Why Lease Options Rock In Buyer Markets

Why Lease Options Are A GREAT Investment Vehicle Going Into A Buyer’s Market (or any market)

The Short Version

First, the short version for the ADD-minded reading this: Lease Options work in a buyer’s market because you can offer today’s fair market value to a seller when they don’t believe they can even sell their home slightly below fair market value. You’ll pay their mortgage until it sells and are responsible for finding a tenant-buyer to buy the property and you’re responsible for most of the repairs, which you actually pass along to the tenant buyer. You, the investor, never have to invest a single dollar into the property and do not require any credit (if using sandwich lease options, which is what I’m going to describe here). You just make money, because you took the time to learn how to do this right. Lease options only work in working class neighborhoods and up, not low income or war zones. The house shouldn’t need any real repair, though some updating needed is ok. So, there’s the extremely short version. Now onto the real post.

For The Naysayers

But first, a note for the ones that want to argue the market cycle comment. I’ll quickly address that comment, but that’s not the focus of this post. Look, a buyer’s market is coming. Some people don’t want to admit that and think they can squeeze a little more time out of the seller’s market. But the market goes in cycles; it’s been proven time and time again. Trying to time it just right is like trying to time the stock market just right and sell at the very tippy top of the peak for maximum profit. That’s what amateurs do. That’s greed overtaking you. If you know you’re at or around the peak and your strategy is to “sell high” then sell when it’s just “high”—don’t wait to time it perfect. Because when the tide turns and you try to sell while it’s going down, fear is going to overcome you and you can lose a ton of money (and sleep) fast! But, if you think “this time will be different” then do your thing. I do not believe it will be a repeat of 2008, but it will go down for a period of time (most of my associates believe a couple years) because history repeats itself. And it’s not so much “it’s going down” but it’s a market correction for an inflated market. Values will continue to go up over time, but for a period of time, they’ll “dip” down compared to now. During that time many people will freak out. So, if you’re using flipping as your primary or only real estate investment vehicle, now might be a really good time to learn other strategies or be extremely conservative with your numbers or talk to seasoned (more than one market cycle) flipping veterans who made it through the last cycle with their shirts on. I’m not much of a flipper, so don’t ask me and if I’m being honest, we got into real estate right after the ‘08 crash, so I cannot speak from experience of actually going through the crash (I count my blessings). My last point on this subject is lease options are not the only strategy that works in a buyer’s market, so don’t think that’s my point. But they work great in any part of the market cycle. Tax liens, subject-to deals, notes, buy & hold, wholesale, and other strategies work as well in a buyer’s market—if you know how to do them right.

About Lease Options

What I focus on is lease options. First, for those that don’t know what lease options (LOs) are, the simplest way to put it is it is a lease of a property, with the option to buy it at a set and pre-agreed upon price within a contract for a set amount of time. They also go by rent-to-own to the average consumer (sellers & buyers). They are legal in all states, though Texas, Maryland and North Carolina do make it a bit more difficult, but still possible (you’ll need an attorney to help you in those states). I’m not going into extreme detail on how exactly to set up a lease option here, but in-depth enough to get the concept down pat. I’ll be posting more content going into more detail on other areas of lease options in the future. Way more to come, so stay tuned!

Ok, so now why are LOs so great (finally, to the point). I’m going to explain it in a hypothetical example, using one of the hardest examples for an investor to overcome with lease options, so that any other example variant is easier. Tone of the toughest way to do LOs is through an agent, so that’s what I’ll use. I’m also going to go into a fair amount of detail in this example so that you understand the concept of LOs pretty well. As for the true nitty gritty details with paperwork examples and such, that will be for another blog. Now, onto to the story.

Lease Options During a Buyer’s Market

So, during a buyer’s market, sellers are stressing out trying to sell their home as it sits on the market. For those sellers that have moved away due to say a job transfer, divorce, or—from my background—a military move, they need to get that mortgage off their back quick. Quite a few will try and rent it, but many don’t want the headache of renters, either out of fear or bad experiences. Many sellers, especially with VA and FHA loans, do not have much equity in the home if they haven’t owned it for long. And these days, those loans are common in a buyer’s market. So, when they bought that $190,000 home 2 years ago when the market was booming, they thought it would keep going up and up, now in 2018 it’s worth say $200,000 fair market value (FMV). Not too bad. So now they want to sell and need to sell quick, so their agent says “if you want to sell it quick, list it for $195,000, which is $5,000 below market value.” The seller says let’s try $200,000 and just see what happens…

