Buying lease options is a little-known investing strategy that has been used by real estate investors to control real estate at low cost while generating strong cash flow.
Rental property investing, on the other hand, is a tried and true investing strategy that everybody knows.
This form of investing has a host of advantages, including cash flow, appreciation, mortgage pay downs, enhanced returns through leverage, and tax benefits, to name a few.
Which is better? Here’s the short answer:
Lease options are a better investment strategy if you want a low-cost, fast-growth strategy that allows you to enjoy strong cash flow. Traditional rental property investing is the better strategy if you want full control over your investment, superior tax treatment, less risk of loss, and the ability to access your equity.
But there’s a lot to unpack when it comes to understanding the different elements of each investment strategy and why one may be better than the other (and most importantly, which one is right for you). We’re going to cover all of that, so let’s dive into it!
The information contained in this post is for informational purposes only. It is not a recommendation to buy or invest, and it is not financial, investment, legal, or tax advice. You should seek the advice of a qualified professional before making any investment or other decisions relating to the topics covered by this article.
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.
This “tenant-buyer” pays a non-refundable fee for this option. The landlord cannot sell the property to anyone else during the term of the option.
Investors can use lease options for real estate investing in a number of different ways. We’ll cover them briefly below.
Common Lease Option Strategies
Sell Lease Option to Tenant-Buyer
In this scenario, you own the property and enter into a lease option with a tenant-buyer. You get the option fee and a long-term renter. This is the classic “rent-to-own” arrangement that you see advertised from time to time.
In essence, this is simply a variation of owning rental property but using a different strategy to rent it out and sell it. This is not the type of lease option investing that is the topic of this article.
If you want to learn more about this type of lease option strategy, check out my article on the topic here.
Buy Lease Option From Property Owner
This is the other side of the lease option arrangement. Here, you are the tenant-buyer. So you pay the owner an option fee and secure a long-term lease. This is the strategy that is the topic of this article.
You want to get a lease that allows you to sublease the property to another tenant. You also want a lease that has below-market rent. You should convince the owner that this is reasonable because you are giving them a very long-term lease.
You then find a renter who is willing to pay market rent and rent the property to them. You pocket the difference between the rent you pay and the rent that your tenant pays you.
You can then rinse and repeat with other properties and build a cash flow empire.
This is the classic lease option strategy used by investors who may not be able to buy a property outright, but still want to get into the rental property game.
You don’t need a lot of money to start and don’t need great credit or strong income because you don’t need bank financing. All you need is a modest option fee and a willing seller.
Note: There is a variation of this strategy called the sandwich lease option, which is where you buy a lease option using the strategy we just described, but instead of renting the property out to tenants through a normal lease, you turn around and offer them a lease option to buy the property.
Only you charge them a higher option fee and higher rent and you pocket the difference for both.
If you want to learn more about this investment strategy, I wrote a comprehensive article on it, which you can check out here.
How Much Is the Option Fee in a Lease Option?
1% of the purchase price is the rule of thumb for a lease option fee, but this is usually negotiable. While the option fee is not refundable, you can often apply it to the purchase of the property if the option is later exercised.
The range of option fees is quite broad (anywhere from 1%-5%), so strong negotiation skills are important to landing at a good price.
Of course, you are also going to negotiate the duration of the option (usually 1-3 years, although longer is better). The length of the lease typically equals the duration of the option.
Ok, now that we have the introductory stuff out of the way, let’s dive into our comparison of buying lease options vs. owning rental properties.
Cost
Buying lease options can be a much more affordable way to control real estate than buying a rental through a standard purchase agreement.
As we covered above, option fees can range between 1%-5% of the purchase price.
That is far less than the 15% down payment needed to buy a rental property with financing.
There are, of course, low and no money down strategies that you can use to buy rental properties. I cover 15 of the best ways to do this in this article, but on balance, lease options are a very effective way to get into real estate without a lot of money.
Ease of Getting Started
If you only take cost into account, then buying lease options can be a much easier way to get started in real estate investing. But buying lease options can be challenging unless you find owners willing to enter into these types of arrangements.
Most owners who want to sell their property would prefer to cash out through a normal sale. That being said, you may be able to find owners who are tired landlords or who are having trouble making their mortgage payments and would like a solution to their problems.
In these situations, you may be able to convince an owner to enter into a lease option arrangement. But you still need to find these deals and that can present a real challenge unless you know what you are doing.
There are some strategies you can use to find these owners. You can respond to rental listings that have been on the market for a while and see if the owners would be willing to do a lease option instead of a straight lease.
Similarly, you can find properties that have been on the market for a long time and ask if the owner would be willing to do a lease option instead of a straight sale.
Direct mail marketing campaigns can also work. You should target out-of-state landlords who may be tired of managing remote properties.
Bottom line is that you may need to do some serious work to find these owners. You will also need specialized contracts for these types of arrangements and that will mean hiring a lawyer. Given these factors, I would say that it is generally easier to get started investing in rental properties than buying lease options. It’s a much more straightforward and conventional process
This is a close one, though.
If getting a down payment is a serious barrier to you, the extra work involved in finding an owner for a lease option may wind up being the easier option.
Property Selection
One of the biggest issues for lease options is the fact that you are limited in the properties you can select for your portfolio.
Because you only deal with owners who want to do a lease option, your pool of properties is small (at least when compared to the number of properties available through a normal sale).
As we discussed above, owners willing to consider a lease option do so because they are not able to sell through normal means.
That could mean that their property is in a declining or undesirable neighborhood. Or the property may be in a decent neighborhood but could be functionally obsolete or have other poor features.
