3 Strategies for Using a Lease Option to Invest in Real Estate Creatively
Lease option investing is a fairly advanced method of investing, and doing so with creativity is even more complicated, so understanding the fundamentals before branching out is imperative. As an investor, you may find yourself on either side of a lease option deal. Let's cover a few strategies on how to use these and give examples of how they might work in the real world.
3 Strategies for Using a Lease Option to Invest in Real Estate Creatively
1. A Straight Lease Option (Lessor)
The most common way real estate investors use a lease option is by being the lessor, or owner, of the property. The investor finds a tenant-buyer and signs an agreement with them, giving them the right to buy the property in a specified time period for a defined price. Then, the investor either sells the property to that tenant-buyer or cycles through different tenant/buyers until one of them ultimately purchases the home.
Because the majority of lessees don’t end up buying the home, the owner may end up renting to two, three, four, or even more different tenant/buyers before someone obtains a mortgage and buys the property. However, if you do some great screening ahead of time, hopefully, the first tenant you place will end up purchasing the property.
If more than one tenant/buyer is needed before the home actually sells, the benefit for the lessor, of course, is that each new tenant brings the opportunity to adjust the price to the house’s current value as well as an additional option fee from the new tenant. Although a lease option in this regard doesn’t help you purchase the property creatively, this strategy can help you monetize by providing an exit strategy. The lease option is definitely a powerful tool to pair with other methods.
Let’s look at an example of how a straight lease option might look in the real world to an investor:
Isaiah is just getting started with real estate investing and owns no properties except his primary residence. Isaiah decides to move, but rather than sell his home, he opts to carry out a lease option.
He places an ad in the local paper and ends up signing a lease option with Carrie, a young urban professional who would love to buy a home but whose credit score is just a bit too low to qualify her for a typical mortgage. Carrie signs the lease, which states that she'll pay $900 per month in rent for the property, as well as the option agreement, which states that Carrie can choose to purchase the home for $119,000 at any time in the next three years. Carrie pays a $3,000 option fee plus a $900 security deposit and $900 for her first month's rent and moves in.
After two years, Carrie has improved her credit rating enough to obtain a loan, so she fulfills her option contract and buys the house from Isaiah for $119,000. Isaiah thereby generated significant cash flow during those two years and was able to sell for top dollar with no sales commission to a real estate agent—a true win-win.
You may be thinking right now that an owner could use this strategy to take advantage of others by charging high fees to tenants who would never qualify anyway, churning through tenants with the full knowledge that they’ll never end up buying. Yes, this does happen, but I am adamantly opposed to such action. We’ll talk a bit more about this later in the “risks and downsides” section of this chapter, but understand that the lease option should be used only as a win-win solution for both parties, not as a method to collect more rent and put the tenant in a worse position than when they moved in. In addition to the ethical reason for this, there are some legal reasons taking advantage of tenants is just a bad idea, which I’ll address shortly.
2. A Straight Lease Option (Lessee)
An investor can also acquire real estate using the lease option strategy by turning the tables and being on the other side of the deal—as the lessee. Although most owners probably would rather have cash, an owner may accept a lease option instead for a variety of reasons, especially if they are having a hard time selling their home. The investor and property owner would sign a lease option for the longest term and lowest rent possible, and the investor would then sublet the property to a tenant for the highest possible rent, keeping the cash flow difference.
When subletting property, such as in a lease option scenario like this, it is vital to let the lessor (owner) know what you plan to do. Don’t try to hide anything—be open and honest about what you intend to do and explain the benefits for them in allowing you to do so. After all, the owner probably doesn’t want to deal with tenants, drama, or any of the other issues that come with landlording, but as a real estate investor, this is your job! Essentially, you will act as a middleman, getting paid well without actually owning the property.
Additionally, because the investor has a signed, legal option to purchase the property at a specific price, the investor can market that property and potentially sell it in the future without even owning the property, because they can sell the option. (This is very similar to what a wholesaler does when they place a property under contract and then sell that contract to a cash buyer. I've dedicated an entire chapter to wholesaling later in this book, so don't worry about it now.) This is probably a little confusing, so let me illustrate this scenario with another example.