A month goes by and some bites, a few offers around the $190,000 and $185,000 mark come in. The problem? They owe $177,467 (24 months @ 4.75% interest with 3.5% down). Then their agent tells them that they would have to bring money to the table to sell it to cover commissions, all closing costs and fees. Wait what? (crappy agent for not explaining this early on). This is where the very dark reality sinks in. “But we just spent a bunch of money moving and want to buy a new home” says the scared seller. The agent replies “sorry, but it’s now a buyer’s market and people are paying less for homes. You can try renting it.” The seller tried renting a home before and the tenants were terrible. They complained often and were always needing repairs and left the place a mess, costing the seller $2,500 in repairs and cleanup after they left—which (because they’re not professional landlords) they didn’t plan for and it stung. So, “No! No freaking way are we renting it again!” So, what does our seller do?

*Cue cheesy music* In rides our knight in shining armor with Lease Options! The real estate investor has just the thing for them. They will lease it from them for five years, with a monthly rent equal to the mortgage price of $1350 and agree to pay today’s FMV of $200,000 if they execute their option to buy. For “worst case scenario” purposes for the real estate investor, we’ll say that the sellers kept their crappy agent. The investor sends the offer letter with two offers, the first offer is to lease option it for $1350/mo with the option to buy it at $200,000 within 5 years. The seller will be responsible for only repairs above $500. The investor is responsible for all repairs below $500 (stay with me, you won’t be). The investor will be subleasing the property, but will pay the $1350/mo regardless of someone rents it or not. The second offer on the offer letter is a cash purchase of $140,000, 14-day inspection period, close within 30 days (classic wholesale offer). Which one do you think will work for them?

“Make ‘Em An Offer They Can’t Refuse”

Now, remember this agent sucks. They’ve never heard of this, so they try to convince the seller it’s a bad deal. But, the agent does know they have to present the offer and so they do. Your offer letter is one page long and uses simple, easy-to-understand terms that help put their mind at ease a bit. You even have a logo and your professional picture on there, so there’s a little bit of a connection there—you’re a person (how many offer letters have a person’s picture on them? Exactly! Maybe you included your website link at the bottom to one of your websites that can reassure them of your legitimacy, credibility and give them more information on how this works. You even include a statement that “we (or I) understand this offer is outside of the ‘typical’ offers you may have received. If you’d like more information, we are more than happy to speak to you over the phone, in person, or you may visit our website to help you understand how our offer can greatly help you.”

Making The Connection

So, now, even though Mr. Crappy Agent says it’s a bad offer, these intelligent sellers do a little research. They go to your website that explains to them how you can help them. You include a passionate video of you explaining lease options--but you use the term “rent-to-own” because it’s easier to understand. [NOTE: Be sure to be excited when you make the video. My first one was very dry, monotonic and booorrring. My own wife couldn’t stand watching it. Live and learn, right? For the technically challenged, recording a video and uploading it to YouTube is easy; if you don’t know how, Google it.]

So now, the seller sees you again, helping to establish a little bit more of connection, beginning to build some trust (it’s just how the brain works, you don’t have to understand it). Maybe you have a couple testimonials on there from previous deals. It doesn’t have to be LOs, it can just be previous clients saying how great you were, the point is to build some trust. You have as many things as possible to make the seller feel at ease to at least call you or your company. Now, whether the seller calls you directly if they’ve fired their agent or goes through their agent doesn’t affect your profit, but an agent in the middle will make it more difficult because many of them don’t understand LOs. You will have to explain it probably to both the agent and seller (if you get the seller to talk to you). Do not get hostile with the agent simply because they don’t understand. Expect them to call you not understanding and having lots of questions and probably with a skeptical tone. Don’t take it personal. Instead, make it a challenge to convince them otherwise!

