One question I get asked all the time: Is it better to buy on a lease option or to buy subject to the existing financing? Before I give my answer, let’s get clear on what the two buying strategies are.
Lease Option
Briefly, when you buy a property on a lease option, you are controlling possession of the property through the use of a long-term lease, and you are controlling all the future appreciation of the property through the use of an option to buy. The seller stays on title until you exercise your option (either by buying it yourself or finding a new buyer to buy the property for MORE than your option price).
Subject To
When you buy a property “subject to” the existing financing, you have the seller deed the property to you, and you take over making the payments. You own the property; you are on the deed. You are NOT paying off the seller’s existing loan(s), nor are you formally assuming this debt. Rather, you are taking title subject to this debt. Many people wonder if you are allowed to do this, and the answer is yes–provided you intelligently lower your risk.
Which is better?
So which is better, a lease option or a subject to deal? On a residential property you are almost always better off buying subject to versus on a lease option. When you buy subject to you never have to worry about whether the seller will honor the agreed upon option price down the road, or if they will go bankrupt, etc.
Also, since you will own the property, you will get all the tax benefits. There are no loan costs for you to take over the payments this way so you save several thousand dollars on the financing. This list goes on…
With all the advantages to buying subject to, why would you ever buy on a lease option? Because it takes an extremely motivated seller to sell you the property subject to, while it only takes a motivated seller to sell it to you on a lease option. My students and I currently average three or four lease option deals for every one deal we do subject to.
Converting a lease option into a subject to deal
One of the best kept secrets in real estate investing is how to convert a lease option deal INTO a subject to deal. When you get good at using this technique, you will be able to convert one out of three lease option deals into subject to deals. This is probably the single most overlooked source of subject to deals.
The reason is that many times by locking up the deal as a lease option will be the first step that gets the seller comfortable with working with you. Then a day or a month or even a year or two later you can convert the deal once the seller is more comfortable with working with you.
So how do you do it? There are three big opportunities to convert your lease option deals.
At the beginning of the deal
The first comes at the beginning of the deal. Have you ever signed up a lease option and then come to find out a few days or weeks later while doing your due diligence that the seller owes back payments, or that the property is in need of a significant repair?
This is the perfect time to trade you putting in that money (which may be a few thousand dollars or more if the numbers in the deal warrant it) for you getting your name on title.
I will almost never consent to putting any significant money into a deal unless I get on title. Just what is “significant” will depend on your financial situation. My rule of thumb is that if I’m putting in more than $5,000 up front into any deal, I make sure I am on title.
There are times when you aren’t putting any money into the deal, but you still convert the deal up front into a subject to deal because the seller had a few weeks to get used to the idea of working with you and to get to know you. This is especially powerful if the seller really isn’t waiting for any equity out of the property. Think of this as the “foot in the door” technique.
When a major repair is needed
The second chance to convert your lease option deal into a subject to deal comes at the point in time of any major repair. In all my lease option deals the seller is responsible for any cost of repair that exceeds $200 in any one month.
So let’s say the roof needs $4,600 of repair work, I say to my seller:
In essence you are trading the repair cost and worry over any future repairs that might be needed for the deed.
When the seller wants to cash out
The final chance to convert your deal comes anytime your seller expresses the desire to just be done with the deal. They will say something like, “Can’t you cash me out now? I just want to be done with this property.”
Your response should be:
Obviously if we are cashing you out early, we’d need a discount on the $15,000 that we owe you to make it a good business decision to pay you now instead you having to wait three and a half years for your money. What do you think would be a fair discount to get your cash now and just have us buy the property and take over making the payment every month?”
I think you see the pattern here.
The bottom line is that where possible you always prefer getting on title. This means that you will keep an eye out for opportunities to convert lease option deals into subject to deals.
The paperwork you need to convert the deal
If your seller agrees, here is a list of the documents you will need. Some of these documents are optional, but I think they are all a good idea.
- Purchase agreement spelling out the terms and condition of the sale-specifically listing you are buying subject to the existing financing. This agreement should be very PRO BUYER.
- Actual deed from seller to you (or the entity of your choice)
- CYS waiver (“Cover Yourself Waiver” where the seller signs off that they are understanding that the loan stays in there name, etc.)
- Limited power of attorney from seller to you
- Land trust agreement
- Assignment of beneficial interest agreement
- Letter to seller’s lender letting them know that the seller put property into trust for “financial planning” purposes
- Letter to seller’s insurance company telling them to switch main insure to you as the TRUSTEE of the seller’s land trust, with the seller as an “additionally insured party” as his/her/their “interest may appear”
It’s worth the effort
Does this sound complicated? It’s not. You can always hire a real estate attorney to draft these documents for you. Good luck to you in converting some of your lease purchase deals into subject to deals. It is definitely worth the effort!