Lease Option and the Single Family Home—The Exit Strategy
By Harold Moses
Students often ask me what my favorite or most-used exit strategy is, and my response is always lease/option. Of course the follow-up question is, why?
My primary real estate strategy is to hold properties as rentals. However, like many other investors, I began my real estate investment career concentrating on buy-fix-sell, but eventually I figured out that at the end of the day I had no real assets; I was not reaping the wealth-building benefits of holding real estate.
So I gravitated toward the buy/hold strategy and began buying all the four-plexes, tri-plexes, du-plexes, and single family homes I could get my hands on. I became a landlord. This strategy worked great since I now owned property, each one its own little business that produced cash flow, with appreciation as well as depreciation. But the landlord part became a bit of a challenge. Collecting rent or lease monies, making sure the property stayed viable for the next tenants, and making transitional renovations (repairs and upgrades when tenants moved on) could get a bit out of hand. Damage and security deposits only go so far, and many tenants actually do more damage than the deposit covers.
When I investigated the lease/option, the following advantages are what I discovered:
• Target a better-qualified tenant
• Still have cash flow
• Still own and control the property
• Maintain tax benefits
• Minimize land lord responsibilities
The Lease/Option strategy differs from traditional rentals in that your target market is better qualified (they have more cash); they have better, more stable jobs or careers; they are generally more responsible; and they have a real desire to be a homeowner. This strategy offers the opportunity to potentially increase the cash flow that the property “throws off.” For example, a qualified tenant/buyer will pay the property owner a price for the right, or option, to purchase the property at a later date for a purchase price agreed upon today.
Lease options allow the property owner to maintain control of the property, technically it is still a rental, so when the tenants want to make changes such as painting or landscaping, they still need to seek approval. Lease options also allow the property owner to maintain the tax benefits of owning investment property, even though the intention is to eventually have the tenant/buyer exercise their option and purchase the property.
When executed properly, lease options will eliminate a lot of the traditional land lord headaches. As an interested potential owner, the tenant/buyer takes care of the normal wear and tear issues, leaving the property owner with only the bigger issues—such as water heaters, appliances, and structural issues, all of which will be covered by a home warranty or other insurance policy.
When determining option consideration, take into account the following:
• How much should the consideration be?
• Does the consideration need to be a lump sum or can it be paid in installments?
• How long should the term be?
There is nothing set in stone as to how much the option consideration should be. I like to find out what the tenant/buyer has to work with and what they are willing to pay; obviously the more, the better. What I typically see in the markets is usually one to three percent as upfront option consideration, which usually works out to be three to six thousand dollars.
So what if the tenant/buyer is unable to come up with the lump sum up front? An effective way to work within this situation is to increase the amount the tenant/buyer pays each month. For example, asking for five thousand up front and the tenant/buyer can only come up with three thousand, offer him the opportunity to pay the two thousand deficit over the life of the option. So, for a 12-month option, the tenant/buyer will pay an additional $167 each month, by a separate check, above the normal rent amount.
The length of the option period should be whatever time period the owner and tenant/buyer are comfortable with. If the tenant/buyer needs time to iron out issues in order to become “mortgage-able,” then a longer option period of 24 to 36 months may be in order. In general, I prefer a shorter, 12-month option period.
In conclusion, in today’s ever-tightening credit environment, the lease/option strategy offers the property owner a more qualified tenant, greater flexibility, and continuing income, as well as offering the tenant/buyer home-ownership potential in the future.
Harold Moses is a real estate mentor for Wealth Intelligence Academy®.
