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.