Selling with a Lease Option
Real Estate Investing Course
By Steve Gillman - 2005
Why can selling using a lease option be a good idea? Because
it may be better than the alternatives. These alternatives are
often either being a regular landlord or selling a house for
less than you would like.
There are many potential buyers out there who can't buy at
the moment. This is not always due to a bad credit score. They
may be uncertain if they want to stay in an area. They may have
good credit, but no money for a down payment. They may work for
a good company, and have great opportunities for advancement,
but not yet have a good salary. There are many reasons that people
look for a rent-to-own or lease-option situation.
There are also many ways in which these deals are structured.
The basic concept is that buyers rent the home, and have an option
to buy it at a set price by a set date. (An option means they
have the right, but not the obligation, to buy.) This gives them
time to save money for a down payment, to increase their income,
and to find financing.
Often there is a non-refundable deposit. It might be $1,000
or $10,000. This is sometimes called an option fee. It is generally
applied towards the purchase price when the buyer closes the
deal. If he decides not to buy the home, he loses the deposit.
As the seller you obviously want to get a large option fee if
you can.
It is also common to apply part of the rent towards the purchase
price. This makes it possible for the buyer to more easily come
up with a sufficient down payment to get reasonable financing
terms. Rent is often higher than normal, to account for this
credit, and as the seller, you benefit from that higher rent
if the buyer doesn't buy.
Another interesting aspect of lease-option deals is that,
unlike with normal rentals, it is common to make the tenant responsible
for maintenance. They are buying the home, after all. There are
many variations in how this is done. The tenant might be responsible
for the first $200 of repairs or maintenance in any given month,
while you have to pay for anything beyond that (It really wouldn't
be fair to ask the tenant to pay for a new furnace three weeks
after he moves in.)
Pricing is normally higher than market. This is possible because
you are making it easier for a buyer to own a home. It is also
because you may be selling the home to him in two years, so it
seems fair that he pay what it is worth then, which will presumably
be higher in most areas. In other words, if the assumption is
that the home will be worth 15% more in two years than it is
worth now, that might be the price at which the buyer can exercise
his option - but in the end this is all negotiable.
Selling Using a Lease-Option - An Example
Suppose you find a home that needs a little work. Its market
value will be around $200,000 after you clean it up. You buy
it for $180,000, with $18,000 down. Your closing costs are $5,000,
and cleaning costs $2,000. Mortgage payments, taxes, insurance
and a water bill run about $1500 per month, so holding costs
for the first two months (Your target for selling the home) will
be $3,000.
You can't make money just buying and selling a home like this.
At the two-month mark you already have $190,000 into it. ($28,000
of your own cash.) The likely sales price is $200,000 and a sale's
commission and closing costs will eat up at least $10,000 of
that.
Then you find that you can only get about $1350 per month
in rent. Your costs run $1500, and you didn't get into real estate
to lose money. What do you do? (Other than planning more carefully
next time.)
You put an ad in the paper saying, "Beautiful home. Why
throw away your rent when you can rent-to-own? Move in this week."
By the way, "rent-to-own" will usually get more calls
than "lease option." You get a dozen calls, and arrange
to show the home to several couples at the same time, to get
a little competition going.
You find a good young couple who both work, and have decent
credit reports. They agree to rent the home for $1750 per month
on a two year lease with an option to buy the home at $220,000
at any point during that two years. They pay a $2,000 option
fee, to be applied to the purchase price if they buy. You also
agree to apply $450 of each rent payment towards the purchase
price.
Since it will hopefully be their home, they agree to pay for
the first $150 in repairs and maintenance each month. You will
cover anything larger than that if it comes up. This means that
in all likelihood, you will not have to spend any time dealing
with backed-up toilets and such, as landlords normally have to
do.
Why are they willing to pay higher than normal rent? First,
it is the only way they can buy this house. Second, since they
expect to buy it, and $450 of it goes towards the purchase price,
the other $1300 is actually a bit less than normal rent.
Why are they willing to pay $220,000 for the home? Because
you are making it easier for them to own a home. Also, it may
be reasonable to assume that if they buy it in two years, it
will already be worth more than that (it is only 4.9% annual
appreciation).
Your Profit?
Let's look at two possible scenarios. First, if they walk
away at the end of the two years, you keep the $2,000 option
fee, and you had $6,000 in positive cash flow over the two years.
Ignoring any gains from appreciation or loan pay-down, you made
$8,000 on the $28,000 you have invested - not too bad for two
years. Now just do another lease option.
If they do buy the home, you have avoided the necessity of
paying a real estate sale's commission. That cuts your costs
down. Here's how it works out:
Sales price : + $220,000
Initial costs, including closing cleaning and purchase price:
- $190,000
Positive cash flow: + $6,000
Equity gain from loan pay-down: + $3,500
Costs associated with selling: - $3,500
Option fee: + $2,000
Application of option fee and rent credit to purchase price:
- $12,800
Total profit: $25,200
(On a cash investment of $28,000.)
Notice that the buyers have a $12,800 credit towards the down
payment ($2,000 fee and the rent credit - 24 months times $450).
Not many buyers would have saved that much in two years. This
is part of the reason that lease options are so attractive. As
for the price, if they had rented for two years and saved for
the down payment, the home might cost $230,000 by the time they
were ready to buy.
To review:
Advantages:
You generally get to collect higher rent, and sell at a higher
price with a lease option, and if the buyer doesn't exercise
the option you may be able to keep the deposit and sell the home
for even more.
Disadvantages:
Bookkeeping can tricky, and many tenants don't complete the
purchase (this can be an advantage actually, but it does mean
more work for you).
Steve
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