What is a Lease Option in Real Estate?- Video
Kathy Fettke: Good afternoon and welcome to the RealWealth’s weekly webinar. I’m Kathy Fettke, CEO of RealWealth and very happy to have you here. On today’s webinar, we’re going to talk about the pros and cons of lease options. There are both good things and things to be aware of. Please note that as always the strategies that we mention here in our presentations may not be appropriate for everyone so always consult with your accountant, your tax adviser and/or attorney to discuss your specific situation.
Of course, past performance is no guarantee of future results. Real estate purchases are subject to investment risks including the possible loss of amounts invested and while every effort is made to maintain accurate and current information, the possibility of errors and/or updates always exist.
That, of course, is what our attorneys want us to say and what I want to say is please just always check in with us because markets are changing, properties are changing and we want you to check in with us at RealWealth. Just between you and me, I don’t know if we have any property teams listening, but sometimes their markets change and they don’t know it yet, but we do or they might be moving into a new area of their market. We just think it’s always best practice to check in with your investment counselor at RealWealth before making any purchase through any of our network property teams.
Also, always get your inspections and appraisals because even with the greatest intentions, there might be things that get missed and if you get that inspection from a third-party inspector, they may find things that will get fixed for you before you close on the property, or at least it can be negotiated with the seller.
All right, so lease options. Hey listen, lease options have been used by real estate investors for decades as creative ways to buy, sell, lease or flip property. However, these contracts can become a legal and financial nightmare for either the buyer or the seller if they’re not done right. I’m about to tell you why. These are really important things. We don’t call our company RealWealth for no reason, this is real. This is real, this just happened to me in a different kind of structure, not a lease option, but a lot of what I’m sharing with you today is from personal experience and a lot of my personal experience I want to share with you so that you learn from the good stuff and avoid the bad stuff..
All right, let’s see. Let’s just start with what a lease option is because sometimes there’s confusion about that. It’s just simply giving someone the option to purchase a property that they’re leasing at the end of a specified rental period.
The lease option gives the tenant the right to purchase the property at a later date for a set price but there is no obligation just the option. It costs money in order to enforce this option according to the law. You need to pay some kind of non-refundable option fee as the tenant and that will enforce this contract. It’s usually about 3% to 5% of the purchase price, but I’ve done deals where it was just a dollar simply to enforce that contract.
Once you’ve got that option, what would be clarified in the option is the potential purchase price of the property that you want to buy. That needs to be specified or you may want to just base the purchase price on the future appraised value of that property at the time that the option is exercised. Which is usually in one to three years, so obviously as a tenant, you’d be better off negotiating a fairly low price in an area where there might be high appreciation. That’s what we’ve done in some of our deals because you may know that the area’s appreciating, but the seller or landlord might not, so trying to lock it in can be great.
If you don’t know and you think maybe prices will remain flat or even decline, then hey, why not just base it on the future appraised value.
This is very different from a lease purchase. We did some lease purchase deals in Atlanta with our network and there was some confusion how it was different from a lease option. Basically, the difference is pretty simple. It’s a bilateral or two-way agreement and is binding for both the seller and the buyer. As I said earlier, the lease option is only binding for the seller, for the landlord. The buyer can just decide whether or not they want to enforce that option.
With a lease purchase, it’s an agreement. It’s a contract and it’s basically a done deal once you sign it. Some states treat these lease purchases as a transfer of ownership even if the contract is not recorded and the tenant buyer is not yet on Title.
This is really important for you to understand because a lot of sellers don’t understand this piece of it. They might tell you that, “Hey, if your tenant doesn’t pay, you can just evict them,” but that may not be the case. You may have to do something else that’s a lot harder which I’m going to talk about in a minute, right here.
In the case of default, let’s say you’re the landlord and you’ve got a lease purchase with a tenant buyer and that tenant buyer doesn’t pay you, then you might have to foreclose rather than evict the tenant buyer even if they’re not on Title. It just depends on the state. Unfortunately for you and great for the tenant, during that process, the tenant buyer could actually live there for a long time without making payments if you’re in a judicial state because it takes forever to foreclose in a judicial state.
That’s why I’m constantly saying judicial states are a great place to buy because they haven’t really worked through their foreclosure for this reason. It’s not a great place to hold a note or to hold a lease option or lease purchase, because again, if a tenant buyer has a good attorney, they could potentially argue that the contract wasn’t even valid or was done incorrectly. In these judicial states you better make sure you’ve got a solid contract that’s been approved by a very, very good attorney who understand these things.
You might say, “Well, I don’t want to do a lease purchase then. I’ll stick with lease option so that I don’t have to foreclose,” but this is the tricky part. It’s imperative that you understand the local state laws before entering any purchase/sale agreement and have a knowledgeable attorney who specializes in real estate and particularly these lease options. Make sure they’re the one’s drafting the contract because some states treat lease options the same as lease purchases and that again is a big surprise for investors who find out later, “Wow, I was just going to evict this person and now I have to foreclose and I can’t.” Or, “It’s taking me forever.” Or, “It’s expensive.” This is so important, and again, not many people know about it.