Want to get started in real estate investing but don’t have a lot of money, great credit, or a high income?
You may want to look into sandwich lease options.
The sandwich lease option is a variation of the lease option, which is more commonly known as a “rent to own” arrangement.
Normal lease option strategies include buying a lease option from an owner and becoming their tenant-buyer. You can then sublet the property to a tenant.
Or if you are already a landlord, you can sell a lease option to a tenant who wants to someday own the property.
But with a sandwich lease option, you combine the two strategies. In effect, you are the middleman making it happen. We’ll show you exactly how this works later on.
Sandwich lease options are an exotic form of real estate investing, but they can yield solid profits, without needing a lot of money to start. If you do it right, you can scale incredibly quickly and generate a ton of cash flow, all without ever owning a single piece of real estate.
Sounds intriguing right?
We’ll get into the benefits and risks of sandwich lease options in more detail later on, but here’s a preview of what we’ll cover:
Benefits of Sandwich Lease Options
Risks of Sandwich Lease Options
Low start-up costs and fast growth
Legal issues around lease options
Monthly cash flow
Risk of owner default
Profits if options are exercised
No bank financing
Tenants may not exercise options
Low maintenance costs
Liable for rent under long-term lease
Since we are talking about some new concepts that may not be familiar to you, we’ll start by covering some definitions, but if you want to skip the introductory stuff, you can jump ahead to the section discussing benefits and risks of sandwich lease options by clicking this link.
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What is a Lease Option?
A lease option is an agreement where the owner of a property enters into a lease with the tenant but also gives the tenant an option to buy the property. The option grants the tenant the right to buy the property within an agreed-upon time and at an agreed-upon price.
In this case, you are the “tenant-buyer” and pay a non-refundable fee for this option. The landlord cannot sell the property to anyone else during the term of the option.
Of course, you are not going to live in the property, which is why you need to include a right to sublet the property in your lease with the owner.
What is a Sandwich Lease Option?
A sandwich lease option is an arrangement where you buy a lease option from the owner of a property and then sell a lease option to a tenant. You are the middleman in the transaction and can make money by negotiating a lease option with the owner that has a lower rent and a lower purchase price than the lease option that you have with your tenant.
Here’s an example of how a sandwich lease option works.
Under your lease option with an owner, you pay a $3,000 option fee to buy the property for $100,000 within three years. Your rent is $1,000.
You then structure a lease option with your tenant-buyer where they pay you $4,000 as an option fee. Under your lease option with them, they can buy the property for $120,000 and they pay you $1,200 per month in rent.
You pocket the difference between the two contracts.
Obviously, you capture the spread between your option fee and the tenant’s option fee. You also pocket the difference between the rents.
If you land the trifecta, your tenant will buy the property from you by using their option, and you will then get to pocket the difference there too.
With that intro out of the way, let’s get into why sandwich lease options can be a great real estate investing strategy.
What Are the Benefits of Sandwich Lease Options?
The main benefits of sandwich lease options are (i) low start-up costs and fast growth potential; (ii) monthly cash flow, (iii) option fees, (iv) profits if options are exercised; (v) no bank financing, and (vi) low maintenance costs.
Low Start-Up Costs and Fast Growth Potential
One of the reasons why sandwich lease options can be perfect for beginners is because the start-up costs are so low. The only significant cost is the option fee, which typically runs between 1% and 5% of the purchase price of the property.
If you assume a 1% fee (which seems to the rule of thumb), that means you can lease option a $200,000 property for only $2,000.
Compare that to the 15% down payment you need to buy an investment property with standard bank financing.
Not only do lease options offer a very low barrier to entry, but they also allow much faster growth because the cost per deal is so small.
Monthly Cash Flow
If you have structured your sandwich lease option correctly, you should be collecting the difference between the rent you pay to the property owner and the rent that your tenant pays to you.
You can improve your cash flow even more because you can often charge tenants above-market rents for rent-to-own properties. In exchange for a higher rent, you may offer a “rent credit” each month in the tenant’s favor that can be applied toward the purchase price if the tenant exercises their purchase option.
The standard rent credit seems to be between 10%-15% of the rental amount.
Word of caution: As we discuss later on in this post, rent credits may have significant legal complications, so please check with your legal advisor before doing this.
If you have structured your sandwich lease option the right way, you should receive from your tenant-buyer a non-refundable option fee that is higher than the option fee you paid to the owner.
I want to mention one thing about the option fee. Your tenant-buyer must understand that the option fee is non-refundable and they won’t get it back if they don’t buy the house.
Some shady operators mischaracterize the option fee as the equivalent of a down payment on the house and mislead tenant buyers.
You don’t want to do that – be crystal clear on this point. You don’t want to be sued because you misled anyone.
Profits If Options Are Exercised
As we showed earlier, if you set up the sandwich lease option so that your option purchase price is lower than your tenant’s option purchase price, you will make a profit if your tenant exercises their option and buys the property.
No Bank Financing
If you can’t invest in real estate because you have bad credit or don’t make enough income to qualify for bank financing, sandwich lease options can be a great option for you.
Pretty big benefit if you are among the many who face these types of obstacles.
Lower Maintenance Costs
Lease options often require tenants to cover repairs to the property on the idea that the property will someday be theirs. Source: Nolo
That’s great for you since a normal lease requires the landlord to make repairs.
In fact, if you structure it right (I am getting tired of saying that), you can take yourself completely out of the picture when it comes to repairs and maintenance.
Here’s how it works.
When you negotiate the lease with the owner, you agree that they will cover any repairs that cost over $150 and you will cover anything lower than that. Seems reasonable since the owner still owns the property and you shouldn’t have to foot the bill for a huge expense, like a new roof or HVAC system.
