DAVID J. WILLIS ATTORNEY
Copyright © 2018. All rights reserved worldwide.
EXECUTORY CONTRACTS IN TEXAS
by David J. Willis, J.D., LL.M.
Lease-options have always been a favorite tool of Texas real estate investors—one of the “Big Three” alongside contracts for deed and lease-purchases—all of which are creative devices for getting under-qualified buyers into a home immediately. However, the Property Code now defines residential lease-options for longer than 180 days as executory contracts subject to strict regulation and penalties if not done exactly right. Exactly right. Specific requirements must be observed and the burden is entirely on the seller to do so. Violation incurs not only penalties under the Property Code (return of payments made by the buyer) but potential liability under the dreaded DTPA, which can involve treble damages plus attorney’s fees. The risk to the seller of using lease-options (or any other executory contract) is now significant, and investors should therefore use them, if at all, with extreme caution.
The Pure Option to Purchase
Before continuing our discussion of lease-options, it is worth remembering that there is such thing as a stand-alone option to purchase, disconnected from a lease. It consists of a contractual right granted to a potential buyer which may be exercised in writing, at a time of the buyer’s choosing, without the requirement of a triggering event, to purchase the property at a pre-determined price. It is not sufficient, however, to say “I have the option to purchase 123 Oak Street for $250,000” and let it go at that. How long does this 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? When you think about it, a well-written option agreement is going to contain all the key points and material terms that are usually found in an earnest money contract. So beware the “one-liner” option, since it often raises more questions than it answers.
Buying and Selling Options
There is a notable change in this area, effective in 2017, which directly affects investors. Property Code sec. 5.086 requires a disclosure for all persons who sell options or assign contracts: “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.” Failing to make this disclosure triggers a requirement in the Occupations Code that such transfers constitute real estate brokerage and therefore require a broker’s license. The usual penalties apply. While not specified, it is likely that future cases will also deem failure to include the disclosure to be a deceptive trade practice.
What are executory contracts and why do lease-options fall within this category?
Another area that should be explored is the connection between any preferential right to buy real estate and executory contracts, since the latter are now heavily regulated by the Property Code.
Executory contracts include any transaction that defers some material action by either party that pertains to real property ownership or possession into the future.So why do lease-options fall within this definition? Because the Property Code says so. Section 5.062(a)(2) states: “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.”There is an exception for lease-options for 180 days or less under section 5.062(c)—otherwise, the TREC 1-4 contract would violate this provision when combined with a short-term lease. Commercial lease-options are not affected.
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 purchaser generally obtains both title and possession. By contrast, in an executory 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.).
Executory Contracts: Requirements
Just for the record, one can still do a long-term lease-option or other types of executory contracts—but consider the 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 nonsubdivision 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. See Prop. Code §§5.069 et seq.
Additionally, it is required that sales advertisements 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 nonexistence of a prepayment penalty. 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 §5.074.
The Short-Term Lease-Option
It is nonetheless true that lease-options may be useful if the term is 180 days or less or if the property is paid for (meaning a lender’s consent will not be needed). Accordingly, an investor should not avoid utilizing a 180-day (or less) lease-option if it is appropriate under the circumstances, particularly if there is a fair possibility that the option may be exercised during that period. Also, if the parties decide in good-faith to renew the option for another short term, they should not hesitate to do so. We recommend using a 179-day option term just to avoid any issue about whether or not the statute has been violated, since it is never a good idea to cut matters too closely when dealing with legal limits or deadlines—not just this time limit, but all of them, across the board.
A Month-to-Month Lease Combined with an Option
What if the lease is “month-to-month?” If it includes an option to purchase, 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. Since the lease can easily extend for longer than 180 days, the option can as well. Accordingly, a court would most likely find this arrangement to be an executory contract.
Potential Solution: Stacking Short-Term Options
What about the possibility of stacking six-month option contracts—i.e., allowing the option to expire and then renewing it again and again? This would appear to be a loophole, making stacking a possible way for a very aggressive investor to still do a lengthy lease-option without complying with the executory contract rules, although at some risk. If 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-option arrangements that endure in the aggregate for longer than 180 days are perilous. The legislature clearly intended to discourage their use in residential transactions and deliberately imposed significant liability on landlord/sellers for doing them improperly.
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. It is common, but not universal, 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 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 qualify for financing.
Are lease-purchases executory contracts? Yes, since fulfillment of a material term is deferred into the future.
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 become 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? In such a case it may not be a lease-purchase at all but an old-fashioned contract for deed.
Two points are worth noting. The first is that each of these devices—lease-options, lease-purchases, and contracts for deed—can, if only slightly modified, become hybridized with something else, sinking the transaction deeper into the executory contract hole. The second point is that regardless of the ultimate form such hybrid contracts take, they remain executory contracts for purposes of the rules and penalties of Property Code sections 5.061 et seq.
All residential executory contracts must now 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.
Lease-Purchases in the Real World
Residential lease-purchases for longer than 180 days are no longer a feasible strategy for 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 here. Add the fact that the Property Code declares open season on the investor/seller whenever a tenant/buyer becomes disgruntled with an executory contract, and there are more reasons to avoid lease-purchases than there are to do them—especially since loss of an executory contract lawsuit (and the ensuing punishing damage award) could present an extinction event for a small investor.
The 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. ROFRs do not specify a price. Circumstances vary, and therefore the language of a ROFR clause may vary as well. For example, a ROFR may be triggered by an offer received by the owner from a third party; in such a case, the owner is obligated to first offer the property for sale to the holder of the ROFR at the same price and upon the same terms. Another scenario may occur if the owner makes the decision to sell the property but does not yet have a buyer; the ROFR may obligate the owner to first offer the property to the holder of the ROFR.