Accepted Offer And The Contract

So, they finally come around accept your offer and you go to the home to meet them (if they’re there) and get it under contract. If not, you get it under contract through the agent. The agent still gets their commission when the house closes unless there is something else in the contract between the seller and their agent which has nothing to do with you (in other words, stay out of it). You can explain this to the agent to help put their mind at ease, but most will still want their commission soon. This is one big reason agents inexperienced with LOs do not like or know about LOs—they want the commission now—and I don’t blame them, but in this case, the agent cannot really help them much anyways. Now if you’re dealing a very old listing that the agent knows they are probably about to lose the listing, so you may be their saving grace to make some money on the deal, even if it’s a few years down the road. Plus, unless you’re an agent yourself, you wouldn’t need a buyer’s agent at all to do this, so the entire commission goes to them. It may not have been their ideal situation, but it’s better than nothing. Remember, this is not your problem, so don’t get sucked into feeling for them and offering them some of your money on the front end (more on that shortly). You’re helping people here, but you’re not giving them all your money. I see this trap a lot with inexperienced investors.

The Tenant Buyer

Once under contract, you get a tenant buyer to get into the property. Real quick on what a tenant buyer is: they are someone who wants to buy a home, but can’t due to bad credit or is nervous and not quite ready to commit to buying a home, but wants the option. They must have enough income to eventually qualify for a mortgage, but right now, they’re credit or personal situation holds them back from a mortgage. I’m not going to go into great detail of how to find tenant-buyers, but will give some simple methods (later, I’ll write a blog titled “How To Find Tenant-Buyers For Lease Options” so stay tuned). Some easy and free methods, in 2018, is posting an ad on Facebook Marketplace (not FB ads) and Craigslist (be prepared for investors calling you with Craigslist ads). Facebook has been a great one for me.

I actually prefer to have a strong list of tenant buyers first before getting properties under contract. This is the safest method, so there’s very, very little chance of you getting stuck with a property and no tenant-buyers to fill it if you chose a good home in a good neighborhood (working class & up) like I said. Again, I’ll go into more detail in another post, but you find the tenant-buyer and make sure they have income and some money saved for a down payment. I require at least 3% of the future home price (what I’m selling it to the tenant-buyer for) down. I use 3% for three reasons: one, it’s the lowest an FHA loan will take down. Two, it’s enough to make sure they’re committed to serious about buying the home. And three, it gives me some up-front capital for my business. Now, I said “down” but it is actually a “Non-Refundable Option Consideration” or NROC. If and when they buy, it becomes a down payment on paper (aka paper credit) on the HUD. You will need to explain this to the mortgage lender or just have your own mortgage lender that you use for lease options (more on that in the post I’m writing for tenant-buyers). So, basically, that money is yours to keep, save, spend, invest however you like. You never have to give it back once the tenant-buyer signs the contract. Now, in my contracts I put that they can get a third of their NROC back if they meet certain conditions, but more on that in the next post on tenant-buyers.

Future Equity

Earlier I said “future price.” Where we make the bulk of our profit is that we buy for what it’s worth today and sell what we expect it to be worth in the future. In an appreciating market (last few years), that can generate some great profits. But in a buyer’s market, the profit is not as much if sold during the buyer’s market, but it is safe and reliable. If no one buys during the buyer’s market, it will go back up after we come out of the dip. In the ideal situation, the tenant-buyer moves in, a year or two later they buy the home, but in this case, a longer timeline or smaller profit can be expected. What do I mean by that? If it’s worth $200,000 today, you may get it under contract for $200,000, but agree to sell it to your tenant-buyer for $210,000 within two years. They agree to the slightly higher price because they cannot qualify for a mortgage anyways, so you are about their only option to buy a home. And during a buyer’s market, banks will likely make it even harder to qualify for a loan. So, they are going to be appreciative of the fact that you are helping them, not be overly picky on the price.

Cash Flow

You also make a cash flow profit each month. How? Well, the rent you pay each month is $1350—the seller’s mortgage payment, which as you remember was for $190,000 at 4.75%. But that’s not what it’s going to be in two years, it will be around $1,777 and we charge them $1800, which means a $450 per month net cash flow for you ($1,800 - $1,350). So how does that work? Well, we’re selling it to the tenant-buyer for $210,000. Secondly, mortgage rates are going up. Now, I use an estimate of 7% interest rates in two years. I do this for two reasons: one, to be conservative with the numbers. I’m slightly overestimating the future mortgage amount so that if I’m wrong, I’m wrong on the safe side to help the tenant-buyer qualify. That leads to number two, I use this so that their rent payment is slightly more than what we expect their future mortgage payment to be (we expect it to be $1,777, we charge $1,800). This way, when the loan goes to the underwriter, they can show that they have been paying a little more than their mortgage payment is going to be for the last year or two, so obviously they can afford it, hence lowering the risk. Now during that year or two’s time, our mortgage lender has been working with them to repair their credit in the interest of getting the loan (and future loan referrals) out of the tenant-buyer. Now you see why I choose to vet my mortgage lender and educate him on the process. They handle repairing (or assisting/coaching rather) the tenant-buyer’s credit while preparing for the loan to go through.

