it is triggered by a bona fide offer from a third-party, does that mean a verbal offer? An email? The submission of a formal contract as offer?

(4) If the ROFR is silent as to price then how will price be determined? A stipulated sum or current fair market value? Does the ROFR clause include a mechanism for this?

(5) Can the holder of the ROFR assign it—perhaps to a real estate investor? Contract and property interests generally are assignable unless prohibited by law or by express language in the contract itself.

(6) What are the remedies for breach of the ROFR? Every good contract includes a default section. How is default defined? Do the parties stipulate to the application of injunctive relief or liquidated damages? Can the ROFR be waived by inaction?

(7) Will the ROFR be recorded in the real property records or kept confidential between the parties?

ROFNs and ROFOs

There are other preferential rights worth mentioning. One is a right of first negotiation (ROFN, sometimes called a right of first opportunity) which means exactly what the title suggests and no more. The seller is obligated to notify the holder of a ROFN of his intention to sell, and the holder will then have the right to negotiate and make an offer which the seller is not obligated to accept. There is no mention of price and no obligation to conclude a deal.

A somewhat lesser right is a right of first offer (ROFO) which obligates the seller to notify a potential buyer of his intention to sell and the buyer will then have the right to make an offer, the terms of which are not specified in advance. There is no right to negotiate, only the right to make the first offer.

ROFRs, ROFNs, and ROFOs are potentially useful substitutes for a lease-purchase but they must be carefully structured and worded so as not to fall into the executory conveyance trap.

Preferential rights discussed in this article can also apply to the leasing of real property, although such uses are more common in the world of commercial leasing and less relevant to investors in residential properties.

What is a bona fide offer?

Many creative contract devices involve the requirement for a buyer to make a bona fide offer. Case law states that in order for an offer to constitute a bona fide offer “such offer [must] be made in good faith [and] be of such a nature and in such form that it could be, by an acceptance thereof by the offeree, caused to ripen into a valid and binding contract that could be enforced by any party to it.” Jones v. Riley, 471 S.W.2d 650 (Tex.App.—Fort Worth 1971, writ ref’d n.r.e.).

A lesson from the Jones case (and many others) is that the meaning of important contract terms like bona fide offer and bona fide purchaser should not be left to definitions derived from old cases. Good legal draftsmanship requires that these terms be defined within the contract itself in a way that is specific to the circumstances.

IMPORTANT RELATED LAW

Statute of Frauds

All of the contracts discussed in this article must be in writing in order to comply with the Statute of Frauds. Provisions of the Statute of Frauds applicable to real estate are found in both the Business and Commerce Code and the Property Code:

Bus. & Com. Code Sec. 26.01. Promise or Agreement Must be in Writing

(a) A promise or agreement [for conveyance of real estate] is not enforceable
unless the promise or agreement . . . is (1) in writing; and (2) signed by the person to be [bound].

(b) Subsection (a) applies to . . . (4) a contract for the sale of real estate; (5) a
lease of real estate for a term longer than one year; (6) an agreement which is not to be performed within one year from the date of making the agreement. . . .

There is another statute that is applicable: Property Code Section 5.021 which is sometimes referred to as the Statute of Conveyances:

Prop. Code Sec. 5.021. A conveyance of an estate of inheritance, a freehold, or an estate for more than one year, in land and tenements, must be in writing and must be subscribed and delivered by the conveyor or by the conveyor’s agent authorized in writing.

Recording Requirement for Executory Contracts

All executory contracts relating to residential real estate (including lease-options and lease-purchases) must be recorded. Property Code Section 5.076 states that “the seller shall record the executory contract, including the attached disclosure statement . . . on or before the 30th day after the date the contract is executed.” Any instrument that terminates the contract must also be recorded.

Buying and Selling Options and Preferential Rights

Property Code Section 5.086 requires a disclosure to be made by all persons who sell options and preferential rights. This disclosure requirement also applies to those who sell and assign real estate contracts generally:

Prop. Code Sec. 5.086. Before entering into a contract, a person selling an option or assigning an interest in a contract to purchase real property must disclose to any potential buyer that the person is selling only an option or assigning an interest in a contract and the person does not have legal title to the real property.

Failure to make this disclosure could mean that the contract assignment constitutes real estate brokerage and therefore requires that the seller-assignor have a broker’s license (Occupations Code Sec. 1101.002.A). The usual penalties for brokering without a license apply. While not stated in the statute, it is also possible that future cases will view omitting the disclosure as a deceptive trade practice.

Creative Contracts in the Real World

Lease-options, lease-purchases, and other devices that fall within the realm of executory contracts present a worrisome prospect of litigation with limited or no defenses for the seller. Even if executory contract rules do not apply, a court can still look to DTPA Section 17.50(a)(3) which prohibits “any unconscionable action or course of action by any person”—a multi-edged weapon to say the least.

The overall result in the real world has been to significantly reduce the use of these creative techniques in buying and selling residential real estate, at least when the term is longer than 180 days. Conservative investors avoid them. Many real estate lawyers will not do them at all since failure to comply with the smallest requirement can trigger significant liability not just for the client but for the attorney as well.

From Our Case Files

Two real estate investors were locked in battle over competing options to purchase a desirable piece of freeway-frontage property. The owner, an elderly gentleman who conducted all his negotiations by means of handwritten letters, appeared to have twice granted an option to purchase the subject tract. Each investor claimed to hold the true option to purchase. They sued and counter-sued one another and the case eventually came to trial before a well-known Houston judge whose courtroom was located in the old 1910 courthouse at 301 Fannin Street.
Three days of testimony revealed that the first investor had likely copied the signature of the owner and fraudulently inserted it at the bottom of an option contract. It was revealed that this investor had a previous career as a forger, a skill for which he had served two years in the Huntsville prison. Even though that episode was more than 20 years in the past, this individual had seemingly retained his talent for imitating the handwriting of others.
The second investor was the one who testified to this sordid history. He had become so obsessed with the property that he had covertly formed a relationship with the first investor’s wife who, blinded by love, now exposed her husband’s secrets in open court for the world to see. Once this was done (and being confident of a legal victory) the amorous investor dumped the first investor’s wife—right in the middle of the trial.
The wife did not appreciate this and indicated her displeasure by standing up in court (unbidden) and declaring that the second investor had not paid taxes to the IRS in 10 years and had instead funneled money to an account in The Bahamas, where he had promised to take her when the trial was over.
The exasperated judge rose from his seat and waived an arm at the massive live oak tree outside the courtroom window. “See that branch?” he asked, “The big one near the bottom? It’s the perfect place to hang both you crooks by the neck until you are dead! Give me one reason not to order the bailiffs to carry out that sentence right now!” The bailiffs stiffened, not in resistance to this prospect but in anticipation of carrying it out.
The judge then glared at the two lawyers. “Would counsel like to join them?” The lawyers, realizing their hourly billings had probably come to an end, tripped over one another in declaring that their respective cases were voluntarily dismissed.