But you then turn around and put in your lease with your tenant that they are responsible for any repairs or maintenance under $150. Again, seems reasonable since tenants are expected to cover some level of repairs in the rent-to-own space.
And voila! You are now covered from both sides.
What Are the Risks of Sandwich Lease Options?
The main risks of sandwich lease options are (i) legal issues around lease options; (ii) risk of owner default; (iii) rent-to-own scams; (iv) due-on-sale clauses; (v) tenants may not exercise options; and (vi) liability for rent under long term leases.
Legal Issues Around Lease Options
Lease option investing is an area that has a lot of legal pitfalls.
So the first and most important thing you need to do is talk with a lawyer who is familiar with lease options and the laws governing them in your state and municipality.
Here are some examples to give you a flavor of what I am talking about.
Note: these may or may not apply to your jurisdiction.
Some states may prohibit lease options outright, while others may impose limitations on your rights to evict or obtain other remedies if you have given your tenant an option to purchase the property.
Other states may require a very conspicuous statement in the contract (in all caps, for example) that highlights that the contract is not a contract to buy or similar verbiage.
Some states may require that you record your lease option if it will be for a certain length of time.
Actually, this may be worth doing anyway. If you record the lease option, you put a cloud on the title, which is a way to prevent the owner from trying to sell your property without your knowledge.
If you offer rent credits, you may run into issues under the Dodd-Frank Act.
In short, these are treacherous waters, so make sure you find a great lawyer who knows this area inside and out.
If you are curious about what a lease option agreement can look like, here is a template form of a lease option agreement provided by HUD.
Now you should not use this form out of the box!
You should get a custom-made form from your attorney that fits with the applicable laws for your situation. But I wanted to provide this document as a point of reference, so you know what some of the provisions can look like.
Side Note: Best practice in terms of the legal agreements seems to be having a stand-alone lease and then a separate option agreement that is not tied to the lease.
Risk of Owner Default
One of the biggest risks of using sandwich lease options is that the owner may default on their obligations. The nightmare scenario is if they don’t pay their mortgage or property taxes.
The lender or state could foreclose on the property.
You and your renter don’t want that to happen.
The owner could also not pay contractors, which in some areas could result in a lien against your property.
If there is a leaky roof or an HVAC that needs to be replaced and the owner doesn’t have the money to cover it, you could be in trouble. Your tenant is going to expect these things to be in working order.
One way to mitigate some of these repair risks is to get a home warranty.
A common solution to the broader default issue is to escrow your rent payments each month. You can then use it to pay for the mortgage, taxes, insurance, and warranty payments.
Don’t trust the owner to just pay these expenses – if they are hurting financially it is too easy for them to pocket your rent and ignore those obligations.
Escrowing is not a perfect solution, but it can reduce a lot of the risk of owner default.
The rent-to-own space is packed with scams.
So much so that the FTC issued a warning about it.
According to the FTC, some of the common scams are (i) seller does not really own the property; (ii) seller hasn’t paid property taxes; (iii) property is in terrible condition; (iv) promised repairs are not made after the contract is signed; (v) the house is getting foreclosed.
The good news is you know about these scams now (at least the most common ones).
Here are some ways you should protect yourself.
Worried the seller does not own the property?
Make sure the seller has title to the property. Ask them for proof of ownership initially. If things progress, you can have a title company run a search to verify ownership before you sign any documents with the owner.
Worried the owner hasn’t paid property taxes or the house is getting foreclosed on?
You can check public records to see if there is a foreclosure in process. Also, a title search should uncover any liens by the state for unpaid property taxes.
Worried about hidden property condition issues (e.g., lead, asbestos, mold, termites, etc.)?
Run a thorough inspection of the property to uncover any issues.
Worried that the seller will not make promised repairs?
If the repairs are critical, make sure you have the owner make them before you sign the contract. Or you can tell the owner you will pay for the cost of making them yourself after signing, but they must reduce the option price accordingly.
If the owner has a mortgage, the loan agreement may contain a due-on-sale clause. These clauses state that if the owner sells the property, the full amount of the loan becomes due immediately.
Even though you don’t own the property (just an option to buy it), the due-on-sale clause may still be triggered. In fact, some loan agreements specifically call out lease options as triggering events.
The bank may not care about enforcing this as long as they are receiving the mortgage payment on time every month. But it is a risk you should be aware of and consider.
Tenants May Not Exercise Options
When you enter into a lease option with a tenant-buyer, you are hoping to make a profit on the back-end when the tenant-buyer purchases the property from you at the agreed-upon price.
But in most cases, that does not happen.
Most tenants are entering into lease options because they are not financially strong enough to buy a home the normal way. There is a good chance that nothing about that will change during the course of the lease option term.
So don’t bank on that back-end profit – it may never materialize.
Liability For Rent Under Long-Term Leases
You are usually signing up for a long-term lease when you enter into a lease option agreement with the owner. That means that even if you can’t find a tenant, you are still on the hook for making rent payments each month. And that can be a lot of months.
You should make sure there is plenty of rental demand for your property before you sign the lease option and that the rents will produce a profit for you.
If you want some tips showing exactly how to do this, check out my step-by-step guide on how to start investing in rental properties.
Sandwich lease options can be a terrific strategy if you are low on cash and don’t have a ton of resources at your disposal. You can get great cash flow, scale quickly and start building a real estate empire on a shoestring budget.
But nothing comes easy.
Sandwich lease options also carry some serious risks that you must pay attention to and manage if you want to be successful with this strategy.