Reginald is a real estate investor with very little cash but a lot of creativity. He spends a significant amount of time looking for motivated sellers and eventually runs into Debbie, a homeowner who is struggling to sell her home. She went through a divorce and no longer needs the large home. She currently owes $215,000 on it, but its market value is barely $230,000, which doesn't leave her enough equity to pay a real estate agent.
Reginald and Debbie sign a lease option agreement so Reginald can take over the property and Debbie can move on with her life. Reginald agrees to pay $875 per month in rent with an option to purchase the home for $220,000 anytime within the next six years. He gives Debbie an option fee of $100 and takes control of the property.
Reginald then finds a tenant to rent the home for $1,475 per month, giving Reginald $600 per month in cash flow. He saves most of this cash flow, making sure he has enough to cover any future vacancies or repairs. The market then climbs about 3% per year for the next five years, and the home is now worth $266,000, so Reginald finds a buyer to pay full price. This nets him close to $40,000 profit (not counting the five years of cash flow he collected) after he pays the closing costs—all for a $100 down deal that most investors would have passed up.
3. A Lease Option Sandwich
The lease option sandwich is so named because it places you in two separate transactions on both sides of the deal—like the two slices of bread on your PB&J. First, you act as the lessee and find a property that you can lease option from the current owner. Next, you find a great tenant looking for a rent-to-own deal, and you sign a lease option with that tenant for the property. So there is a lease option on the front end of the deal and another lease option on the back end of the deal, and you are the peanut butter and jelly holding the "sandwich" together.
This strategy is very similar to the example above, but rather than finding any random buyer after five years, Reginald would actively seeks to rent the home to the same person who will end up buying it. Let’s look at an example of how this lease option sandwich would work in the real world.
Jerry is a motivated seller who has been transferred to another city for work but can’t sell his current house, even though he has been trying for months. Real estate investor Kevin meets with Jerry and agrees to sign a five-year lease option agreement for $70,000, in which Kevin will pay Jerry $500 per month over those five years. Kevin gives Jerry an option fee of $1,000 and takes control of the property.
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Once the contract is signed, Kevin begins marketing for a tenant/buyer to sign a secondary lease option with. After a few days and a couple of Craigslist ads, Kevin makes an arrangement with a local graphic designer, Rhoda; she pays a $3,000 nonrefundable option fee, signs a two-year lease with a two-year option to buy the home for $100,000, and agrees to pay a monthly rent of $1,000.
At this point, Kevin is simply the middleman. Rhoda pays Kevin $1,000 each and every month, while Kevin pays Jerry $500 per month, giving Kevin a monthly cash flow of $500. Additionally, Rhoda put down a $3,000 option fee, whereas Kevin gave Jerry only $1,000 for the option fee, which means Kevin is not only making significant monthly cash flow but he also made $2,000 on the deal. (However, if Rhoda ends up buying the property, that $2,000 will come off the top of what Kevin would get at closing. He is smart and saves that $2,000 for a rainy day.)
Two years later, Rhoda decides not to buy the home. She moves out, forfeiting her $3,000 option fee, and Kevin (with three years left on his five-year lease option contract) decides to look for another tenant/buyer. He finds Sam, a local bank teller, who pays a $3,000 option fee and moves into the property, paying $1,100 per month for rent and getting an option to purchase the home for $110,000. After one year,
Sam is able to qualify for a mortgage, completing his option and paying $110,000 for the property. Kevin sends all the paperwork to the local title company who carries out the sale, and he walks away from the deal with almost $40,000—in addition to the cash flow he had been receiving for months.
[This article is an excerpt from Brandon Turner’s The Book on Investing in Real Estate With No (or Low) Money Down.]
Have you ever used lease options creatively in real estate?
Let me know your experiences with a comment!