Lease Option Tenant

11 Replies

I have an interested lessee to do a lease with option to buy agreement. We ran a background check with a tenant screening website on both the husband and wife. The both have credit scores between 520 and 550. Their income is greater than 2.5x the rent (I'm waiting for check stubs to see if that's net or gross) and they have no evictions. 

The do have some collections on their reports that could be a bit alarming, but the wife has informed me of her efforts to repair her credit and has even offered documentation. 

The terms of our lease option are $5000 down/$1600 per month/$200 per month towards mortgage. We settled on $5000/$1550/$100. After we dragged our feet on moving forward (waiting on a buyer) they offered me $6000/$1550/$100 to show they were serious and motivated. 

Is there anything further we should do to vet this tenant? My partner and I, unfortunately, have different opinions about the tenant's history. I think they are a good candidate. He thinks not. I don't want us to make a decision based on emotion considering that we do not have experience as landlords, yet. 

What would you do?

Forgive me. The 'y' seems to be stuck on my keyboard. lol

Are you offering your personal residence?  If so and this is the first time you have done so you may be fine but the Dodd-Frank Act has added significant regulations to these types of sales.  I am not clear what you mean by $200 toward the mortgage but if that could be considered to be giving your tenant/buyer an equity position it could be problematic.  Please seek legal advice before finalizing the agreement.

$6K down may seem like a fair amount of money and it may be adequate for you (I don't know your situation).  When I look at the down payment I try to gauge what it would cost to start a foreclosure proceeding (it will be more expensive than an eviction) and how many months of lost rent I may have if a foreclosure is initiated.  In that light the $6K may not seem like all that much.

I've been playing phone tag with a lawyer but the $200 towards the mortgage is intended to be a credit towards the cost of the home when they decide to exercise the option to buy.  If the don't exercise the option the monthly option would be refundable,  but not the $5000 option fee. I'm basing my terms on stuff I've read on Bigger pockets and elsewhere.  I don't think we are giving them an equity position.  But I'll contact a lawyer.  And it's not my primary residence that I am offering.  What difference would that make? 

Giving money toward the price of the home may indeed be giving the tenant/buyer an equity position, an equitable interest.  Dodd-Frank impacts financed home transactions.  There are safe harbors for homeowners selling their own residence.  Regulations and potential penalties are much stricter for investors.  Make sure you speak with that lawyer before going too far.

Originally posted by @Shannon Elam :

I have an interested lessee to do a lease with option to buy agreement. We ran a background check with a tenant screening website on both the husband and wife. The both have credit scores between 520 and 550. Their income is greater than 2.5x the rent (I'm waiting for check stubs to see if that's net or gross) and they have no evictions. 

The do have some collections on their reports that could be a bit alarming, but the wife has informed me of her efforts to repair her credit and has even offered documentation. 

The terms of our lease option are $5000 down/$1600 per month/$200 per month towards mortgage. We settled on $5000/$1550/$100. After we dragged our feet on moving forward (waiting on a buyer) they offered me $6000/$1550/$100 to show they were serious and motivated. 

Is there anything further we should do to vet this tenant? My partner and I, unfortunately, have different opinions about the tenant's history. I think they are a good candidate. He thinks not. I don't want us to make a decision based on emotion considering that we do not have experience as landlords, yet. 

What would you do?

 Shannon:

First, let's talk about your applicant. They obviously don't have great credit, but that's who ends up being interested in lease options. They're either going to have poor credit, or they will be self-employed and unable to prove income. Think about it. Someone with good credit can get a loan. And there are plenty of fairly cheap entries like FHA. People with good credit that are renters aren't going to be interested either. So you end up working usually with people with poor credit.

After doing dozens and dozens of these over the years, I quit doing them probably 6-7 years ago.  What I found is that a zebra can't change his stripes.  If they have bad credit, they have habits that caused them bad credit.  That's problematic in one of these deals.  They all start off with good intent, they're buying a house, they're excited.  In the end their habit patterns come to the fore.  If you think about it, that's the whole basis for the idea of credit reports to begin with....people do what they have always done.

