Lease Options: A Viable Investment Strategy in Today's Market

By Rich Schiffer, REALTOR, e-PRO

A couple of years ago, a client who was going through a divorce asked me to look for properties she could "rent to own." 

At that time, the market was just beginning to shift in our area.  Sellers were selling, and Landlords were Landlording.  Very rarely did the two types overlap.  Some agents would even categorize "rent to own" transactions in the same category as Santa Claus - something some people think exists, but is really just imaginary.

In that market, rent-to-own might have well been imaginary.  I could not find the right situation for her, and she ended up moving in with her mother.

Now, nearly 2 years later, the market has shifted.  Many properties are staying on the market much longer than in the past, and many people that would have been buyers back then, are finding themselves forced to rent for a while longer, till their credit scores meet today's tougher standards.

This is exactly the market conditions where a Lease Option makes sense - for both the tenant/buyer and the landlord/seller, creating a potential for a real WIN-WIN situation.

Here's the scenario:

• Agent is working with Client A that has insufficient credit to qualify for a mortgage, but has decent income and moderate savings.
• Client A applies to rent a property, but is denied by landlord because their low credit score represents an uncomfortable risk level.
• Agent is also working with Client B who wants to invest in real estate.
• Agent creates a win-win situation, by finding a property that the investor could purchase and rent to Client A
• Agent looks for properties that listed for sale which meet Client A's needs.  Client B might even attend the showing, also.
• Client A agrees to rent the property from Client B, contingent on Client B purchasing the property.
• Client B agrees to sell the property to Client A, contingent on Client A purchasing an "Option" and agreeing to a monthly option fees, in addition to the monthly rents.
• Client A and Client B negotiate terms - of the lease, and the potential re-sale down the road.
• Client B negotiates sale terms with the Seller.  If no agreement is reached, the Option money from Client A is returned.
• Client B settles on the property.  Client A settles in the property.
• After the agreed lease term, Client A has the option to purchase the property from Client B, at the pre-negotiated Price.

Here's how the numbers might work:

Purchase Price of Home:	$160,000.00
Advance Option fee from Client A:	$3,200.00	(2% of purchase price for example)
Cash From Seller	$16,000.00	(10% down-payment)
Mortgage Amount	$144,000.00	(90% LTV in this example)
Interest Rate	7.50%
Monthly Principal & Interest Payment	$1,000.00	(estimated)
Monthly Expenses	$300.00	(Taxes, Insurance)
Monthly Rent	$1400.00
Monthly Option Fee	$100.00
Pre-negotiated Resale Price	$166,400.00	(4% appreciation, in this example)

If Tenant exercises the Option, and purchases at the end of the year: 

Purchase Price of Home:	$166,400.00
Total Option fees applied:	$4,400.00
Additional Cash from Tenant/Buyer	$11,800.00	(Option + Cash = 10% down)
Mortgage Amount	$ 149,760.00	(90% LTV in this example)
Interest Rate	6.50%	(estimated, of course)
Monthly Principal & Interest Payment	$950.00	(estimated)
Monthly Expenses	$300.00	(Taxes, Insurance)
Buyers new Monthly Payment	$1250.00

The Landlord's Cash on Cash Profit:

Cash out at purchase	$16,000.00
Annualized Cashflow	$1,200.00
Equity at Resale:	$22,400.00
Gross Profit	$7,600.00
Marketing Fee paid to Agent's Broker	$1,400.00	(one month rent)
Transaction Fee Paid to Agent's Broker	$2,000.00	(broker fee, pre-negotiated)
Net Profit	$4,200.00
Return on Investment	26.25%

If the tenant does not exercise the purchase option, the Landlord pockets the $4,400 in option fees collected, making his Gross profit $5,600, with no Transaction Fee to the Broker, keeping his ROI the same.  In this case, I intentionally set it up that way, to reduce the landlord's temptation to attempt to influence the tenant's choice whether to excersize their purchase option.

So, in this situation,

• Client B stands to make over 25% on his investment.
• Client A gets a place live when other landlords turned them away, and potentially a home of their own. 
• The original seller got what they wanted (their house sold),
• The Agent's Brokerage gets paid for 2 or three transactions.
  • Initial Sale ($4,800 co-op fee, for example)
  • Rental placement ($1,400)
  • Potential Resale transaction ($2,000)

In effect, this goes beyond a WIN-WIN situation.  All four parties involved benefitted from this type of transaction, making this a WIN-WIN-WIN-WIN situation.

So...Yes, there is a Santa Claus.

There is also a Risk Clause:

Every situation will be different, and each potential property being considered for a transaction like this must be evaluated in the light of local conditions, market rents, and projected appreciation.  Not every transaction will go as projected, and investors need to know that as with any investment, there is a chance that you could lose money on a deal like this if market conditions change for the worse.  The advantage to the Lease-Option is that the added payments from the Tenant/Buyer serve as a hedge against some of that risk.

Before jumping headlong into this type of transaction, agents should be warned:  The required language of the contracts used to set up the Lease Option will vary from state to state.  You should of course consult an attorney to ensure that the specific contracts you use meet your state's requirements.

 

Rich Schiffer is a Realtor serving Investors, Tenants, and Homebuyers in Delaware County, PA.

HOAs-Are They For You?

My First Post to AR-Hello Everybody!