Lease Options
In order to understand how lease options work there are a couple of basic definitions that should be addressed:
- LEASE: gives a tenant (or renter) the exclusive use of property for a specific period of time.
- OPTION: gives the right, not the obligation, to buy a specific property, at a specific price, on or before a specific date.
This is a way that you can help rescue a person from near financial ruin and make a profit. A lease option is often a good arrangement for a potential home buyer because it lets him move into a house he may potentially buy without having to come up with a down payment or financing at that time.
Here is a scenario to show how the process can work:
A homeowner puts her home up for sale because she is moving to another part of the country. She is asking $150,000 for the property. The home sits on the market for months until finally she is approached by a couple presenting a unique offer. The offer is $3,500 for the option to buy the home from her for the full price of $150,000 within the next 24 months. In the meantime the couple will rent the home from her, covering her mortgage plus a little cash flow until the property is finally purchased outright by the couple.
The seller needs to move and the home, which has sat on the market for months, is costing her money every month. The homeowner decides to accept this offer for a couple of reasons:
- The tenant/buyers are coming in with $3,500 plus first and last months rent of $1,000 per month. Their $5,500 is significantly more than a traditional tenant has available, adding financial protection for the seller in this transaction.
- If the option is exercised, the seller would get top dollar for the home because she will receive the full $150,000 (which she expected to negotiate) plus the $3,500 option payment AND does not have to pay a real estate commission on the sale. Up front this saves and ultimately makes her THOUSANDS more!
- The tenants' ultimate goal is to buy the home. They have a vested interest in the property because their option fee. This means that they are more likely to take excellent care of the property.
- If the tenant/buyers cannot exercise their option to purchase, the seller gets to keep the equity increase during the two years of the lease option term while the tenants occupy the home. This is due to appreciation. She also gets to keep the option payment and enjoy the tax benefits of ownership during that time period. She can then sell the property for a greater gain OR offer to lease option it to another prospective tenant/buyer.
For an IRA that is sizable enough to buy a home in its entirety, this is a tremendous way for the IRA to protect itself from the hazards of rental real estate. There are many benefits to holding lease options inside your IRA. Like tax liens, sub-lease options offer a wonderful alternative to the stock market for investors with smaller retirement accounts.
Sub-Lease Options
A rental agreement or lease between a tenant and a new tenant (called a sub-lessee) who will either share the rental or take over from the first tenant. The sub-lessee pays rent directly to the tenant. The tenant is still completely responsible to the landlord for the rent and for any damage, including that caused by the sub-lessee. Most landlords prohibit subleases unless they have given prior written consent.
A sub-lease allows an investor or IRA to obtain the option, or right to buy a property, and then rent or lease it to another party (often referred to as lease option sandwich). Many sellers are willing to offer this type of sub-lease because they need to move quickly or are financially burdened. In this way, sub-lease options can create win-win situations for the seller and IRA investor. Here's an example to help clarify:
While reading through the local discount newspaper you come across an advertisement that says – "NEED TO SELL TO AVOID FORECLOSURE. BRING ALL OFFERS!" So you place a call to this seemingly motivated seller and discover that this single parent lost his job and is on the verge of losing his home. Above all he does not want to go into foreclosure, which would complicate buying a home in the future.
This seller is willing to sell for what he owes on the property. Four years prior, he purchased the home for $148,000 which he paid down to $140,000 during that time period. The payments on the property are $1,050 per month and he is behind $3,450 (three months' rent and $300 in late fees). Essentially he needs the mortgage balance ($140,000), his back payments ($3450) and excise tax for the transfer of title ($2,520 at 1.8%) paid in order to get out from under the overwhelming debt.
In the last four years, homes in that area have appreciated at a rate of 6% per year. This means that the home he originally purchased for $148,000 is now worth approximately $185,000. Upon a quick walk through the home, you decide to offer this man $148,000 for the home. The offer is to have your IRA make up his back payments of $3,450 and rent the home from him for the next five years; at which time you will cash him out. This will net him over $5,000 when your IRA purchases the home (back payments and the mortgage reduction over the lease period). The key is that he will not get paid until your IRA does AND he has to sign over a deed of trust to the property to protect your investment. It is also crucial that you be given the ability to sub-lease the property.
Shortly after having the deed signed over to you and recording it with the county, you place an advertisement in the newspaper for a "Lease with the option to purchase. No bank financing required. Bad credit? OK!" The advertisement results in many calls. You are able to find a young family that you think would be perfect fit for the home.
The home is currently worth $185,000, which you are willing to sell the home for within the next two years. For that right (option), you are charging $5,000 which will be credited toward the purchase of the home should the tenant/buyers exercise their option. You are also asking $1,250 per month for the lease of the home. The buyers are able to come up with the $5,000 plus first and last months' rent. Your IRA has an immediate profit of $1,550 because you paid $3,450 to catch up the back payment for the previous owner and you took a $5,000 non-refundable option payment. You realize an instantaneous 44%, cash on cash return. It gets better yet! The tenant is going to pay $1,200 per month and you only owe $1,050 per month. That is a positive cash flow of $150 that your IRA realizes each and every month. If the tenant/buyers exercise their option to purchase, then the IRA would collect the net difference between the purchase price from the original seller at $148,000 and the sales price after the option credit of $180,000.
So why are so many investors enthusiastic about this sort of hypothetical investment? If the tenant/buyer did end up purchasing the property, your IRA would profit $37,150 on its original $3,450 investment or 1008% in just two years… tax deferred! What if they do not exercise their right to buy? Then you can do it again! You keep the option payment of $5,000 and the monthly cash flow of $3,600 ($150 over 24 months), and you can acquire another lease option tenant! You negotiated a five year option…..and then you sold a two year. That means you have 3 years left on your original deal. Also, if they don't exercise the option is it likely the home has appreciated another 6% over those two years? Probably! So the next time your IRA sells the option on that home, the new purchase price could be adjusted to $205,000.
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