Using a lease option to buy or sell your home.

A Lease Option is a great tool to have in your real estate investing kit.

What is a Lease Option?

One of the great things about coaching people with Real Estate Investing is that it provides great questions that can be answered in our newsletter and blog.  So what exactly is a Lease Option?

If done right, (check your local laws I am not an attorney), a lease option is a great way to purchase or sell a home.  It is especially effective if a seller needs to get a home occupied quickly and really wants to sell it but doesn’t want to go through the inspection and full qualifications processes banks use.  It is a great opportunity for a buyer who can afford the payments but may have weak credit or needs to sell their previous home before they can qualify for a new loan.

How it works:

It generally requires two documents, a lease and an option to purchase the property at a specific price before a specific date.  The seller leases the property for a set period of time, usually 1 – 5 years.  The seller, for a fee, gives the lessee the right to purchase the property within a specified time period for an agreed upon price.  This fee can be any amount agreeable between the owner and the lessee.

The option fee may or may not apply to the purchase price of the property and is never refundable.  In other words, if the lessee doesn’t purchase the home within the agreed upon time frame, they do not get the option fee back.  This should be clear in the option agreement.

It is important that the documents are separate and that the lease document does not reference the option contract because some courts have concluded that the option fee or payments with credit towards the purchase price give the lessee “equitable interest” in the property.  If the lessee establishes “equitable interest” in the property the owner may need to foreclose rather than evict if things go poorly.

We use this method to lease out homes in one of our manufactured housing communities.  Given the price point of these homes we generally get $1,000 – $2,000 as an option fee.  Since the lessee has indicated a desire to purchase the home we also stipulate in the lease that the lessee will be responsible for all repairs and maintenance less than say $350.  This method has worked well for us so far.

Sandwich Lease Option: 

A Sandwich Lease Option is an effective way for investors to build a portfolio.  Ideally here is sample of how this might work.

The property owner, party “A”, leases the property to party “B”, who just happens to be an investor, for $1,000 per month for 5 years.  For this to work properly party “B” must ensure that they have the right to sub-lease the property.  There is also an option signed to sell the property to party “B” anytime within the 5 year period for $200,000.  The option cost is $5,000.

Party “B” then finds someone else, party “C”, who wants to lease the property for $1,200 with an option to purchase it for $220,000 anytime in the next 24 months.  This option fee was $6,000.

In this example party “B” is then able to pocket $200 per month and gets all their money back from the option fee they paid plus $1,000.

In the end, does party “B”, the investor, have any money into this deal?  No!  Sweet deal!

Why did we limit the party “C” to 24 months rather than the full 5 years?  If party “C” cannot close within the 24 months party “B” will have some options.  Party “B” can extend the option agreement for an additional option fee or find a new person to put into the property for 24 months.

If party “B” is smart he/she will keep great records of payments received as proof to the bank that party “C” can make the payments.  Furthermore party “B” will work with party “C” to help ensure they can close on the property within 24 months.  This may include connecting them with good credit counselors and/or encouraging them to get rid of other debt so they can qualify for the new loan.

It should be noted that about 70% of all lease options are never actually exercised.  We believe this is due to the fact that the right expectations were not established at the beginning of the transaction.  The lessee must really want to purchase the house and understand that it can truly be their home.

When using a Sandwich Lease Option to get control of a property it is usually in the investor’s best interest to put as little money into the option as possible and get the term of the option as long as possible.  The exact opposite is true when the investor was to us a lease with option to sell a property, get as much money for the option as is reasonable and keep the period to perform short but also reasonable.

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