All that said, I was able to work with people with poor credit.  That option money they put up helps.  Even if they get off track, the option money goes a long ways to helping while you get them out and then re-market the house.  As it turned out however, that wasn't my biggest problem with lease options.  The biggest problem had to do with repairs.  Without going into alot of detail, I consistently got houses back that had not been taken care of.  Either they didn't do the repairs at all, or the did substandard or completely incorrect repairs.  I finally decided that I would rather do the repairs myself and just rent the house.

If you're going to do them, you want to be careful about the terms you use.  It's not "down payment" or "down".  It's option money.  "Down" makes it sound like a sale.  $100 per month "toward the mortgage".  I don't know what you're talking about here, but typically you apply a monthly credit toward the purchase price, IF, and only IF, they exercise the option.  It's non-refundable.  Otherwise you're potentially creating some type of equitable sale which might need to be foreclosed.  Your paperwork is important.

What I used to do was have the tenant/buyer put up a security deposit with the lease, and then a separate option money with the option agreement.  This way, if they exercise you can just apply the security deposit to the purchase.  If they don't, you can give some of their deposit back to the extent you don't have to spent it repairing things.  And, it helps to create the idea that it is a lease with a separate option.  It also helps in case the IRS questions whether you have sold.

In recent years some states have passed legislation that would apply to lease options, so definitely check with a lawyer to find out what, if any, the rules are in your state and/or Dodd Frank.  Some states a lease option would be considered a sale, and therefore you would have to do a non-judicial foreclosure rather than an eviction.  Again, check it with a real estate lawyer.  You don't want to be foreclosing non-judicially.  In my state I can evict, and have done so more times than I care to remember without issue.

You need to have paystubs or tax returns.  2.5X isn't enough.  But that may well be net as you said.  Prior rental history is very important to check.  Do they have evictions?  Criminal background? Are their jobs stable?  As far as credit goes, I like to look at the report, not just the credit score.  I try to understand what their priorities are in terms of credit.  In other words, do they make rent a priority, and miss a credit card payment?  I'd rather see that than the other way around.

Let us know what you decide to do.

hi Shamnon

Consider instead of a lease with option to use a lease with an ROFR which  is a right of first refusal to buy the property which can be tied to a future appraisal.  This allows them to feel certain that they can't lose the house and you can open up a savings account for them over two or three years to save up the money for a down payment. Upgrade my credit.com is a service that I use to help the tenant buyer increase their FICO score over the course of The lease. give them 12 month lease with possible extensions if they pay the rent on time and if they keep the property in good order.

If you search on bigger pockets why a row for is better than option there's more information there good luck

Hook them up with a mortgage broker with you having the right to discuss the tenant buyers situation/financials.  Ask how long it would take for him to help them improve their credit enough to purchase.

As far as giving money towards the mortgage meaning that we are giving them an equity position,  isn't it understood in doing a lease option that the option fee is more of a deposit until they exercise their option?  So that doesn't count as owner financing and we should be able to evict instead of foreclose if need be.   

We have decided to do a lease option after not being able to sell in the market so anything less than that would not be advantageous to us.  So while I appreciate the use of other strategies we have decided to go with a lease option and want to know how to make a lease option work in everyone's favor and legally. 

@JimPiper Should 2.5X the monthly rent be net or gross? And to be clear,  the $100 per month is the amount above market rent that would be applied if and only if they exercise the option.  We were advised by a realtor to use this option fee and that it had to be above market rent in order for banks to accept it as apart of the down payment in the event that they exercise their option to buy. 

@Kelly B. That's a really good idea.  Is that something that you do? 

@Brian Gibbons I'll have to look into upgrademycredit.com. Is this something that you did with ROFR or lease option or both? 

