Real Estate Lease Option Pros and Cons for Both Landlords and Tenants – Videos 1 & 2
Video 1 Transcript
Kathy Fettke: All right, you might be saying, “Well, I don’t want to do any of it,” but before you go there let’s talk about the benefits of getting a lease option for the landlord.
First off, the tenant will feel a pride of ownership most likely in the property because they’re hoping to buy it someday. That’s the idea. Hopefully, they take better care of your property, yes, first. Second, the tenant-buyer pays a non-refundable option fee. It’s not a deposit like they put if they were renting, it’s non-refundable and it’s 3% to 5% of purchase price, so whether they can exercise the option or not, they have to pay you this option fee and that can really increase cash flow.
In addition to that, the tenant-buyer tends to pay a higher monthly payment, higher than regular lease payments because in some contracts, if you write it this way, a portion of the payment goes towards the eventual purchase price. Let’s say that the normal market rents are $1,000 you might charge your tenant $1100 with $100 or $200 going towards the purchase price. This works out well for the tenant, which I’ll talk about later why they would want to do that.
Now, some lease-options require the tenant-buyer take care of repairs and maintenance as if it were their own home. This is just another way to really increase your cash flow by writing this up in the contract.
Then, if they do eventually exercise their option and purchase the property, the sales fees would be lower for you most likely unless you’ve made a different arrangement because you already have the buyer in place and you already have the sales contract in place. You’re not maybe necessarily paying that 6% unless an agent drafted this for you and wants their fees.
Again, be careful of that because sometimes agents draft these lease options, pulling them down from the internet, from some legal site, and as you can see, as I’ve already said, you don’t want to do that. You want to make sure a really good attorney has reviewed your lease option.
The risks of a lease option to the landlord- I already went over this but I’m going to emphasize it again- the tenant-buyer could be late on payments. This could result in eviction costs, turn-over costs and vacancy.
In states where it wouldn’t necessarily be a foreclosure but if they stopped paying you still have to a victim them– Well, it’s just like any rental property you would face fees for that but it’s a lot cheaper and faster to evict, so lease options can be great options for the landlord in states that don’t treat them like a sale.
In the case of default, the landlord may have to foreclose rather than evict. This is a huge risk. Again, make sure you understand the state laws. That’s why we’re here at RealWealth because we help you understand those different state laws.
Market fluctuations could be in your favor or not depending on how you drafted the contract. Let’s just say that you sold a property on contract in a lease option and the value of that property went way up during the option period and now, you’re giving a bunch of equity away. That’s great for the tenant, maybe not so great for you. You got to be really careful in understanding where you think the markets going to go. That’s why, in most cases, it’s better for you as the landlord to have a higher option price.
It shouldn’t be too high, and I’ll explain why later, but it needs to account for potential appreciation and something legitimate. You can’t just say, “I’m just going to go 15% or 10% because it has–” I mean, that’s not accurate, but 6%, 5%, that would be pretty averages. If you just look at the average of the area where the property is, I think that would be legit and that way, if it doesn’t pan out and it ends up not appreciating, well, the tenant-buyer doesn’t have to buy it if they don’t like the price or they can come back and negotiate it. It doesn’t hurt the tenant really to offer a higher option price, but it could hurt you if values go way up and now the property is worth much more and you’re leaving money on the table.
All right. Some states have very strict lease option laws or don’t allow them at all. Again, this is why you need to talk to somebody with experience. Texas would be one of those places. Very, very strict new laws because so many investors and landlords were offering these lease options and taking all these fees, the option fee, and raising the lease payments and having the tenant-buyer pay for maintenance but all the while knowing they never stand a chance of ever buying that property and that they’re just going to lose all that. Some states are really, really protecting the consumer and you don’t want to get in trouble for hurting consumers for sure.
When you sell property to investors, there aren’t so many laws protecting investors, but when you sell property to a consumer, very, very different. There are consumer protection laws that you may or may not know about, so you need to know about them.
Video 2 Transcript
Kathy Fettke: What are the benefits of a lease option to the tenant? The tenant can lock in an option price while cleaning up their credit, saving for a down payment, paying off debt, or establishing a two-year work history. As you can see, some people may be not in a position to purchase a property, but they like your property, and they want it, and they fear that prices will go up. They just want to lock it in. That gives them time, it basically just buys them time to get the money they need, and clean up the credit and all that. It can be a really great benefit in that regard.
