Legal Question in Real Estate Law in California

Re: Refinancing a Lease Option home

In general, it is "legal" in the sense that it isn't prohibited. However, there are some caution flags here; it is very possible that someone's rights might be trampled upon and give them cause to sue.

First, is the lease option contract recorded with the county recorder? It is permissible to record lease options and in some cases it may be desirable for either the owner or the option-holding tenant, usually the latter, to record the instrument creating the option (and the lease or a memorandum thereof, if they are separate documents). If it is recorded, that would presumably eliminate any issue as to disclosure.

OK, beyond this preliminary comment, I can see a possible problem with the option holder if he thinks he can assume the present loan, if the option agreement contains any promise on your part to keep the property free of (new or additional) liens and encumbrances, or if the new loan has the effect of impairing your ability to perform if the option is exercised, for example, if you were to take cash out or otherwise drain the equity.

I can also see a possibel problem with the lender, if it is unaware of the facts, e.g., that the house is tenant-occupied and that the house is subject to resale in the near future to someone presently holding an option. (The reason for the latter is that lenders are expecting to get interest income for some future period in order to recover their up-front costs not covered by fees and points or prepayment penalties.)

All in all, I think this is legal but fraught with possible breaches of some contract or duty unless the full details are laid out for the proposed lender and the option holder, and both approve the refinancing.

I'm going to do a little research on this interesting question, and if I find anything that gives me a different opinion, I'll post a follow-up response.

Re: Refinancing a Lease Option home

OK, here's a supplement to my earlier post on this question.

When the option holder exercises his option and acquires the property, his title "relates back" to the date the option was given, thus extinguishing intervening interests in the property claimed by anyone with notice of the option, such as any deed of trust you might give a lender. The optionee is entitled to receive title as it existed at the time the option was granted. See Wachovia Bank v. Lifetime Industries, Inc. (2006) 145 Cal.App.4th 1039.

So, the lender would be in a position of losing its collateral if (1) it knew about the option either because it was recorded, or otherwise; and (2) the option holder exercised the option.

The watershed question is whether the lender has actual or constructive notice of the option.

I think the lender would be stupid to make the loan if it knows about the option and lends anyway, because it stands a good chance of losing its collateral. If it did, however, it could sue you, the borrower, directly on the now-unsecured promissory note.

If, on the other hand, the lender is in the dark about the option, and makes the loan, you need to be in a position to deliver title to the option holder, free of the lien of the new loan, since the option holder, upon exercising the option, is entitled to receive title at least as clean as it was at the time the option was granted. If you are able to pay off the new loan, fine; you will be able to perform and avoid a breach of the contract with the exercising option holder. If you can't, however, because you took out too much cash or had a misfortune of some kind, you will be in breach and liable for damages to the optionee.

So, it's "legal," but has very obvious risks, restrictions, pitfalls and other limitations.