@Shannon Elam    I take it you don't have a background in lending, so if you want this to be a successful LO, get them to a RMLO to look at where they stand. 

also search BP for a post I did on "How to Set the Numbers on a Lease Option"  that will help you a lot. 

AS far as 2.5 x the rent....that really doesn't mean much in the world of successful LO's.

You want to look at DTI. Debt to Income. lenders typically look at 43% MAX. so you take their gross monthly, times .43 then deduct their reported debts such as car payment, credit card, child support, student loans etc.

What is left is the amount per month they could qualify for. 

Regardless, you are devising a financing arrangement if you accept funds with funds being under your care, custody and control that are to be applied to a pending sale, it is irrelevant if you have any agreement to return funds at some future date, you're also servicing a depository function.

This is also a good example of predatory lending/dealing, the term of your "option" and lease must be sufficient for the buyer to reasonably perform, that reasonableness is not you opinion or unlikely the opinion of your attorney unless he is skilled in underwriting issues and very, very few are.

A ROFR will have little value if it is tied to a future market price, you can set such a FROF, but charging a fee to grant the right may be predatory in "selling" the idea of such agreement being worth thousands over a short period of time, there is no measurable value in giving someone to be the first in line if a seller elects to sell at a future date at the "then" current value. Some aspects to commercial properties involving benefits of business transactions are not transferable to residential transactions.

You mentioned too that your attempts to sell failed, most likely you're asking too much or it would have sold. Devising any transaction to overcome the marketability issues basically is another predatory matter, selling for more than it is actually worth (reasonably as to market value) selling the buyer on the terms rather than the property value, the terms do not add value to a property beyond what customary financing would cost to accomplish the sale.

Property condition also comes into the picture, is the property marketable as collateral for most customary loans? A tenant nor an optionee has the right nor obligation to improve a property and doing so extends more equitable interests in the property to that buyer.

While this wreaks of predatory issues, I don't think that you are trying to do anything intentional, you're simply seeking a solution to getting rid of a property at a profit, but the methods employed with this buyer form predatory issues by design, unknown to you until now.

What are the risks of predatory dealing and financing? It's a big unknown, if everything works as agreed and the buyer actually performs, not much. In reality, most don't perform. Some walk away without issue. But, what also happens is that unknowing buyers are later informed of the issues and they decide to assert rights of equity and play to their advantage of being the victim. Dodd Frank applies here, even if you were exempt, the base line to view predatory issues will still be seen from compliance with the Act to some extent.

Another point is that if your option price is greater than 10% of the sale price, your deal will likely be construed as a disguised sale. Even if it is less and you are in control of payments to be credited toward a purchase price, you may well be required to follow foreclosure avenues rather than an eviction.

Lastly, you said this buyer showed "documents" concerning attempts to improve credit. That implies to me that she may well be seeking assistance from others, many do, credit counselors, financial advisors, perhaps an attorney in collection matters. If so, this increases the chance of discovery of your transaction with some third party advisor and they may well be versed in financing matters. At some point, your buyer will end up seeking financing from some RE lender and they will be pointing out financing shortcomings and have to deny credits as proposed. That Realtor is correct that only credits above fair market rents may be applied, the issue too is that fair market rents are determined in the future at the time of appraisal, not the historic contract date. This will be another underwriting failure of the deal and predatory issue that will be discovered by the buyer at the time they try to finance the deal.

All in all, you don't have a qualified buyer, just because they may have cash burning a hole in their pocket doesn't mean they are qualified for homeownership or in some installment contract.

I'd suggest you simply do a lease at market rents, you can sell them an option of less than 10% but that option price needs to consider the buyer's ability to perform in residential dealings, the worse they are, the less the value of the option really is.

You need to take these folks to a lender who can map out a course of action that leads to the ability to finance the deal. they must be clear about what they must do, agree to do it and that needs to be documented for you to CYA!  It's not impossible to sell to those with poor credit but it is more involved to avoid trouble. Good luck! :)    

   

  

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