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Lease Options: Gold Mine or Fools Gold?

by Marty Boardman on June 24, 2011 · 19 comments

  

lease options fools goldHave you heard what an ounce of gold is selling for these days?  According to GoldPrice.org it’s around $1,552.  That’s a 176-year high.  Back in 2007, when the housing market first started its downward spiral, gold was worth approximately $600 an ounce.

I’m no financial expert but it appears to me that this gold buying frenzy we’re seeing now is mirroring what happened in the real estate space just four years ago.  I wonder how many people will lose their retirement funds this time around.  Will all of these infomercial gold buyers and hedge funds get blamed in the media and sued by the feds if the bottom falls out?

When the real estate market in Phoenix went into the toilet in 2007 lease-option deals were my little gold mine.  I owned 55 properties – all “subject to,” 1-3 year option contracts.  Some cash flowed, others didn’t.  But they all had one thing in common at the time – equity and lots of it.

Notice I said they HAD equity.

The bubble burst and I was locked into lease-option deals that were plummeting in value.  A few of my tenants left voluntarily before their options expired.  That allowed me to sell some of the houses before I lost money.

However, a majority of my tenants refused to leave.  I had no way out.  All I could do was sit there and watch the house prices drop far below what I paid for them.  Of course, at the end of the option agreement I knew these tenants would never get a loan to purchase the properties.  This made the process even more painful.

So I lost money when the real estate market crashed.   A lot of investors did right?

But what may surprise you is that I lost money prior to the market collapse doing lease-options.  Even worse, I got sued.  Here’s a quick case study in how this happens (remember this is during the market boom):

The investor (me) buys a house for $200,000 and sells it to a lease/option tenant for $230,000.  In three years the home’s value increases to $350,000.  However, the tenant cannot qualify for a loan to purchase the property at $230,000.  The investor evicts the tenant for failure to exercise.  The tenant then sues the investor.

What did the tenant sue me for?  You name it.  His lawyer used terms like “equitable mortgage” and “unconscionable profit.”  Finally, this tenant claimed I was robbing him of his “equity.”

My lease-option contract was rock solid and iron clad.  I even videotaped the signing so there would be no confusion.  The bottom line is anybody can sue anyone at anytime for any reason.  And that’s exactly what this tenant did.  Both the tenant and his lawyer knew they wouldn’t win in court.  That wasn’t their objective.  No, their plan was to legally extort thousands of dollars from me in the form of a settlement agreement.

real estate uncertaintyThis is why I’m not a big fan of lease-option deals in unstable real estate markets like Phoenix.  From 2004-2006 prices here shot up by more than 40%.  What followed was an unprecedented decline of 50%.  Many experts claimed we bottomed out in April of 2009.  There were some moderate increases and then another 12% decrease after the tax credit expired April 2010.  That’s more than unstable, it’s downright VOLATILE.

There are contributors on BiggerPockets.com that have had tremendous success doing lease-options.  Yes, they can be profitable – just not in every real estate market.  If you want to strike it rich in a market like Phoenix, or other cities with uncertainty, you may find that lease-options are the real estate version of fools gold.

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{ 19 comments… read them below or add one }

Linda June 24, 2011 at 11:43 am

You were lucky that you were able to afford the lawsuit and fight it in court. I know many people who would have just settled.

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Marty Boardman June 24, 2011 at 2:19 pm

Linda, we did settle. I paid my attorney over 20K in legal fees and the tenant 18K.

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Joe Salcedo June 24, 2011 at 12:57 pm

Right on, Marty.

Was thinking the same thing. “When the CEO of a company graces the cover of Forbes, it’s time to sell.”

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Marty Boardman June 24, 2011 at 2:21 pm

Joe, most investors, myself included, often lack perspective. If only I could see the same thing happening in real estate back in 2006. I’d be sitting on beach in Mexico right now. Thanks for the comment.

