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4 Benefits of Using a Master Lease Option for Apartment Buildings

Why buy an apartment building when you can RENT one?

apartment buildings

Use a Master Lease to control the property.

If you are investing in an apartment building with the intent of improving and flipping it within a few years, the Master Lease Option may be the way to go.

Instead of going under contract, raising the down payment through syndication, and obtaining a large bank loan (which you may have to sign personally), use a Master Lease to control the property, with an option to purchase it at an agreed upon price for a few years. You then sublease to the existing and new tenants for cash flow.

When you have the building performing at its peak potential, you can either exercise your option to purchase and resell it through a double closing, or sell your option to a third party for a profit.

There are four main advantages of using the Master Lease Option for apartment buildings:

1. Less Money Down out of Pocket

Many investors buy apartment buildings with 25-30% down payments, which is quite a big chunk. On a $2 million building, that’s $400,000 to $600,000 down, PLUS loan fees and closing costs. In addition, you will undoubtedly have to come out of pocket more for fix up costs, negative cash flow, reserves, and other costs.

As a general rule, the more money you put down on an investment, the lower your annual return (assuming your carrying costs are reasonable). Conversely, the less money you have to put down, the higher your return on investment. And, the less money you put down for your down payment, the more cash you can allocate towards repairs and improvements.

Also, with less down out of pocket, you may not need partners, or you may get away with having fewer partners. Fewer partners is certainly easier in terms of logistics and the potential “headache” factor.

2. Cheaper Than Hard Money

Many investors use hard money or “mezzanine” financing to purchase an apartment building, with the intent of refinancing in a year or so.

Using a master lease instead of a loan may result in a lower payment than the equivalent temporary loan at a high interest rate. And, since temporary financing usually means a low loan-to-value ratio, you will undoubtedly have to put up a large down payment if you don’t use the Master Lease Option for Apartment Building Strategy.

Furthermore, if you use the Master Lease Option for Apartment Building Strategy you won’t have to pay the typical loan original points for a temporary loan, which can be 3-5% of the loan up front. (Ouch!)

3. Less Money At Risk

When employing the Master Lease Option for Apartment Building Strategy, your option money may be as little as 5-10% of the option price. On a $2 million purchase, that’s $100,000 to $200,000, significantly less than if you purchased it with a loan.

If the deal goes bad, you don’t have to exercise the option, so your downside risk is limited to your option money, time, and improvement costs. While these amounts are not insignificant, they are certainly less painful than having to walk away from than a 25-30% down payment.

Furthermore, if you structure the master lease properly, it will be in a single purpose entity with no personal guaranty. If the thought of being on the hook for a multi-million dollar loan scares you, IT SHOULD! Even if the seller insists on a personal guaranty on the master lease, at least its limited to only a few years.

4. No Debt Financed Income Tax on IRA Investments

If you’ve invested with your IRA on property that is debt-financed, you may know that income from that investment may be subject to unrelated debt financing income tax (UDFI). A Master Lease is not a loan (as long as the master lease is not long term with a declining balance, thus a disguised lease), the net income to your IRA is not subject to debt financed income tax.

However, the down side to the Master Lease Option for Apartment Building Strategy is that when you exercise your option to buy and simultaneously flip the building, you haven’t been in title long enough to qualify for a long-term capital gains tax treatment. Thus, the gains from the sale may be taxed at a higher rate.

A Few Drawbacks

While there are many advantages to the Master Lease Option for Apartment Building Strategy, there are also some pitfalls.

First, the seller could simply renege on the deal when it comes time to exercise your option, leaving you with an expensive litigation option. Second, the seller may end up in bankruptcy or get a lien against the property in the interim. Third, the seller may die or disappear, leaving you with a legal mess that will take time to clean up.

While these problems can be mitigated with some good legal paperwork drafted by a good attorney, you should prepare yourself for the risks of any lease option deal.

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About the Author...

William Bronchick, J.D. is a nationally-known attorney, author, and speaker. He has been practicing law and investing in real estate since 1990 and has been involved in over 2,000 real estate transactions.

Bill has served as President of the Colorado Association of Real Estate Investors since 1996. He is the author of many excellent real estate investing courses.

You can visit Bill Bronchick at his web site: LegalWiz.com

Comments

  1. George R. Thibodeau says:

    I agree with what has been said. Theoretically, this is great. I’ve never been able to find an owner that would consider a Lease Option. Maybe I’ve only talked to owners who had already decided to sell or those who were happy with their current arrangement.

    • SBATTLE LUXE INVENTORY LIST says:

      George.. There are quiet a few..Distressed mutil million dollar property
      owners willing to wk these terms. The market has opened up many oppt.
      to negotiate terms sutible to releave more financial pit falls.. Keep looking
      and not in just your area go out side your line. Smiles..

  2. Paul d says:

    In a master lease how does rental net cash flow ? And who covers CAM?

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