Lease Options, or Rent-To-Own, programs are becoming very popular.
They provide benefits of a regular leased, or rental, property
along with some upfront cash and an almost guarenteed exit strategy.
The tenants are usually "better" because they have a
stake in the property and plan to buy it out in 2-4 years.
When you are working with buyers who may not have much experience
with real estate, it's important to put them at ease. This means
avoiding complicated jargon. For an investor, a term like lease
option rolls off the tongue like honey. But for some retail buyers,
such a term can seem complicated and intimidating.
When you talk to buyers, instead of using terms like lease option,
lease purchase option, or sandwich lease, say rent to own. Thanks
to all those rent-to-own furniture stores that have cropped up
over the years, people understand the concept of rent to own far
better than they do a lease option, even though they are essentially
the same thing.
Negotiating Points
Most lease option buyers either haven't seriously considered making the
jump from renting to buying, or have had a hard time qualifying for
a loan with a high enough LTV to make it possible to buy without a
large down payment. When negotiating with a lease option buyer, it's
important to emphasize the flexibility and easy terms you have to offer,
so the higher price you're asking doesn't become an issue. When you
buy a new car, you usually get to test drive the car to determine if
it's a good fit for you. When you buy a house, this isn't usually the
case.
Not so with a lease option! You're willing to let the tenant-buyers try
on the house for up to 36 months to make sure they really like it. You're
going to let them rent to own with a much smaller down payment than they
would have to come up with to buy the house. You are giving them time
to improve their credit to qualify for a low-interest loan from a lender.
You'll let them in, even with their blemished credit, and they won't
have to wait 30 to 60 days to close; they get to move in right away!
Here are the terms.
Long lease term. The longer the lease
term you can negotiate with your buyer, the
more money you will make on the deal. Shoot
for two to three years if possible, one year
minimum. If they want to stay longer, offer
to consider a one-year extension (for a fee)
if they have taken care of the property and
paid the rent on time.
Sell for future value. When selling a property on a lease option, figure
the property's future value at the end of the lease. You can get the
percentage of appreciation for the neighborhood from a local realtor.
Let's say, for example, that the property is currently valued at $120,000,
and the neighborhood has been appreciating at a rate of 7% over the last
three years.
Adding 7% to the value of the property for each year the property is
leased will give you the potential future value. On the house above,
a one-year option would mean that you could sell the house for $128,400.
At the end of year two, the house would be worth about $137,388 ($128,400
+ 7% = $137,388). By year three, assuming the same level of appreciation,
the same house would likely be valued at $147,005 ($137,388 + 7% = $147,005).
On a three-year lease, your asking price could be as much as $147,000.
If you want to give your buyer a great deal in order to sell more quickly,
you could lower your asking price to $139,000 and still make an $18,000
profit. And that's not counting the option fee or the spread on the monthly
payments.
Rent amount. The amount you charge
for rent should be around 20% higher (or more)
than the amount you are paying to each month.
It is up to you how much, if any, of on-time
payments go toward the purchase price. I think
that 10% to 25% is fair.
Option consideration. The amount to charge depends on your goals with
the property. You may or may not want the tenant-buyer to purchase the
property at the end of the lease.
For example, you may want that lump sum payoff at the end of the lease
term. In that case, I would charge as much as possible as an option fee,
and allow a higher percentage of on-time payments to go toward the purchase
price. The reason for this is that the more money the tenant-buyer has
invested in the property, the more likely he or she will purchase it
in the end. It's hard to walk away from a property when you have a lot
of money in it.
On the other hand, you may want to hold the property longer than three
years for the capital appreciation and long-term cash flow, but don't
want the headaches of a traditional renter. There are a couple of things
that you can do to encourage the tenant-buyer not to exercise his or
her option to buy at the end of the lease period.
- Low option consideration. Charge a lower option consideration
so that they feel better about walking away from the house at
the end of the lease period (1% to 2% of the purchase price is
about right).