Virtually No Expenses

Earlier I said “net” cash flow and probably buy & hold investors go “wait, wait, wait, what about expenses, property management, capital expenses (capex), etc.?” Well, no need really. So first, expenses and capex. Remember how I said the seller (still home owner) covers anything above $500 which is a good deal for them? Well, the tenant buyer covers everything below $500. This is explained to them and if they’re going to be owning the home, they should get used to having to make some repairs. Of note, if they’re first time home owners and not used to repairs and can afford it, I’ll offer to put a home warranty on the house, but their rent will go up some to cover the home warranty, usually between $50-$100 per month. I don’t make anything on that, it’s just good service. So, no expenses there for me. What about property management? No need. If I vetted them well and they put down 3.5%, $7,875 in this example, that acts like their property “management” to ensure they treat it like home owners, not renters. Because it’s in the contract that if they trash the house, they lose that nearly eight grand NROC, yikes! So, you don’t get those calls of “hey the toilet is overflowing cuz my kids flushed marbles down it and you need to fix it.” What I normally get is “hey can we buy new appliances for the house?” or “can we do some landscaping to make the outside more beautiful?” Why sure, go ahead and beautify the property and help it look better for the appraisal come closing time. This single point alone is why I LOVE lease options. Mostly because I hate entitled mentality, which I see often in renters (not all, but it’s common). My tenant buyers love the fact that I’m helping them get the home of their dreams, which they are a part of making it even better. The seller certainly doesn’t mind. In their mind if someone else wants to improve their home and buy it from them, shoot, have at it!

So, the ideal scenario is they buy the home in two years, it closes, everyone’s happy. My company made $20,800 over two years without a penny invested. The math on that is $210,000 minus $210,000 equals $10,000 plus $450/mo cash flow times 24 months equals $10,800 totaling $20,800. Not a huge profit, but steady and in a buyer’s market, not bad. All I did was shuffle some papers around and make some calls…ok there’s a little more to than that, but once you build a system like I have done, it is not very hard. Now, that’s not the best example, but that’s more like worst case, crappy super-conservative numbers.

Alternatively, I can do a longer lease option with the tenant buyer or if they don’t buy, you “rinse and repeat” and put in a new tenant-buyer, collect a new NROC and now that we’re climbing out of the buyer’s market in two years, make a larger profit when you go to sell it for say $220,000 or $230,000. The longer it goes, the more you make. Now, remember how I said I offer a third of their NROC back? I only do this if they meet 3 conditions: one, they give me 60 days’ notice they are not going to buy and have met their lease terms, two they let me show the property to new potential tenant-buyers, and three they take care of the property. I refund them one third, but only once I have a new higher NROC (3.5% of higher selling price) from a new tenant-buyer. So still no money out of my pocket and my profit keeps going higher. The tenant-buyer is actually not mad at me because I offered them some of their money back and they usually feel bad they didn’t buy. Normally they cannot buy because of something like job transfer, divorce, job loss, maybe growing a bigger family, stuff like that. So, when I’m giving them a few thousand dollars back on something I made clear was non-refundable in the beginning, they are ok with that—in fact they’re very appreciative normally. Now, I don’t have to worry about a tenant-buyer trashing the place because if they do, they lose a few thousand bucks.

Wrap Up

So, hopefully by now I’ve explained it in more than enough detail for you to at least grasp the concept quite well. I’m sure some of you have more questions and I’ll be building more tutorials for folks new to lease options. For future content, I’m working on one just focused on the tenant buyer side coming up next and making some videos teaching lease options to my six-year-old daughter--so anyone can learn it. I’ll also do a blog where I go over the paperwork in detail and in that I’ll probably include links to free resources and document examples and templates. By Christmas I hope to roll out a very detailed guide of how to build a system just like mine from start to finish (might have to be an e-book later with how much I intend to put in there). Thanks BP community for sticking with me til the end and good luck!