Making Money with Lease Options

Modified from the original article first published at ControlYourCash.com 

Here’s what you need:

1. 20% of the price of a house, condo or townhome.
2. A few months’ worth of patience.

Welcome to the lucrative world of lease options. They’re a way to increase your wealth with almost zero downside.

lease option involves you buying a second home, renting it out, and giving the tenant the choice (or option, if you will) of buying the home once the lease expires. What makes the lease option so wonderful for the average landlord – correspondingly less so for the average tenant – is that you can charge above-market rates throughout the lease. After all, you’re doing the tenant the favor of letting her own the house after a year (or whichever term) expires. It’s like a layaway plan for what the hackneyed expression calls “the biggest investment you’ll ever make.” You let your tenant lock in a price for the house, essentially saying “You can buy the house for $x a year from now, regardless of what the market does. What’s a better deal than that?”

Meh…I don’t know. I’d have to charge an awful lot more than market rents to make it worth my while, if I’m going to have to surrender the asset within a year.

First, kudos for understanding that the house in question is an asset, and can help you grow your wealth regardless of what market conditions are doing.

My pleasure. You do realize that I’m not an actual person, and merely a device of your own creation that you use to clarify your thoughts, right? You’re talking to yourself.

Anyhow, you can typically charge at least 10% above market rent on a lease option. But that’s not really important. What’s important is this:

Most tenants never pick up the option. When the time comes for them to exercise it, it turns out they didn’t spend the previous year saving the requisite cash for a down payment. That’s one reason why they’re renting instead of owning in the first place. Renters, by and large, aren’t as bright as landlords. (Hopefully the smart-but-sensitive renters reading this can comprehend the phrase “by and large”.)

A lease option is similar to stock options, or commodity futures – you’re assuming market risk for the tenant. Real estate prices might rise 50% in the next year, but you’re offering the tenant a chance to lock in a price today. If your $100,000 house ends up being worth $150,000 a year from now, you, the landlord, will have forgone $50,000.

Of course prices could fall, too. Should they, even by just 1%, you’re protected. Obviously your tenant isn’t going to exercise an option to buy a $99,000 house for $100,000. Which means free money for you: you just received a year’s worth of premium rent payments that went well beyond covering your mortgage payments. That’s the ultimate hedge against a declining real estate market.

And if the market rises, rather than declines, you as the landlord still won’t necessarily get screwed. Again, the typical tenant doesn’t plan far ahead enough to take advantage of the lease-option. If the house does indeed rise in value 50%, and theoretically turns into an immediate $50,000 bonus for your tenant, she still needs to exercise the option. That isn’t easy. For an FHA loan, she’d need to put down 3 1/2% to buy the house from you. If she can’t put the necessary down payment on the house together once the lease expires, her opportunity will disappear and she’ll be back where she started, with no equity in a home and a rent payment due at the end of the month. (Actually, the tenant will be several steps behind where she started; now with 12 months of rent payments gone forever.)

Let’s see how this works in practice.

Say you buy this house for  $50,900 with 20% down. We’re assuming 20%, so you won’t have to pay mortgage insurance. With a 30-year fixed rate non-owner occupied mortgage at 5%, that means you’d be making monthly payments of $244.16. You find a tenant who wants to own a home one day, and offer her a lease-option. Once you do, there are two ways you can do this.

Get the lease-option money up front, or
Spread it over the course of the lease.

Let’s assume a 1-year lease, and that fair-market rent is $750 a month. That’s what you’d charge an ordinary tenant who has no intention of buying the place. That ordinary tenant would pay $1,500 up front (1st month’s rent + security deposit).

With a lease option, you could ask for an extra $750 payment up front, and let the security deposit apply to the down payment if the tenant exercises the option (which she probably won’t.) Now you get a total of $2,250 up front, $750 of which the tenant will never see again, after a year expires and she’s nowhere near amassing the down payment that would guarantee her the house.

Or instead of getting an additional $750 up front, you could just raise the monthly rent. Using our rule of thumb from above, of charging a 10% premium, that means you’d collect monthly rent payments of $825. Now you’re netting an extra $787 per year simply for getting the tenant to sign one additional piece of paper. Your cash-on-cash return goes from an impressive 15.29% to an astronomical 20.25%. Even better, your lease-option tenant is going to be a little more motivated than the average tenant to keep the place looking nice and in good repair. After all, the lease-option tenant hopes to own the place, and relatively shortly.

By the way, that $75 premium applies to the option only. Technically, it’s not even part of the rent even though you’re collecting it every month. If the tenant doesn’t exercise the option, you keep the premium payments.

Imagine test-driving a car for a year, and paying for the privilege.

