Mortgages & Creative Financing

Risks Associated with Lease Options

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Lease Option Risks

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.

Related: Rent To Own Homes: How to Profit from a Lease Purchase

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.

Photo: BenRogersWPG

Ken Corsini is a seasoned real estate investor and business owner based in Woodstock, Georgia. Ken is best known for his role on HGTV’s hit show “Flip or Flop Atlanta,” and has flipped over 800 houses in Metro Atlanta since 2005. With over 15 years of experience in the real estate industry, Ken has expanded his original flipping business into multiple independent real estate businesses, including Red Barn Real Estate, with over 180 agents in Metro Atlanta across four offices; Red Barn Construction, a custom home-building company specializing in modern farmhouses across North Atlanta; Red Barn Renovations, a full-service renovation company; Black Oak Mortgage, a direct lending company based in Woodstock, Georgia; and InvestorSumo, a technology company focusing on CRM and data needs for real estate investors.
    Lee Keadle
    Replied over 7 years ago
    We rarely see lease to purchase contracts actually sell in our market – they usually just remain as leases until the term is up. However, these situations often make for good tenants because as Ken points out they usually take better care of the home (since they plan on buying it one day). So even if the purchase part doesn’t happen, both parties still benefit. Reply Report comment
    Lee Keadle
    Replied over 7 years ago
    We rarely see lease to purchase contracts actually sell in our market – they usually just remain as leases until the term is up. However, these situations often make for good tenants because as Ken points out they usually take better care of the home (since they plan on buying it one day). So even if the purchase part doesn’t happen, both parties still benefit.
    Brian Gibbons
    Replied over 7 years ago
    Hi Ken, I like lease options for exit strategies a lot, but they are for the right people. There are other tools for exit strategies, like: A lease and a ROFR – Right of First Refusal – for low probability people who are tough to get financing for. Contract for Option and a Lease – for folks that need a push to get financed. They have to finish the lease to get the option, held in escrow with escrow instructions. They have 60 days to get finacing, starting in month 10 of a 12 month lease. Legal issue: Once you give the option you are open to “equitable interest” issues.in court if the TBer brings a suit. I like the Lease Option Assignment model, find a seller that cant sell, usually no equity, nice house, no repairs; find a buyer that just missed financing, then assign the deal for a 3% fee. Good tool, out in 60 days.
    Ali Langston
    Replied over 7 years ago
    to avoid having to do a foreclosure to remove a tenant, have them sign 2 contract. For that discusses the option to purchase. This in fact is an isolated contract without the person having to do in conjunction with a lease. This can be done between any one as investor in the stock market use options all the time. The second contract will be the lease, this is your standard lease, that you will use if you need to evict. This should also elinmate any confusion as to how to treat the option fee. It won’t be misinterpreted as a down payment, giving the tenant equity or a deposit which may need to be refunded.
    Mike Berlay
    Replied over 7 years ago
    Regarding selling price, it should be stated that purchase price will be based on average of 2 appraisel on time of exercuting option. This way you will get most of the value.
    Adam Arrigoni
    Replied over 7 years ago
    Ken, Have you ever tried a sandwich lease option or known anyone who has success with this? (Where you take control of the property from the actual owner, and then lease option it to the buyer) Thanks, Adam Reply Report comment
    Adam Arrigoni
    Replied over 7 years ago
    Ken, Have you ever tried a sandwich lease option or known anyone who has success with this? (Where you take control of the property from the actual owner, and then lease option it to the buyer) Thanks, Adam
    Adam Arrigoni
    Replied over 7 years ago
    Ken, Have you ever tried a sandwich lease option or known anyone who has success with this? (Where you take control of the property from the actual owner, and then lease option it to the buyer) Thanks, Adam Reply Report comment
    Brian Gibbons
    Replied over 7 years ago
    Hi Adam, The biggest risk if the Tenant Buyer (TBer) gives you headaches, like does not pay you and you have to pay the owner. Dodd Frank has stipulations too. Best thing is to get a RMLO (Reg Loan Originator) to underwrite the TBer. That gets you compliant with Dodd Frank. The law is very new, starts 10 Jan 2014. And do NOT use rent credits.
    Brian Gibbons
    Replied over 7 years ago
    Hi Adam, The biggest risk if the Tenant Buyer (TBer) gives you headaches, like does not pay you and you have to pay the owner. Dodd Frank has stipulations too. Best thing is to get a RMLO (Reg Loan Originator) to underwrite the TBer. That gets you compliant with Dodd Frank. The law is very new, starts 10 Jan 2014. And do NOT use rent credits.
    Jeff Hug from St Peters, MO
    Replied over 3 years ago
    It seems a lease option could be a great way to secure an exit strategy for mobile home investments, as the mobile home certainly won’t be in good shape 30 years down the road.