Risks Associated with Lease Options
I’ve long been a proponent of lease options … in fact I’ve structured over 150 lease option or lease purchase deals over the last few years. From an investors standpoint, there are so many benefits to using a lease option as a means to sell and lease property.
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As an investor, I love to put a tenant in a property who believes he or she will own the property at some point during the option period. It almost always results in having a more reliable tenant that tends to take better care of the property as. It’s also a great way to sell a property without paying commissions and other concessions that a retail buyer would typically need.
Risks with the Lease Option
While I definitely believe the positives outweigh the negatives, it is important to examine some of the risks associated with this type of transaction.
1.) The most obvious risks associated with lease options are the same risks that apply to a rental in general. This would include a late paying tenant, a destructive tenant, eviction costs, lost rents, turn-over expenses, etc. While an up front down payment (or option fee) does tend to mitigate some of this, it’s definitely not a guarantee that you’ll have smooth sailing.
2.) Market fluctuation is another important factor when structuring a lease purchase. I recently had one of my tenants apply for financing after having been in a lease option for 2 years. The tenant's purchase price was set at $109,000 (which I thought would be stretching it 2 years ago). Interestingly, the appraisal on his loan just came back at $125,000! That's great for the tenant, but at the end of the day, I actually left a good bit of money on the table. No investor has a magic crystal ball that will tell them what a property will be worth a few years down the road, but I think it's a good idea to estimate on the high side if possible. You can always choose to lower your price for the tenant if the appraisal comes in lower than your sales price.
3.) While this is not something I’ve encountered, I have heard of some jurisdictions interpreting a lease option agreement as a transfer of title. In some cases, investors have actually had to foreclose on tenants to get the property back. It’s crucial that any investor have their contracts carefully inspected by a knowledgeable broker or real estate attorney that is familiar with local laws and regulations.
There are lots of reasons to use a lease option as an exit strategy or even as a means to a longer lease term. However, it’s good to go into this type of transaction with eyes wide open.
How about you? I’d love to hear if some of you have encountered unforeseen issues with your lease options.