If you are a landlord looking to boost your cash flow and get tenants who will treat your place like their own, you may want to look into lease options.
Landlords have been using lease options for decades. Often referred to as “rent-to-own” agreements, they are an alternative way to buy, rent, and sell investment properties.
Lease options come with a host of benefits as well as some important risks that you need to keep in mind.
We will cover all of those benefits and risks in detail, but here’s a preview:
Benefits of Lease Options
Drawbacks of Lease Options
Strong monthly cash flows
Legal issues around lease options
Nonrefundable option fees
Tenants may not exercise options
Possible profits when options are exercised
Deferred maintenance by tenants
Inability to sell in declining market
Involuntary sale of high performing properties
No realtor fees on sales
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 options for landlords 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 are a landlord, this is the strategy for you. This is true especially if you want to sell your property but are having a hard time doing so with traditional methods.
By using lease options, you can 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.
If you are an investor, 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 obtain a lease option from an owner like I just discussed, but turn around and offer a “rent to own” program for your tenants.
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.
Obviously, this strategy can work if you are a landlord as well. You just need to find an owner willing to sell you a lease option with the right terms.
With that intro out of the way, let’s get into why lease options can be a great real estate strategy for landlords.
What Are the Benefits of Lease Options For Landlords?
The main benefits of lease options for landlords are (i) strong monthly cash flows; (ii) nonrefundable option fees; (iii) possible profits when options are exercised; (iv) long-term leases; (v) motivated tenants; (vi) lower maintenance costs; and (vi) no realtor fees on sales.
Strong Monthly Cash Flows
Landlords often charge tenants above-market rents for rent to own properties. In exchange for a higher rent, the landlord applies 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.
Non-refundable Option Fees
Landlords receive from their tenant-buyers a non-refundable option fee. This usually runs into the thousands of dollars. The option fee is negotiable but can range between 1%-5% of the purchase price of the property.
It is very important that your tenant-buyer understands that the option fee is non-refundable. 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.
Possible Profits If Options Are Exercised
One of the key terms in a lease option is the purchase price of the property. That is the price that the tenant must pay if they want to exercise their option to buy the property.
If the lease option has a set purchase price, the landlord may make a profit if that price is higher than the market value of the property at the time of signing the lease option.
Let’s take a simple example:
The current market value of the property is $100,000. The option states that the tenant can buy the home for $120,000 at any time during the next three years. If the value rises to $120,000 or more, then the tenant will want to exercise the option. If the tenant does so, the landlord will make a profit of $20,000 minus closing costs and any rent credits due to the tenant.
Sometimes the lease option does not have a set purchase price. Instead, it states that the purchase price will be the market price at the time the option is exercised (or it can state some other formula for determining the purchase price). In that case, the landlord’s profit will be less certain.
Landlords usually insist on longer-term leases for rent-to-own arrangements. Longer leases mean fewer vacancies, less turn-over costs, and more money for you.
Lease options usually contain a provision that states that if tenants violate their lease, the purchase option becomes null and void.
Because the tenants have paid an option fee that they can’t get back, they will be very motivated to make sure that they do not violate the lease. That means a higher chance of receiving rents on time and a general adherence to all of your lease requirements.
Also, tenant-buyers often view the property as their future home, rather than a regular old rental, so they will tend to take better care of “their” property.
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 the landlord since a normal lease requires the landlord to make repairs. It’s a nice benefit for the landlord because it saves them money, time, and hassle.
No Realtor Fees On Sale
Because the sale of the property in a lease option is done through an existing contract, there does not need to be a realtor involved in the transaction. That means the landlord can save the realtor commissions on the sale, which are typically 5%-6% of the purchase price.
That can be a savings of tens of thousands of dollars – certainly not chump change.
What Are the Drawbacks of Lease Options For Landlords?
The main drawbacks of lease options for landlords are (i) legal issues around lease options; (ii) unexercised options; (iii) deferred maintenance by tenants; (iv) inability to sell in a declining market; and (v) involuntary sale of high performing properties.
Legal Issues Around Lease Options
Lease option investing is an area filled with 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 of the legal complexities and requirements relating to lease options.
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 language).
Some states may require that you record your lease option if it will be for a certain length of time.
And if you offer rent credits, you may run into issues under the Dodd-Frank Act.
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.
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, here is a template form of lease option agreement provided by HUD. 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.
Tenants May Not Exercise Options
When a landlord enters into a lease option with a tenant-buyer, they are hoping that they will make a profit on the back-end when the tenant-buyer purchases the property from them 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 lease-option term.
So don’t bank on that back-end profit – it may never materialize.
Deferred Maintenance By Tenants
As we talked about before, tenants are usually on the hook for repairs. While that’s great if the tenants are honest and conscientious, not all tenants are.
So some tenants may ignore needed repairs because they don’t want to come out-of-pocket for those expenses. Small issues can turn into big issues if that happens.
Make sure you run periodic inspections of the property to prevent that from occurring.
Inability to Sell In Declining Market
This drawback can be meaningful. If the market in your area is declining and your tenant does not want to buy the property from you, you are stuck. You can’t sell to someone else and your property value could continue to drop.
It’s a scary proposition. You may be able to mitigate some of this risk by negotiating with the tenant to see if they will release the option so you can sell. They may want some of their option fee back. Either way, this risk is something to consider.
Obviously, a shorter option term reduces the risk here and you may want to push for that. The tenant will probably resist because it's in their interest to have a longer option term.
Involuntary Sale of High Performing Properties
One of the risks you face when using lease options is that the tenant-buyer may exercise their option when the property is appreciating rapidly.
The property may be in an area that is being revitalized, which means higher prices and escalating rents. You may not want to sell, but you will be forced to honor the deal.
You can prevent some of this risk by tying the option purchase price to market value at the time of sale. But even if you do, you may lose a star property in your portfolio. Those are hard to replace.
Lease options can be a terrific investing option if you are a landlord because you get great cash flow, long leases, low maintenance costs, and the juicy prospect of a back-end profit if the tenant-buyer exercises the option.
But they come with real risks that you must pay attention to and manage if you want to be successful with this strategy.