How lease options work

I am wondering how a lease option contract works. I own a couple homes and I am looking to target buyers that cannot qualify right now but in the next 6-12 months will be able to qualify for a mortgage. My understanding is that you agree to a monthly payment similar to what the mortgage would be. You also agree to a purchase price for 6-12 months down the road. At the time of the contract the renter/future buyer pays a down payment. Possibly 3-7% down. Once the buyer qualifies you credit that down payment back to the seller.

Am I correct on these points or am I missing anything. Please advise. Also if anyone could provide a sample lease optino contract it would be greatly appreciated.

Edited: 06/26/2010 at 06:31AM

Jon Holdman

Real Estate Investor · Wheat Ridge, Colorado

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Dec 02 '08, 09:03 AM

You have the basic concept.

The rent is typically about market rent. Maybe a small amount, 5-10%, is a "rent credit" that's credited when the option is exercised, assuming it actually is.

The lease should be a perfectly ordinary lease. If you also have rentals, use the same lease. There should be a security deposit, just like any other lease. I have seen these were the T/B can choose a higher rent and get a higher rent credit. For example, $1000 rent with a $100 rent credit, $1100 rent with a $250 rent credit.

The option is a second, separate agreement. You can agree on a price ahead of time, or determine the price when the option is exercised, whatever you and the tenant/buyer agree to. There would be a non-refundable option fee. I've heard toward the low end of the range you say, but its negotiable.

When the option is exercised, the option fee and the rent credit are credited to the buyer. You might also choose to credit the security deposit to the buyer.

If the buyer doesn't move exercise, and moves out, you keep the rent credit and the option fee. The security deposit is handled as for any other lease.

Edited: 06/26/2010 at 06:31AM

Jon Holdman, Flying Phoenix LLC

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Dec 02 '08, 10:23 PM

Do you have anywhere where i can get samples of these option contracts?

Edited: 06/26/2010 at 06:31AM

Jon Holdman

Real Estate Investor · Wheat Ridge, Colorado

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Dec 03 '08, 01:26 AM

Both Bill Bronchick and Andy Heller & Scott Frank have them included in their courses. Not sure where to find them for free.

Edited: 06/26/2010 at 06:32AM

Jon Holdman, Flying Phoenix LLC

Mike C

Real Estate Investor · Ohio

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Dec 11 '08, 04:51 AM

Eric,

Jon is on the money as usual. You need to define your goals going into your lease options. What I mean is are you lease optioning for cash flow or are you L/O for a big payday at the end and less concerned with getting maximum cash flow.

If you don't care as much about cash flow, you can set your lease payment for just above your mortgage payment, have a nice spread to what you owe and what your option price is and make a nice payday down the road. This may be below market rent, depending on your existing financing. You also have some control of whether they cash you out by who you put into your home. If you care mostly about the backend profit, you must make sure your tenant buyer will be able to realistically qualify for a mortgage during your lease term.

If you care more about cash flow, you want your rent payment as high as possible to maximize your cash flow. You will still get money on the backend, just not as much as in scenario #1 above. You can use rent credits to increase your cash flow as Jon suggested. Be glad you are in OH and not TX as well because they are really cracking down on lease options there. They may be called rent credits or additional option consideration as recommended by your attorney. This is less of a concern here in OH (for now at least).

Your money down of 3-7% is in the ball-park and will be called " non refundable option consideration." My advice is do not compromise on the money down you want if it takes longer to fill than you want. Getting the right tenant buyer is much more important in the long run. I won't let anyone in for less than 3% down, even if it takes a little extra time. You shouldn't have too much trouble finding tenant buyers in this market.

As far as forms, you have a couple of options. Either buy a program from someone and use their forms (after a signoff from your attorney) or just hire a local attorney well versed in RE to write your forms for you. This will be cheaper in the short run but if you want to expand into this business having access to more paperwork can be beneficial. You decide.

My priorities are max money down and cash flow. Yours may be different. Just be sure and define your goals now and then decide how to construct your paperwork as needed. Good luck. You will probably grow to like L/Os a lot.

Good luck

Mike

Edited: 06/26/2010 at 06:38AM

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Dec 11 '08, 08:29 PM

Mike,

I appreicate your response all your tips were helpful. I suppose I am in the market of buying low and fixing up then getting buyers into a lease option with 3% down. That way once they qualify for a mortgage I can credit that 3% back to them to cover the 3% required down payment to qualify for an FHA mortgage. I see you are in Ohio as well so you probably know that you can buy good homes for dirt cheap these days.

Edited: 06/26/2010 at 06:38AM

M S

Real Estate Investor · Oxnard, California

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Dec 12 '08, 11:01 PM

My friend who owns his own brokerage said as of about a month ago or so, the FHA stopped allowing sellers to credit the buyer the 3% down to cover the FHA required 3% down payment. Have you guys heard this same thing? Are there any legal ways around this anyone have heard of?
So Eric, if this is true, your plan might not work like planned.

Edited: 06/26/2010 at 06:39AM

Mike C

Real Estate Investor · Ohio

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Dec 18 '08, 01:44 AM

Eric,

Yes there are a lot of cheaper homes out there now. That is not my area of interest though. I deal more with the middle market of homes, i.e. newer homes in subdivisions in the 125-250k or so price range (obviously dependent on your market and goals). I don't mess with much on the low end, except to wholesale to another investor or end user. Just my personal preference. I have friends that buy cheap (as in 15-35k range), rehab and just rent out the homes as keepers. To each is own. Good luck.

M S

That is interesting and I had not heard that. I will have to look into it. Because of my market though, most of my tenant buyers have gotten more conforming financing, i.e. Freddie or Fannie paper. I have only had one go FHA. That is something that would be good to know however, especially for those who specialize in the lower priced homes. Off the top of my head though it seems that should not affect a L/O deal where you are being cashed out. Why? Because you are not just providing a phantom credit to get them financed as a conventional seller may try to do by just inflating the sales price by the amount of the credit they give to the buyer. That is probably what they mean. As a L/O tenant-buyer, they really did give you a down payment (your option consideration) when you started the L/O term (or you had better not let them in). Yes, it was a year or more ago but it is real money and you could provide a cancelled check to verify they really gave you the money if necessary. Now you have a verifiable down payment, possibly rent credits for more money as a verifiable down down payment (which they may not like), and now 1-2 years seasoned payment history. Sounds like an underwriter's wet dream to me, especially in this market. This was just my opinion and I would never recommend defrauding anyone but that is how I would see it. Definitely need to look into it to find out for sure.

Thanks for the info.

Mike

Edited: 06/26/2010 at 06:42AM

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Dec 18 '08, 03:04 AM

I am a licensed FHA loan officer so the one part i have a firm grasp on is the financing. You are correct. FHA recently abolished seller contributed down payments, however, the buyer can get a down payment gift from a family member. As Mike noted when you set up a lease option you are going to require a down payment which then can be credited as teh 3% down payment down the road. But you must docuemnt everything.

Edited: 06/26/2010 at 06:42AM