When it comes to lease options, your method of choosing properties is not always driven by fundamentals like cash flow, appreciation potential, good tenant demand, etc. Rather, you must choose among the properties that make it past the lease option funnel. The bottom line is that you are probably not choosing from the cream of the crop.
If you typically buy properties in lower tier neighborhoods, then this might not matter as much, but if you are buying in better areas, you could have slim pickings if you are using a lease option strategy.
In my view, location matters more than anything else, so I prefer straight-up rental property investing to buying lease options, but many investors successfully use lease options and make good money doing so. You will need to become very good at managing a broad range of properties (include ones in more challenging areas), but it certainly can be done.
Regardless, when it comes to property selection, there is really is no contest. You will have far greater flexibility to choose the properties that wind up in your real estate portfolio through standard rental property investing than through lease options.
Cash Flow
This one is tough because both strategies have the potential to yield strong cash flow.
A hallmark of rental property investing is its ability to generate steady cash flow each month.
But lease options can also give you positive cash flow if you structure them correctly. As we discussed, the key is to make sure your lease with the owner of the property has rent that is below market. Then you can keep the difference between the rent you pay to the owner and the rent you get from your tenant.
I think two factors can help clarify which strategy should win in this category.
The first is scale. I will go into this in more detail under the section on growth potential, but the upshot is that if you start with the same amount of money, you can control far more properties through a lease option strategy than through standard rental property investing. If you control seven properties through lease options vs. one property through rental property investing, your overall cash flow is going to be dramatically higher with lease options.
The second factor when evaluating cash flow is its reliability. Most experienced landlords will tell you that the location of your rental will determine the type of tenants you attract. So if you bought your rental in the right neighborhood, you should be able to land reliable tenants that will pay their rent on time every time.
But, as we just discussed, when you are in the lease option business, you may have to be less choosy for your rental property locations. This means that the renters you attract to that property could be less reliable when it comes to paying rent.
Now I am not saying that you cannot find lease-option deals in great areas where the tenant quality is superb. But I think they are going to be tougher to find.
On balance, I think lease options have the potential to generate greater cash flow, so I will give it the win, but I would highlight that you should proceed with some caution when using this strategy because of the location issues I just mentioned.
Profit Potential
Rental properties can be very profitable because they generate money for you in several ways.
First, you get cash flow each month. Second, you increase your net worth each month when your rental income pays down your mortgage. Third, you gain the full benefit of any appreciation that your property experiences. Fourth, you get significant tax benefits, including depreciation that can reduce your tax liability from your rental property income. Source
Buying lease options can also yield very good profits. First, you get serious cash flow each month. Second, you may be able to reap significant profits if the property that you have an option to buy increases in value (i.e., your option price to buy the property is less than the market value of the property when you exercise the option).
But if the property’s value stagnates or declines, you will have paid a hefty option fee with nothing to show for it. You also do not get to enjoy the full range of tax benefits that a rental property owner would.
So which one wins this category? I think on a per-property basis, rental property investing is the clear winner because of the multiple ways you can profit off a single property.
But if you take into account that you can control many more properties through the lease option strategy with the same amount of money, I think the cash flow that is possible from that many properties probably gets you more bang for your buck.
Risk of Loss
Both strategies have the potential for loss, but I think rental property investing can be less risky. The main reason for this is because option fees are non-refundable. So if the lease-optioned property’s market value declines or stays flat, you have essentially paid for an option that has no value. You still get the cash flow, but you could be out thousands of dollars for each option that doesn’t pan out.
One could argue that a rental property could stagnate or decline in value as well. That’s true, but you are not fighting against the clock when you own a rental property.
You can ride out any dips in value and sell when the property values are in a better place. You can’t do that with lease options. Once the option expires your loss is final.
Another reason why there is greater potential risk of loss using the lease option strategy is rent stability.
As we discussed earlier, you may not be getting the highest quality tenants if your lease optioned properties are in sketchy areas. Evictions and vacancies can result in significant losses. That’s because even if your tenants don’t pay, you still need to make rental payments to the property owner.
Liquidity
Rental properties aren’t particularly liquid, but if you buy a solid property in a good neighborhood, it can be sold at market value without much fuss. It may take a few months, but you should be able to get full value (or close to it) when you sell.
Lease options are not liquid. You don’t own the property, so you can’t sell it. And as I mentioned before, your option fee is non-refundable.
You can’t force the seller to buy it back from you. You can try to sell your option to another investor (assuming your option contract permits it), but there is not really a big marketplace for that (at least when compared to the broader real estate marketplace).
Think the answer is pretty clear here. Traditional rental properties are better when it comes to liquidity.
Growth Potential
Lease options have a big advantage when it comes to growth potential. Because lease option fees cost much less than a down payment to purchase a rental property, you can control a lot more real estate with the same amount of money.
Here’s a simple example to illustrate the point:
Let’s say you have $30,000.
If you buy a solid $200,000 rental property, you will need 15% down. That means your entire $30,000 (and probably a bit more due to closing costs) will go toward the acquisition of that single property.
But you can likely secure around 7 properties (each worth around $200,000) with that same $30,000 through lease options. That’s a massive difference!
It’s no-contest. Lease options are the clear winner when it comes to growth potential.
Conclusion
So there you have it, a full head-to-head comparison of lease options vs. rental property investing.
Which strategy came out on top? They each won an equal number of categories, so that’s not going to help decide the question.
I hate having inconclusive conclusions, but I think the answer turns on what is more important to you.
If you want a low-cost strategy to get into real estate investing that allows you to grow quickly and enjoy great cash flow, then buying lease options may be the better strategy for you.
If you prefer more control over your rental properties (including more flexibility in choosing its location), less risk of loss, and knowing that you can sell your property for value, then rental property investing may be the right option for you.