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Dave Alan June 24, 2011 at 1:38 pm

I like how you tied in gold prices to the real estate market. I whole-heartedly agree. Too much speculation instead of sound investing. As far as lease-options, you are perfectly highlighting their downside. On one hand, you may have a genuine buyer in a few years, on the other, a BIG HEADACHE!!!! Do you guys have a facebook page?

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Marty Boardman June 24, 2011 at 2:24 pm

Dave, I’ve killed at least a dozen bottles of Advil from all the headaches lease-option deals have given me. And yes, we have a Facebook page, facebook.com/freerealestateeducation.

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Joe Salcedo June 24, 2011 at 2:05 pm

Rich insight, Marty. Arizona and is similar to Nevada and my friends did exactly what you were saying (lease-option 8 homes at a bad time). I’m just not sure if they learned the lessons you unselfishly share in this article. Thank you. Great post to learn from. esp from a fellow hard hit State-r.

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Marty Boardman June 24, 2011 at 2:30 pm

Joe, I’ve found that the laws here in Arizona favor a lender more than a landlord in a seller-financed exit strategy. I’d rather make the tenant an owner (seller-carry back) and foreclose if they don’t pay or refinance within a specificed period of time. The laws here allow me to do this rather quickly.

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Rob Viglione June 24, 2011 at 3:11 pm

That’s a bad legal system, but valid financial vehicle. Too bad, because options provide an additional layer of liquidity and risk transfer that should, in theory, make markets more efficient. Inequitable legal systems add costs and inefficiencies that make some business considerations artificially unattractive.

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Marty Boardman June 24, 2011 at 3:25 pm

Rob, options may be liquid in equity markets but not in real estate. The landlord in an option deal is contractually obligated to sell the property at a set price for a set period of time. Sure, the landlord could sell the option but there aren’t many buyers out there. I know some investors that would tell you that a lease-option deal in ANY real estate market may be the most illiquid form of investing there is.

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Dan Duran June 25, 2011 at 8:20 pm

Thanks for the post Marty! It is nice to get input from all sides. I’m marketing for lease options currently and needed to hear the other side of the coin. Fortunately, I think Nor. Cal. is a little more stable when it comes to property prices, but the threat of a lawsuit is always present.

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Marty Boardman June 26, 2011 at 9:59 am

Dan, I recommend video taping your signings and explaining to the lease/option tenant in detail the consquences of not paying on time/failure to exercise the option. Be sure to have them verbally acknowledge that they understand the agreement. While the video recording I had didn’t prevent me from getting sued it did help keep me out of court.

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Dan Duran June 26, 2011 at 11:32 am

Thanks for the tip Marty!! I never would have thought about recording the signing, but it makes sense.

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Lowry Davison June 27, 2011 at 2:12 pm

Just a reminder that Texas has for all intent and purposes done away with lease options in residential property.

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Marty Boardman June 27, 2011 at 9:07 pm

Lowry, I’ve been told that unless you own the property free and clear then Texas law prohibits doing a lease-option. However, I’ve also heard that there are creative work arounds. As always, consult a local real estate attorney.

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Mike Grayford June 27, 2011 at 2:53 pm

Thanks for this article, Marty. Having heard and read a lot about lease options, I was really wondering what happened to all these deals when the market tanked. Your experience confirms what I guessed. It seems like the lease option is best reserved for a market that is stable or slightly increasing. Much like you said about Arizona volatility, I can’t imagine doing one of these deals in California right now.

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Marty Boardman June 27, 2011 at 9:05 pm

Mike, I suspect that investors doing lease-options in Nevada, California, Arizona and Florida all got hurt when the market tanked.

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Mary November 6, 2013 at 9:10 am

I am very new to investing, and I realize, this must be a stupid question, since no one mentioned it, but here it goes. Couldn’t it be in the contract that the buyer would have to pay the legal expenses if case goes to court? or atleast if they loose?

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Sergey April 11, 2014 at 9:29 am

Here is another question from newbie, what if you would spend 18k, that you paid your tenant to settle, to win case in court and make tenant pay you your legal fees + damages?

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