Why the lease option is a better investment… especially in the beginning.
I started my real estate investing career in 2005. I had moved out of state to join another investor and start my own real estate business. By 2009, I had partnered with some investors and bought a series of multi-family properties within a small radius of the downtown area of Raleigh North Carolina.
All our properties were within walking distance of one another, so I frequently spent the day managing contractors, showing units to prospective tenants, collecting rents, and managing the day-to-day operations.
The Economy Takes a Turn…
As time went on, the economy had gone from boom to bust! By the spring, we couldn’t keep any unit rented for more than a couple of months. Once we found a tenant for one unit, we would find another one had gone empty over-night.
Overnight the vacancy rate had skyrocketed to 50%, and I knew I’d have to dig into reserves to come up with the mortgage payment. What was worse, all of the vacant units needed a substantial amount of repair.
I stood on the corner and looked at yesterday’s growing empire that was now in flames. I paused for a second and noticed something about the duplex that was giving me the most trouble. I remembered something: I technically did not own that property–I had leased it!
What Is a Lease Option?
Have you ever leased an apartment? It’s the same principle in that you agree to make monthly payments for the apartment in exchange for the right to live in it and enjoy it. This is referred to as “possession.”
You can exclude others from coming into your apartment, and trespass those that are unwanted and refuse to leave. This is called exclusion.
You have to make monthly payments according to your lease agreement. However, you are not responsible for the taxes–or more importantly–the mortgage on the property.
Essentially a lease is an agreement that allows you to control a piece of property without owning it.
An option is simply the exclusive right, but not the obligation, to buy the property over a given period of time for a pre-determined price.
How Does It Work?
Performing a lease with option to buy transaction is a simple matter of getting the right paperwork together, setting proper expectations for all who are involved, and recording paperwork in the county records.
The duplex I had leased is known as a “sandwich lease.” I leased the property from the owner and then subleased the property to a tenant. It’s important that the right to sublease be included in the lease agreement that you use. Be forthcoming and honest with regard to setting expectations.
So, if the property is rented at $1,000 per month and the rent payment is $600 that leaves a gross-profit of $400. I always reserve at least 20% of the gross rent for vacancy and repair.
$1,000 (Gross Rent)
$200 (Vacancy & Repair Allowance)
$600 (Rent Payment)
= $200 Net Income
The numbers will vary based on the situation, but the principles are the same.
Know Your Landlord-Tenant Laws
I use a residential lease agreement based on the ones that are typically used in the state of North Carolina. Landlord-tenant law varies from state to state so be sure to use a lease agreement that is appropriate for you state.
A key distinction here is that the landlord is responsible for making repairs and maintaining a safe and habitable residence. Since this was an investment property, we used a clause that stated that the tenant-buyer (me) would be responsible for the first $250 in repairs.
So I took care of the common repairs such as small leaks, fixtures, and appliance repair. The owner of the property remained liable for major repairs such as HVAC replacement, roof, water heater, etc.
Why Use a Lease Option
Think back to the original example, we had a large amount of empty apartments and mortgage payments to make! There were multiple 30-year-fixed mortgages where we personally guaranteed to make payments every month for the next 30 years–no excuses.
With a lease option, I use what is called a buy-out clause that states that I can “buy-out” of my lease for ANY reason or NO reason as long as I give 30 days written notice and pay a termination fee of 1 month’s rent. A buy-out clause is very common and is used in many residential lease agreements.
This is a great way to be able to cut loses with a problem property that is losing money and is not worth keeping. The property I had leased in the above example continued to lose money and cause the owner heartache after he re-took possession of it.
We’re in This to Make Money, Right?
Many experienced investors come to learn that the first properties they buy tend to lose money because they’re still learning. It’s human nature. We want to be able to tell our friends, girlfriends, that we own X amount of properties, and that we’re doing great in the real estate game.
But remember, when you mortgage a property, you’re signing that you will continue to pay every month regardless of whether or not your tenant is paying you. You are personally liable for the debt.
A lease with an option to buy is a great way to get started. It allows new investors to “get their feet wet” by getting their first rental property under their belt.
If the property produces a nice return, you can exercise your option and buy the property. If it doesn’t work out, you can exercise your buy-out option with a reasonable financial loss that’s not crippling.
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