The Lease Option: How I Creatively Structured a Deal With Very Little Down
Recently, I had a friend who came to me looking to sell her property because she is an out-of-state investor who just didn't want to deal with the property anymore. I could have simply listed the property for sale for her as an agent; however, I knew that she bought this property almost about two years ago at a price that was slightly above market value at the time. Given today's market value, it would be difficult to sell her property at a higher price, and I thought at best it would hit the price that she purchased the property at, which was $65,000.
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Now, the reason the property was purchased at an above market value was the fact that she bought it OWC, or “owner will carry.” Because she didn’t use traditional financing, she ultimately ended paying a bit more for a chance to leverage her cash. In my opinion, this is probably not the best time to sell the property because the property value hasn’t risen above what she paid. On the other hand, it was a property that she didn’t want to keep anymore, and she did not have enough time to deal with it.
Oh yeah, she purchased this property with 20% down, 6% interest with 30-year amortization, and a five year balloon. So at the end of the five years, she is going to have to pay about $48,300. She put down $13,000 in the beginning.
Figuring Out a Mutually Beneficial Deal
So let's just say I do sell the property at $65,000, with transaction costs running 8% (which ends up being about $5,200) and the loan balance at about $50,600 at this point. She is only going to get back $9,200, which comes out to a loss of about $4,000. If we were to get to the real nitty gritty details, she may have had some extra cash from the 2 years of renting out the property. However, the cash flow isn't that high.
Being a friend and a real estate investor, I wanted to see how I can help each other. While I’m still in the market for buying properties, I’m not terribly excited about buying more rentals unless I get a really good deal or I don’t have to put much money in. Can I take the bet that property values may go up in two or three years? Possibly. The question is, how much am I willing to pay to find out?
After some thinking, I asked her, "Why don't I buy the property?" But in order to make this purchase work for me, I only wanted to put about $2,500 down. I didn't want to spend too much more. So, I asked whether or not she was willing to finance me $62,500 to purchase the property. It made more sense for her because 1) I wouldn't have to charge her commission so she could save about 6% there, 2) it would be a quick sale because she wouldn't have to put it on the market, and 3) she could make money on the to loan me. After a bit, she agreed.
However, the transaction got a bit tricky because I wanted to do a AITD (all-inclusive trust deed) in which my mortgage would wrap around the other mortgage. Now, this can usually be done easily without the banks minding if the loan came from regular banks. Since most mortgages are packaged up anyway, they won't really care as long as the mortgage gets paid. However, the due-on-sale clause, which allows the bank to call the loan due in case they find out the deed has changed, was in effect for this loan as well. In other words, the original seller who owned the note might just call it in if they find out that I bought the property from her AITD, which was not in my intention.
The Lease Option Agreement
Rather than be at the mercy of the original seller, I decided to write up a lease option agreement instead. A lease option agreement will not cause a title change until it comes to the time I buy the property. So the way we structured the deal was that in the lease agreement, I agreed to buy the property at $65,000 in two years, with my initial option at $2,500, which goes toward my principal. The lease terms are: monthly payment of her debt plus the interest from the down payment I borrowed from her plus the rest of the costs of ownership, i.e. insurance, taxes etc. — and I also have the right to sublease.
That way, the title doesn’t change until the end of the two year mark, when I’m supposed to buy it from her. By then, I should have a pretty clear idea whether I want to keep the property or sell it. If I call it right and prices go up, I stand to make a decent bit for a very low down payment. If I am wrong and the prices don’t go up, I’ll just have to try to renegotiate with the original note holder or pay the balance and keep the property. But in the meantime, I’ll hopefully have a renter in there to keep my cash flow close to even.
There are many ways to buy and sell a property. Sometimes it’s all about getting creative.
How about you? Have you done some creative deals in the past as well?
Let’s discuss in the comments section below!