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Option to Purchase Agreement: Understanding Key Terms

Option to Purchase Agreement

Understanding the Key Terms in used in an Option to Purchase Agreements

An option to purchase agreement is an arrangement in which, for a fee, a tenant or investor acquires the right to purchase real property sometime in the future. While option contracts are used in both commercial and residential real property transactions, this article focuses on the option to buy contracts in residential real estate sales.

In the residential context, an option to purchase is usually a part of a rent-to-own agreement, also called a lease-option. This lease option involves a tenant entering into a standard lease or rental agreement, in addition to acquiring the option to purchase the rental property in the future. In this arrangement, a portion of the tenant’s monthly rent payments is applied toward the principle of the house. For more details, see our article; The Basics of Rent or lease to Own Agreements.

What to Include in an Option to Purchase Agreement

An option to purchase can appear as a series of clauses in a lease or rental agreement or as a separate document. No matter the format, an option to purchase must: 1) state the option fee, 2) set the duration of the option period, 3) outline the price for which the tenant will purchase the property in the future, and 4) comply with local and state laws.

The Option Fee

To be contractually enforceable, the option to purchase must be given in exchange for consideration, or value. While the value of an option contract cannot be nominal, there is no special floor or ceiling; it’s a matter of negotiation between landlord and tenant. Depending on factors such as the price of the home, the option fee can range from several hundred to several thousand shillings.

Option fees are typically nonrefundable. In other words, if the tenant decides not to exercise his or her option to purchase the house within the agreed-upon time frame, the tenant forfeits the option money. The option fee is also usually forfeited if the tenant defaults on the lease by failing to make timely and exact rent payments or by breaking a term of the lease (such as housing pets when pets are prohibited). Upon the purchase of the home, the landlord deducts the option fee from the principle of the house, and the option fee, therefore, deducts the sale price.

The Duration of the Option Period

An option to purchase agreement or contract must conspicuously state the length of the option period. There is no correct or preferred unit of time and option periods can range from months to years. Typically, however, in the residential context, option periods range from one-to-five years.

Depending on the terms of the contract, the tenant may exercise the option to buy the house at any time during the set option period or at a date specified in the option-to-purchase agreement. If the tenant lets the period pass, the option expires and becomes null and void. In that situation, the tenant forfeits the option fee.

Purchase Price of the House

An option to purchase must address the amount for which the tenant will buy the rental property in the future. Sometimes, the purchase price is a set price that is determined based on the current appraisal value of the house. This approach does not always make sense, however—the longer the option period, the higher the likelihood of fluctuating home values. So, when longer option periods are contracted for, landlords and tenants usually agree to re-evaluate the purchase price of the home periodically. Alternatively, the landlord and tenant may agree to determine the actual value of the house by appraising the house at the time the option is exercised. Ultimately, as long as both parties are in agreement as to how the value of the house is to be determined, the option contract is enforceable.

No matter how the value of the property is determined, it is likely going to be decreased by a percentage of monthly rent payments. This decrease is so because, in an option contract, an agreed-upon percentage of the monthly rent is typically placed in an escrow account. The landlord then either reserves the escrow funds and refunds the tenant upon purchase of the home or simply applies a percentage of the rent payments toward the principle of the house. In this manner, the tenant builds equity in the house throughout the duration of the lease agreement. The tenant forfeits these payments if he or she does not purchase the property within the option period. Check with the Kenya Revenue Authority to find any applicable taxes that may apply to your option to purchase contract.

Adherence to State and Local Laws

Some local by-laws specifically protect tenants from entering contracts they do not understand—for example, by requiring option contracts to contain conspicuous wording in specified font size, to inform tenants of the possibility of forfeiting the option fee. To be valid and enforceable, an option to purchase must comply with the nuances of state (and any local) laws that govern the transaction. Check with the Ministry lands to find any applicable laws that may apply to your option to purchase contract.

Do You Need a Lawyer to Draft an Option to Purchase Agreement?

Typically, yes, it’s important to work with an experienced real estate attorney. A lot is at stake financially for both landlord and tenant, and state and local laws (such as property disclosures), often come into play as with house purchase agreements. Some countries require option contracts to be recorded in the courthouse in the manner of a deed transfer; the rationale behind this is to encumber the property and ensure that the landlord is unable to sell the rental property to a third party.