Lease Option Real Estate Investing: Advantages and Disadvantages

One creative way to get started investing in real estate is to use a lease option. The biggest advantage of using lease options to invest in real estate is –control. This method of investing, basically gives the investor the right to possess — be in control of — and profit from a property without owning it.

A real estate lease option contract is a combination of two documents.

The lease part of the contract is where the owner agrees to let you lease their property, while you pay them rent for a stated period of time. During the lease period, the owner can not raise the rent, rent it to anyone else, or sell the property to anyone else.

The option part of the contract represents the right you purchased to buy the property in the future, for a specific price. If you decide to exercise your option to buy, the owner has to sell it to you at the negotiated price. The option part of the contract obligates the seller to sell to you during the option period — but it does not obligate you to buy. You are only obligated to make rental payments as agreed during the lease period.

When the lease option contract is written and structured properly, it can provide tremendous benefits and advantages to the investor. If the lease option includes the “right to sub-lease”, the investor can generate a positive cash flow by renting the property to a tenant for the duration of his lease, or lease option the property to a tenant-buyer for positive cash flow and future profits. If the lease option includes a “right of assignment” the investor could assign the contract to another buyer for a quick profit.

Lease option real estate investing, is a flexible, low risk, highly leveraged method of investing that can be implemented with little to no money.

High Leverage

It is highly leveraged because you are able to gain control of a property and profit from it now–even though you don’t own it yet. The fact that you don’t own it, also limits your personal liability and personal responsibility. Only if you decide to purchase the property by exercising your “option to buy”, would you take title to the property.

Little to no money

The real estate investor’s cost to implement a lease option contract with the owner requires little to no money out of pocket, because it is entirely negotiable between investor and owner. Also, there are a variety of ways the option fee can be structured. It can be structured on an installment plan, balloon payment or other agreeable arrangement between both parties. The option fee can even be as little as $1.00.

In order to secure the property for purchase at a later date, tenant-buyers typically pay a non-refundable option fee of approximately 2%-5% of the negotiated future purchase price to the seller. Depending on how the lease option agreement is written and structured, the investor could possibly use the tenant-buyer’s option fee money to pay any option fee owed to the owner.

Flexible

Lease option real estate investing is a flexible method of investing because the terms of the agreement, like payment amounts, payment dates, installments, interest rate, interest only payment, balloon payments, purchase price and other terms are all negotiated between seller and buyer. Responsibilities of both parties are also negotiable. For instance, if the investor doesn’t want to act in the capacity of a landlord, he could specify in the lease option agreement that tenant-buyer will be responsible for all minor maintenance and repairs and the original seller will remain responsible for any major repairs.

Financially Low Risk

It is low risk financially, because if the property fails to go up enough in value to make a profit, you have the purchased the right to change your mind and let the “option to buy” expire. Even if your tenant-buyer decides not to buy the property, you have profited by a positive monthly cash flow from the tenant-buyer’s rent payments, and upfront non-refundable option fee.

Let’s look at an example of a lease with option to buy structured in a way that the investor profits in 3 separate phases of the investment.

Profit #1: non-refundable option fee

Future sales price negotiated with the current owner is $125,000 with an option fee of 2% of the sales price. Option Fee you owe the owner is $2,500. The future sales price you set for your tenant-buyer is $155,000 and the option fee is 4% of the sales price. Option fee the tenant-buyer owes you is $6,200. You collect $6,200 from tenant-buyer and pay $2,500 to the owner and your profit = $3,700

Profit #2: monthly cash flow from rental payments

The Monthly rental payment you negotiated with the owner is $1,000. You set the monthly payment at $1,250 per month for your tenant-buyer. Each month you collect $1,250 from your tenant-buyer and pay the owner $1,000 each month. Your profit is $250 monthly positive cash flow during the lease period.

Profit #3: is set up when the lease option contract is initially written

The third profit is the difference in the negotiated future purchase price with the owner, and the future purchase price set for your tenant-buyer. Let’s say the property goes up in value to appraise for at least $155,000. Your tenant-buyer decides to exercise their option to buy. You buy the property from the owner at $125,000 and then sell it to your tenant-buyer for $155,000. $155,000 – the $125,000 you pay to the owner = $30,000 profit.

Of course the key to making lease option real estate investing work, is finding motivated sellers and buyers. Finding these motivated sellers and buyers shouldn’t be difficult. The continuing down turn in the real estate market, has created a large number of sellers who can’t sell their property and buyers who can’t get financing to buy. The seller could possibly get a fair offer to be paid in the future, by selling their property to a real estate investor on a lease option basis. A potential tenant-buyer could obtain home ownership, without having to qualify through traditional home loan guidelines.

One disadvantage of lease option real estate investing, involves the tenant or tenant-buyer possibly defaulting on monthly rental payments. This would make it necessary for the investor to come up with money out of pocket to pay the owner, and possibly have to proceed with eviction process. However, there are certain provisions that can made, and also various “contract clauses”, that can be included in the lease option agreement, to deter buyers from defaulting on payments.

If the investor fails to do “due diligence” before entering into a lease option agreement, he could end up with a property that is unmarketable. There could be a number of liens on it, issues involving ownership of the property or it might be in foreclosure. By diligently performing research before entering into a lease option agreement, the investor can avoid these mistakes. A few things the investor could do is– perform background and credit checks on both the seller and buyer, search public records in reference to ownership and property status, or do a title search.

Despite the few disadvantages, lease option real estate investing continues to be an excellent way to invest in real estate with little to no money and low financial risks. It also remains to be an excellent way to gain control of a property you don’t own, to generate cash flow now, and possible future profits on flexible terms.

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Elizabeth Brunner

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