The principal benefit to a ROFR is that it is not an executory contract, even when combined with a lease. Caution: As soon as a specific price is included, it is likely that a ROFR will be transformed into an option and become an executory contract. ROFRs are therefore not an effective tool for the investor/seller who wants to preset an above-market price in order to lock in a long-term profit.
ROFR versus Options
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 it is 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 generally 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 with document wording and deletes the word “option” from the document, substitutes ROFR language in its place, and then goes on to specify a dollar price? Under the Brownsville case, once price is specified, it is likely that the ROFR becomes an option and therefore an executory device. Further, courts are more 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 by the investor.
Drafting ROFR Language
All of this presents an interesting challenge when attempting to draft a ROFR. Here is one example:
In the event Owner offers the Property for sale, then Holder [of the ROFR] will have the right (but not the obligation) to purchase the Property under the following terms and conditions: (1) Once Owner has established an asking or listing price for the Property, Owner must first notify Holder in writing of Owner’s intent to sell and shall then offer the Property for sale to Holder at this price. Holder will have 10 days from receipt of such notice to consider this offer, and if Holder accepts, Holder will have 45 days to close. Consideration may be cash or third-party financing or, if agreed between Owner and Holder, by assumption, wraparound, or owner finance. (2) If Holder declines or fails to purchase the Property at the listing or asking price, Owner will be free to offer the Property for sale to others. However, if a bona fide offer is received from a third-party prospective buyer, then Owner must again notify Holder in writing and offer the Property to Holder at the price and upon the same or better terms as named by the prospective buyer. Holder will have 10 days from receipt of such notice to consider this offer, and if Holder accepts, Holder will have 45 days to close. Holder may shorten or eliminate any applicable time periods in this paragraph by waiving or declining in writing to exercise Holder’s right of first refusal. The right of first refusal described in this section shall entirely expire on ______________201___.
The advantage of the foregoing method is that the ROFR sales price is ultimately set by a third-party buyer. However, what if the ROFR as drafted merely gives the holder a general right? Some method has to be found to establish price. In the following instance, value is determined by reference to prevailing fair market value:
In the event Owner intends to offer the Property for sale, Owner must first offer the Property for sale to Holder at a price equivalent to prevailing fair market value. Terms of sale shall be cash or third-party finance, and closing shall be within 45 days.
If the parties cannot agree on what constitutes fair market value, then two appraisers shall be promptly selected, one by Owner and another by Holder. The two appraisers selected shall proceed to promptly determine the fair market value of the Property, taking into consideration its condition, comparables, and any outstanding indebtedness, liabilities, liens, and obligations relating to the Property. The appraisers shall deliver their respective reports within thirty (30) days. If the two appraisers arrive at different valuations, then these two valuations shall be averaged in order to produce a final valuation. The final valuation shall be binding on both parties. Each party waives the right to contest the final valuation in court. The costs of the appraisals shall be split equally between Owner and Holder.
The ROFR is a useful tool which stops short of being an executory device, but only so long as one does not try to stretch the language in order to make it an option by a different name.
Other Preferential Rights
There are similar preferential rights that also fall within this general category. 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. Another 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. 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.
Statute of Frauds Applies
All preferential rights to real estate must be express (not implied) and 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 the Business & Commerce Code sections 26.01 and 26.02(b): “[A] contract for the sale of real estate is not enforceable unless the promise or agreement, or a memorandum of it, is (1) in writing; and (2) signed by the person to be charged with the promise or agreement. . . .”
There is another statute that is applicable: Property Code section 5.021, sometimes referred to as the “Statute of Conveyances,” which states: “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.” For more detail on the requirements of the Statute of Frauds, see our web article on the subject.
Preferential Rights and the Leasing of Real Estate
It should be noted that certain of the preferential rights discussed in this chapter also apply to the leasing of real property, although these are more commonly found in the world of commercial leasing and are thus less relevant to an investor in SFRs.
Preferential Rights and Executory Contracts in the Real World
Preferential rights often cross the line into the zone of executory contracts, and the result has been to greatly inhibit their use in buying and selling real estate. Burdensome requirements and stiff penalties applicable to executory contracts cause sensible investors to avoid them. Many real estate lawyers will not do them at all, since failure to comply with even the smallest requirement may trigger significant liability not just for the seller but also for the attorney preparing and filing the various disclosures and documents.
Caution to Investors: Avoid the Courtroom
Lease-options, lease-purchases, and other devices that may fall within the realm of executory contracts present worrisome prospect of litigation with limited or no defenses for the investor, who is seldom the most admired person in the courtroom. Even if executory contract rules are inapplicable, 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. Investors should find a good real estate lawyer, one with courtroom experience, and pay attention to what he or she says about how a judge or jury may react to a proposed deal and the documents that underlie it, particularly if there are executory contract implications. A good lawyer knows that real estate documents should always be drafted as if one will someday have to defend them in court.
Information in this article is provided for general informational and educational purposes only and is not offered as legal advice upon which anyone may rely. The law changes. Legal counsel relating to your individual needs and circumstances is advisable before taking any action that has legal consequences. Consult your tax advisor as well. This firm does not represent you unless and until it is expressly retained in writing to do so.
Copyright © 2018 by David J. Willis. All rights reserved worldwide. David J. Willis is board certified in both residential and commercial real estate law by the Texas Board of Legal Specialization. More information is available at his website, http://www.LoneStarLandLaw.com.