Substance over form
Ihad an interesting case come across my desk this week that had to do with a lease option going bad.
At first, I typed “gone bad,” but the situation has not fully resolved, so I changed it. But it’s a great illustration of what not to do as an investor and I thought I would tell you about it so you don’t make the same mistakes.
Lease options have become a popular exit strategy lately because they have the ability to convert a negative cash-flowing rental into a positive cashflow situation. Now if you are not familiar with it, a lease option is where you rent a house to someone who is close to being able to purchase a home and sell them the right to buy that house from you in the future for an agreed upon price.
Often these tenants have some sort of credit issue they are working through that they can clear up in the next two to three years. They really desire to own and not rent and typically already have cash saved up for a down payment. They are just waiting to be preapproved for a loan.
In the lease option scenario, they rent from you until they can obtain the loan and buy your house. Meanwhile, they get to live in their forever home while they wait — which they love.
Now, how the lease option has the ability to turn a negative cashflow into a positive is twofold. First, the tenant is going to agree to rent the home at market, or slightly above, rent rates. And they’re going to perform because if they don’t, they lose the right to buy the house. This means you won’t have any missed payment and have a zerovacancy rate until it sells.
Next comes the option. That’s where you sell the tenant the right to buy your house sometime in the future. And since they are purchasing that right from you, they have to pay you a sum of money called option consideration for that right. This money is nonrefundable, often gets applied to the purchase price at the time the deal closes. But as soon as the option is signed, it belongs to the investor.
It’s important to note here that option consideration is not the same thing as a down payment or earnest money. Option consideration is compensation paid to the investor for giving up the right to sell their house to anyone else other than the tenant during the term and in accordance with the conditions set forth in the option contract. And that’s a pretty big right to give up.
For instance, let’s say you entered into an option agreement with someone in 2019. It had a fiveyear term and the purchase price was based off what real estate was selling for in 2019. That means you gave up all the appreciation we have seen over the last four years, which was a ton.
Now that’s part of what happened with the deal that is going wrong that I mentioned before. They made an agreement before all the appreciation happened. And they called it a lease option.
After reading the single document, I realized quickly what I was reading was not a lease option. You need two documents when doing a lease option. You need the lease which is the contract — that grants the tenant the right to use the property to live in in exchange for rent — and then you need the option contract — which is where the landlord sells the tenant the right to buy the house for an agreed upon price sometime in the future.
The thing I was reading was one document that was titled “lease option,” but read like an installment sale. The document referenced earnest money, a purchase price and a term of 10 years with no prepayment penalty. It had a monthly payment that was not referred to as rent, that would be applied to the purchase price and it even referenced an amortization schedule.
All these terms are things associated with a sale and have nothing to do with renting a property.
The biggest take away here is that the title of your document makes no difference. What the document says is what matters. In this case, it’s an installment sale. Straight up. And the investor now knows that, because he tried to go to Magistrate Court and evict his tenants after a missed payment. The tenant hired an attorney who saw the document for what it was and had little trouble convincing the judge of that fact. The judge said he could not evict and said they would have to go to Superior Court if they wanted to continue.
You see, the substance over form doctrine came into play here. The form was a lease option, which is a tenant-landlord relationship and governed by Magistrate Court. The substance, however, was that of an installment sale, which is governed by Superior Court and must be remedied through judicial
foreclosure in the State of Georgia. And the Magistrate Judge realized that fact.
I don’t know what is going to happen next. My guess is the investor is going to either have to wait the rest of the ten years or see if they can renegotiate with the buyer, because he now knows they are not tenants.
But learn this lesson. Have proper documents. Go to classes to learn how to use them, pay an attorney to look over your contracts and make sure that your documents have the right substance and form.