Interested in real estate investing, but don’t have money for a down payment? Can’t qualify for a mortgage because of bad credit or low income?
If this applies to you, the lease option strategy may be your answer to start investing in real estate.
This creative strategy, sometimes known as “rent to own,” can be a great way to make money from real estate when you are just starting out.
But the strategy has its risks and drawbacks, which you need to understand and address.
We’ll get into the benefits and drawbacks of investing in real estate through lease options later on, but here’s a preview of what we'll cover:
Lease Option Investing
Lease Option Investing
Low starting costs
Risk of owner default
Monthly cash flow
Lost option fee if property value declines
Profit from appreciation
Liable for rent under long term lease
No bank financing
Less control over selection of property
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 drawbacks of lease option investing 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.
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.
There are three main ways investors can use lease options for real estate investing.
Common Lease Option Strategies
Sell a 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. The tenant-buyer gets the lease and the right to buy the property.
If you want to invest with little money down, this is not the right strategy for you. The reason's obvious, of course: You need to own the property first to use this strategy.
But if you own a property and are having a hard time selling, this may not be a bad option. You secure a long-term tenant and receive some option money to boot.
Buy a Lease Option From a 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.
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.
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.
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.
Structure a Sandwich Lease Option
A sandwich lease option strategy is where you offer a “rent to own” program for tenants. In that strategy, you do exactly what I described above, but when you are looking for tenants you offer them a lease option.
Here’s an example:
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 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 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 lease options can be a great real estate investing strategy.
Clarification: When I am discussing the benefits and drawbacks of lease options below, I am referring to the second form of lease option investing (where you buy a lease option from a property owner).
I am not talking about where you are the owner selling a lease option or you are doing the sandwich lease option. Sandwich lease options are complex. They can raise significant legal issues too, so I will not cover them in this post (although I plan on writing a post covering them).
What Are the Benefits of Lease Options For Investors?
The main benefits of lease options for investors are (i) low starting costs; (ii) monthly cash flow; (iii) profit from appreciation; (iv) less vacancy; (v) low maintenance; and (vi) no bank financing.
Low Starting Costs
As mentioned before, the only significant start-up cost for lease options is the option fee. If you assume a 1% fee, 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, they also allow much faster growth because the cost per deal is so small.
Monthly Cash Flow
As we illustrated before, you can get monthly cash flow because the rent you pay to the owner is less than the rent you get from your tenant. You may be able to boost your cash flow even more if the property is suitable for Airbnb.
Profit From Appreciation
If your property value goes up before your option expires, you stand to make a tidy profit. Let's say the exercise price for your option is $100,000. If the property goes up to $125,000, you can make $25,000 (minus closing costs) by exercising your option.
What if you don’t have the down payment or the credit score to qualify and buy the property? You can sell your option to another investor who can buy it. There will be no shortage of investors who will pay you a few thousand dollars for the chance to make $25,000.
If you have a long-term lease with your owner, you can enter into a long-term lease with your tenant. That means less vacancy and more money in your pocket.
When you negotiate your lease with the owner, try to make sure that they pay for all repairs and maintenance, just like a standard lease. That way, when you rent out the property to your tenant, you can offer your tenant the same benefit.
When your tenant gives you a repair call, you pass it along to the owner and they take care of it. Or you can take care of it and have the owner pay for it.
If the owner doesn't want to be on the hook for repairs in the lease, you will need to think of other options or walk away. But you might be able to win them over.
If you let the owner know your plans, they will probably understand that you are not going to attract tenants if you don’t cover repairs. Especially if every other landlord does.
No Bank Financing
We touched on this already, so I won’t belabor the point. If you have bad credit or don’t make enough income to qualify for bank financing, this is a big benefit.
What Are the Drawbacks of Lease Options For Investors?
The biggest drawbacks of lease options for investors are (i) risk of owner default; (ii) lost option fee if property value declines (iii) rent to own scams; (iv) due on sale clauses; (v) liability for rent under a long term lease; and (vi) less control over the selection of property.
Risk of Owner Default
One of the biggest risks of using lease options as an investment strategy is the risk that the owner will 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 do it – if they are hurting financially it is too easy for them to pocket your rent and ignore those expenses.
Escrowing is not a perfect solution, but it can reduce a lot of the risk of owner default.
Lost Option Fee If Property Declines
This risk is straightforward. Your option fee is non-refundable, so if you do not exercise the option within the term, that option expires worthless. If your property value is not above the exercise price during the term of the option, you won't exercise the option.
Pretty obvious right? You are not going to exercise the right to buy a property for $100,000 if the property is only worth $90,000.
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 the seller 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 seller.
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 seller make them before you sign the contract. Or you can tell the seller you will pay for the cost of making them yourself after signing, but they must reduce the option price accordingly.
If the seller 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.
Liable for Rent Under Long-Term Lease
You are usually signing up for a long-term lease when you enter into a lease option agreement. 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.
Less Control Over Selection of Property
Because you only deal with owners who want to do a lease option, your pool of properties is small. These properties may be in declining neighborhoods.
Or they may be in good neighborhoods, but may be functionally obsolete or have other poor features. How you choose your properties is not driven by fundamentals like cash flow, appreciation potential, good tenant demand, etc. Rather, you have to work with the properties that make it past the lease option funnel.
It may work if the properties you find are great. But if the properties you find aren’t suitable investments, you may need to look in a different market or use a different strategy.
Lease options can be a terrific investment strategy if you don’t have a lot of cash or can’t qualify for bank financing. If properly structured they can give you solid cash flow month after month.