Of course, lease payments can be credited towards the purchase price, reducing the purchase amount. This is really great for people who just have a hard time saving money. Things come up. If they’re bound to this contract, they’re forced to save money for that down payment. Again, that can be really great, especially if it’s a three-year lease option, by then, they should have reduced the purchase amount fairly substantially.
Tenants can also lease option the property, fix it up and then resell it for a profit before the lease option expires. This is something that a lot of investors do. It, again, can be a very lucrative way to tie up the property, not have to get a loan because you’ve just lease optioned it and now you’re just renting it. That would be the loan payment, you don’t have to qualify for a loan.
You do what you do, and fix up the property and sell it when it’s time for you to exercise your option. That again, can be a great opportunity. It’s actually something we did at RealWealth just recently. We didn’t do it recently, but people got paid out on it recently. We did more of a commercial deal where we lease optioned a commercial building in Dublin, California. The option price was 10 million, we had a couple of years on that term. We only had to put an option fee of $1.2 million. Now, that’s again, nonrefundable. It’s a little scary, but on big deals like that. We paid a $1.2 million option fee, tied up the property at 10 million.
This was back in a few years ago when land prices and prices hadn’t gone up yet. We really believed that they would. We felt safe in this situation, we knew that the city of Dublin wanted residential housing in that area and that they would be okay with re-entitling. That was our plan. During the option timeframe, we re-entitled that land and turned it into residential lots, tearing down that old commercial building. We were able to find actually, four national builders wanted to buy those lots for $20 million. Remember, we tied up the property for 10 million. Here’s an example where that seller did not know it was happening.
They didn’t realize that prices were going to go back up. Because when prices are down, people think that they’re going to stay down. When prices are up, people think they’re going to stay up. That’s why you always got to understand market cycles. In this case, we really knew what was happening in that part of Dublin, that it was being completely rezoned to be the new downtown and that there would be a huge upside, and of course, there was. The investors in that deal, just got their cheque this week. They’re going to be really happy when they receive it because that was really a great deal.
This can be done on a much smaller scale. Let’s say, you find $100,000 property, you lease option it and pay $3,000 to $5,000 for that option fee and maybe you have a two year period where you can buy it, you can just rent that property and fix it up or lease it out, lease it out and fix it up, increase the value and sell it hopefully for a profit, for more than the option price. Those are some of the benefits.
What are the risks of a lease option for the tenant? If you end up not being able to fulfill the purchase, if you can’t come up with the money or you can’t sell it or you don’t know what to do with it, you can lose that non-refundable option fee, you can lose all the money that you paid and higher lease payments for that down payment. If you made any repairs, those aren’t reimbursed. You can lose a lot of money if you don’t do it right.
With the Dublin deal, that would have been terrifying. What if all of a sudden, the city of Dublin decided they didn’t want to re-entitle it? We had a couple of backup plans for that. We would just improve the commercial building. It was old and resell it as an improved building. We obviously, had a backup plan with those kinds of dollars, but a lot of people don’t.
You need to to be aware that if you cannot fulfill the option, you’re going to lose a bunch of money that you invested in that property because you’re not going to be able to buy it. You’re just going to have to renew. You have a couple of choices. You can renew your option if the landlord lets you, or you could try to sell the property to someone else who will pay that fee but if you don’t, then you lose the money you invested.
In the case of the landlord defaulting, this is something you don’t really think about but in the last six years, there were a lot of real estate investors who couldn’t make their payments and just defaulted on the property but meanwhile, they were collecting rents from the tenants living in those properties. The landlord may be not paying their bills but the tenant is. The property gets foreclosed and the tenant loses their position and all the money they invested. This was prevalent over the great recession, for the last six years. There were a lot of attorneys out there helping tenants.
I don’t think we’re going to see much of that in this coming phase, but it’s certainly, something to be aware of. Make sure you have a way of knowing if the taxes, insurance, and bills are being paid, certainly the mortgage by the landlord.
Informal contracts; this is a huge risk. A handshake, a lousy contract that isn’t really protecting you, too many people just trust other people. I have been guilty in the past and I no longer do that. I trust but verify with somebody who really specializes in whatever it is I’m trying to do. Don’t do these deals with a handshake, no oral agreements, it’s not going to hold up in court, an email, not so much. Have a solid contract. I’ll talk about some of the things you need to have in there in just a minute.
Of course, like I already said, the value of the property could decrease. The landlord might decide, “I don’t really want to lower the price. If you want this property you’ve got to pay the higher price”. Once again, here you are having invested all this money but you would have to put more money on the table to close on the property and that would be a bummer. Don’t over pay for the property in these lease options deals. Make sure you’re getting market value or better yet under market value.