- Smaller portion of on-time rent payments applied toward purchase
price. If only 10% of the monthly payment goes toward the purchase
price, they have far less money invested in the property over
the course of the lease period. They won't feel as bad about
not exercising the option with such a small amount invested.
- Refund some of the option consideration if they walk away.
Offer to refund some of the option consideration if they choose
not to exercise the option to buy at the end of the lease. This
may actually encourage them to leave, opening up the property
so that you can find another tenant-buyer and lease option the
property again for several more years. Imagine your accumulated
cash flow and capital appreciation after two consecutive three-year
option periods compared with just one!
Legal Considerations
Lease options offer significant benefits over conventional rentals or
purchase for both buyers and sellers. But just because you are lease
optioning property to tenant-buyers instead of renting it out the old
fashioned way doesn't mean that you are off the hook for following
your state's landlord and tenant law. A detailed discussion of landlord
and tenant law is beyond the scope of this lesson. However, I would
like to touch on a couple of important points for you to keep in mind
as you pursue lease options.
Discrimination. There
are very strict laws regarding
housing discrimination. Even
the appearance of intent to discriminate
can have serious consequences.
Asking certain questions to a
potential tenant can get you
sued in a hurry.
The Civil Rights Act of 1968 makes it illegal to discriminate on the
basis of race, sex, religion, or nationality in the rental of real property
(United States Code [U.S.C.] Title 42, Section 3601-17). Asking anything
of a potential tenant that relates to any of these issues can result
in a civil action whereby the tenant can sue for damages both actual
and punitive. Subsequent amendments to the Civil Rights Act make it illegal
to discriminate against the handicapped or families with children. The
penalties for violating these laws can run into the tens of thousands
of dollars, so be careful.
Lead-based paint disclosure.
In 1996, the Environmental Protection
Agency began requiring that tenants
be given notices regarding the
potential dangers of lead-based
paint in rental units built after
1978. You're required to give
the pamphlet Protect Your Family
From Lead in Your Home to all
tenants of residential rentals
with at least one bedroom. In
this lesson's Supplementary Material
section, you'll find a link to
the Web site where you can download
this information.
You're required to give the pamphlet and lead disclosure form to tenants
of the above type of units even if lead paint was never used in the unit.
State laws. There are various state laws pertaining to evictions, late
rent, security deposits, maintenance, liability, asbestos, and the like.
These laws vary from state to state, so it would be wise for any property
owner charging rent to a tenant to consult his or her state's landlord
and tenant laws to ensure compliance. Your local library should have
this information readily available. There are also many local landlord
associations throughout the country that may be of help.
Disclaimer.
The foregoing is not intended
to be given as legal, financial,
or tax advice, but is intended
for instructional use only. If
you require legal, financial,
or tax advice, you should seek
the assistance of a qualified
professional.
Summary
Lease options are a terrific alternative to conventional renting. The
advantages for sellers include no maintenance headaches, a higher sales
price, higher quality tenants, the ability to make money with an option
fee, a higher-than-market rent amount, and a higher back-end sales price.
For retail buyers, advantages of lease options include getting to "test
drive" the property and the neighborhood before deciding to buy.
The lease period affords them the time needed to clean up their credit
and qualify for a bank loan by the end of the option period. With little
cash needed out of pocket and a good credit record not necessary, lease
options make home ownership possible for those who would otherwise be
unable to own a home.
When you buy on a lease option, you want to buy for the current market
value or less, and sell for the future value of the property at the end
of the lease period. You also can collect an option fee and higher monthly
payments than you are paying to your seller. Only commit to the deal
when you have a buyer ready to buy from you. When you buy, agree only
to a month-to-month lease. When you sell, negotiate a one-to-three-year
lease for more than you paid for the property. Avoid complicated jargon
when speaking with your buyers. Set them at ease by using terms such
as rent to own instead of lease option.
There are landlord
and tenant laws on both the federal
and state levels that must be
followed
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