The Benefits of Lease Options

The benefits of lease options are huge for real estate investors. You can use lease options to buy and sell real estate, especially during difficult housing market conditions.

1. No Credit

You usually don’t need good credit to purchase real estate through lease options. This means no bank qualifying and no mortgage application.

2.         No or Little Cash

You don’t need cash other than for the option fee and the monthly rental.

The option fee can be negotiated down to very little. In addition, if you are doing a sandwich lease option you can usually use the tenant’s cash to pay the owner the option fee and the monthly rent.

3.         No or Little Risk

Using lease options is a huge risk mitigation tool. There are two areas where you pass the risk on to someone else.

The first area is the risk associated with buying the property. The great thing about an option is that you have a choice as to whether you will exercise the option to purchase.

Let’s use an example of a house that you lease option for a three year period. At the time you entered into the lease option agreement the house was worth $200,000 and you set the option price at $200,000. The local market had seen significant appreciation and the value of the house is now $235,000.  If your option price is substantially lower than the value of the property at the end of the option period you will probably exercise the option, right?. Why? Because you are going to make a nice profit.

However, lets say that the market has been very soft and the value of the home had not appreciated and was still only worth around $200,000. In this case you probably wouldn’t exercise the option to purchase the property.

Or lets say that you tenant buyer is unable or unwilling to buy the property from you. Instead of exercising the option to purchase the property and risking finding a new tenant or lease option tenant you can simply give control of the property back to the owner.

The main point here is that you got the opportunity to wait and see how the local property market would perform. This is huge risk mitigation as you don’t need to peer into a crystal ball and guess the future.

The second area of no or little risk is that you have not burdened yourself with a mortgage and the accompanying loan agreement and promissory note. If the deal is not a good one you can simply walk away with out any attached liability. The liability for the loan repayment remains with the owner.

4.         Rent is usually cheaper than a mortgage

 As a general rule it is usually cheaper to rent a property than to own a property.

Non owner occupied or investor home loans are not cheap. Obviously the higher the interest rate on the loan the higher the monthly repayments you will be obliged to make to the lender. This is one reason why it is usually cheaper to rent than own.

When you lease option the property you get the appreciation benefit of owning the property but you get to do it at the cost of the rental, which is lower than the mortgage. This is a huge saving and is critical to helping you build a solid and stable real estate portfolio. 

A good example of this is my Colorado Springs property. My home loan PITI costs me $1,622 per month but the market rate of rent in the area is only $1,300. By owning the property it costs me $322 more per month to control the property. Imagine I lease optioned the property I could have enjoyed all the benefits of controlling the property with out the additional $322 monthly cost of ownership or the approximately $7,000 closing costs.

5.         You can Earn Immediate Cash  

Lease options are a great way to generate cash. When you sell on a lease option you can get cash from three main areas – the option fee, the monthly rent and the option price. You can all of this with very little risk or cost on your part.

You can also use the positive cash flow to reinvest in other deals that may be more speculative or focused on appreciation. 

6.         You Can be the Cash Flow King 

Lease options are a fantastic cash flow tool. 

In a normal lease agreement without an option to buy, the tenant simply pays rent. In a lease option there are three addition areas for an investor to receive additional cash from the tenant. 

There are three main areas where an investor will get cash are: 

• 1. Lease Option Fee. The tenant will pay the investor an upfront lease option fee at the time of signing the lease option agreement. The important term here is the word “fee”. A fee is not a deposit. It is deemed to be earned at the time it is paid and, unlike a deposit, may be immediately used by the investor. If the lease option payment was a deposit it would be placed in escrow and could not be used by the investor. The fee is basically free cash.
• Most of my lease options have been done in a soft rental market. A soft rental market makes it very difficult to cash flow rentals. In a soft rental market the lease option fee is very important as it helps to compensate for negative cash flow.

 Here is an example of how the lease option fee can help combat negative cash flow.

I purchased a single family home for $242,000. I put 10% down and have a first mortgage of $218,000. My monthly mortgage payment, including PITI, is $1,622. 

I put a lease option tenant into the house the day after I closed. The tenant paid me an option fee of $3 000 for a one year lease option and pays rent of $1 300. The tenant is responsible for utilities, water and HOA fees.

On the surface it would appear that I have a negative cash of $322 per month. This is not the case as I can apply the $3,000 to compensate for the negative cash flow. The lease option is for 12 months, so if you divide $3,000 by 12 you get a monthly amount of $250 that can be applied towards the monthly cash flow. This means that I only have negative cash flow of $72. You can see how the lease option fee helps to mitigate negative cash flow. 

• 2. Rent Credit. I use rent credit as a tool to get more monthly cash from my tenants. Rent credit works as follows. The tenant pays a monthly rent normally equivalent to the market rate for the area. Then, in addition to the rent, I charge my tenants an additional amount that is credited back to the tenant at closing.

In the example above my tenant pays rent of $1,300 per month which is the going rate for the area. However, our agreement states that the tenant will pay rent of $1,500 per month.

In return for paying an additional $200 per month I credit the tenant with $200 towards the purchase price of the property. This means that after one year the tenant has a credit of $2,400 towards the purchase price of the property. 

The importance of this is that the additional rent helps my cash flow. Instead of having $72 in negative cash flow every month I now have $138 in positive cash flow every month. 

• 3. Equity at Sale. If the tenant exercises the option and closes on the house you will make a profit being the difference between the price you paid for the house and the price you sold the house.  

Option Price to Investor:                                      $195,000

Option Price to Tenant Buyer:                              $225,000

Gross Margin to Investor after 12 months:           $  30,000

One of my investors has a simple system whereby he likes to sandwich lease option two houses per month on a one year lease option so that, in theory, every twelve months he gets paid out on the sale of two houses. This amounts to roughly fifty thousand dollars per month every month. 

As long as he sandwich lease options with positive cash flow he is able to continue to buy two houses a month every month. 

I use the words in theory because it presumes positive cash flow, no vacancies and buyers who exercise their option. In reality this never happens because there are always problems with tenants, toilets and deals not closing.