Again, like in any deal, you’ve got to look at the potential downside: the tenant might be one of the responsible few who actually exercises the option. In this unlikely case, at the end of the lease you’d credit the tenant $1,650 (or $1,500, if we’re using our initial scenario of getting the lease-option money up front.) Now the tenant only has to scrounge up closing costs and qualify for an FHA loan to take title of the house.

And even if that does happen, you’ve still got a year’s worth of above-market profits to show for it. Plus, you won’t be obligated to your mortgage lender for the next 29 years. Then you can buy another house and do the same thing again.

Math, Math. (And only then, Location).

These are the (new) three most important words in real estate today.

In preparation for my class of the above name on Thursday, I scoured the Las Vegas Multiple Listing Service for residential resales to use as examples.  Here’s what I found:

Property 1:

3 bedrooms/3 baths, 1180 square feet in northeast Las Vegas just 4 miles from Nellis Air Force Base.
Seller is a bank or finance company.
List price is $50,900. Year built, 2007
Based on photos, the property is in good condition with artificial wood floors, clean carpet and new paint, but no appliances.
At list price with a 20% down payment, 6% in closing costs, $1800 for appliances and a 5% 30-year fixed loan, the property is estimated to cash flow at $2,221 before taxes.

If you could get the seller to discount the price to $46,800, the annual income jumps to $2,739.

Property 2:
3 bedrooms/3 baths, 1598 square feet in Henderson, Nevada, near the intersection of two auxiliary interstate highways.
This is a short sale.
List price is $79,900. Year built, 2001
Based on photos, the property is in good condition with carpeted floors throughout and all appliances.
At list price with a 20% down payment, 6% in closing costs and a 5% 30-year fixed loan, the property is estimated to cash flow at $3,941 before taxes.

I thought the list price was high so I also ran the numbers with a sales price of $69,900 (a 12.5% discount).  The reduced price brings in $4,456 before taxes.

Property 3:
3 bedrooms/2 baths in Henderson, Nevada within one of the top school zones in the county.
This is a short sale.
List price is $95,000. Year built 1985
Based on photos, the property is in fair condition.
At list price with 20% down payment, 6% in closing costs and a 5% 30-year fixed loan, the property is estimated to cash flow at $3,753 before taxes.

At $90,000, the property would cash flow $4,010.

An embarrassment of riches.  Each property flows positively.  Each would make a great investment. If you were investing, which property would you choose and why?

If you want to learn more about these properties and similar ones; how to calculate rates of return for real estate investments; and how to find, negotiate and close on great real estate deals, come to my class:

Thursday, October 20th, 2pm
Keller Williams Realty Las Vegas
3090 S. Durango #100 (at Sahara)
RSVP KMcMurray@KW.com

**This article is featured in theHow to Make Money with Real Estate Blog Carnival: December 1, 2011 Edition**

 

 

 

 

My 7 Links Project


Thanks to Financial Uproar, this link round-up is the perfect post to reintroduce my site.  I hope you enjoy these classic posts.

Your Most Beautiful Post:

In 2 parts:

Photo:

How often do you see this?

Text:

“We plan our lives according to a dream that came to us in our childhood, and we find that life alters our plans. And yet, at the end, from a rare height, we also see that our dream was our fate. It’s just that Providence had other ideas as to how we would get there. Destiny plans a different route, or turns the dream around, as if it were a riddle, and fulfills the dream in ways we couldn’t have expected.”

Ben Okri

Your Most Popular Post:

The Underdog Advantage, #5 in my Lessons from the Lemonade Stand series about turning obstacles into opportunities. It’s all about the importance of your story in positioning your company for success.

Your Most Controversial Post:

I wrote about guns and abortion. In the same article.  How does it not have 200 comments?

Life Liberty and the Pursuit of Happiness

Your Most Helpful Post:

Here are 2:

Learn how to create a personal investment policy in A Peek Behind the Curtain and what 3 numbers you need to know in What’s in a Number.

A Post Whose Success Surprised You:

Reading through my old posts, I realized that I talked a lot about the weather and taxes.  This one is about the latter.

Irony in the wake of tragedy

A Post you Feel Didn’t Get the Attention it Deserved:

Everyone says we need more good news.  Here it is. Sort of.

We need a Hero

The Post that You are Most Proud of:

A totally self-serving, self-promoting post about my first book.  It should be first on this list.

It’s finally here.

Umm….Tag, you’re it!

Part of the rules of the My 7 Links project is to tag 5 other bloggers that you think should share some links. Here are the bloggers I’d like to see participate:

Len Penzo

Control Your Cash*

Ken Jennings

Notorious Rob

The Pioneer Woman

Traffic Generation Cafe

*Even more shameless plugging