The Pros and Cons of Lease Options

InvestorDirector.com

Buying or selling a home through a lease option has its perks but also some disadvantages

 Because mortgage lending guidelines have tightened considerably since 2007, prospective home buyers often find themselves unable to receive the financing they need to purchase a home. When fewer home buyers can get financed, sellers compete against one another as housing inventories grow; this ultimately drives home prices down. Low prices are good for buyers, but bad for sellers; especially in today’s unique market, as many sellers and investors owe more on their homes than they are actually worth.

Some clever sellers can see past the problem of being overleveraged and are allowing buyers, who may not currently qualify for a traditional mortgage, to lease their home for a period of time while the buyer builds their credit profile to a level that qualifies them for a mortgage under today’s banking guidelines. This type of transaction is often called a lease option or “renting to own”, and can be beneficial to certain sellers and buyers based on their financial circumstances. There can be pitfalls for both parties however that need to be understood. Whether you are a buyer or a seller, this article will help you identify the advantages of a lease option and foresee various pitfalls; helping you decide if a lease option is right for you.

The pros of a lease option

• A lease option sale can rescue sellers and real estate investors who owe more on their homes than they are worth because certain buyers in today’s market are willing to pay more for a home. Because traditional mortgage providers have guidelines too strict in today’s market for many buyers to obtain a mortgage, certain buyers don’t mind paying too much for a home, knowing their lease (and eventual mortgage) payments, in combination with eventual appreciation, will put them in a favorable financial position later on. Sure there are many great deals in today’s marketplace right now; but if certain buyers can’t qualify for one, then a high priced lease option is the next best alternative.
• With a lease option, the buyer’s initial down payment to the seller helps them obtain traditional bank financing later on. The days of “zero down” real estate are gone. Flagstar Bank has a conventional loan product with 5% down – the lowest we’ve seen for conventional mortgages since 2008. The Federal Housing Administration (FHA) insures loans with a minimum of 3.5% down. Either way, the buyer has to put some “skin in the game”. One important advantage for both lease option sellers and buyers is that required down payments can be contributed to the eventual purchase through the lessee-buyer’s monthly payments. Both parties should make sure a well executed lease agreement states how much money on a monthly basis goes toward the eventual home purchase.
• A buyer’s lease payments can “buy time” for sellers who are in competition with other sellers in today’s market. Time is what’s needed for the market to rebound; which is another reason why lease options are advantageous for certain sellers. A lease option buyer’s lease payments cover most of the seller’s mortgage payments every month when sellers are overleveraged. In situations where a seller has a small loan to value (LTV), the lease payments will often cover not only the mortgage, but property taxes, insurance and there may even be a few bucks extra at the end of every month to provide a cash flow.
• Lease options allow buyers a sense of ownership; without the owner of the house having to deed possession of the house to the buyer. This is unlike a land contract, where ownership is transferred to the buyer and taking possession back in the case of nonpayment, can take months through an expensive foreclosure process. With a lease option, the lessee is really just a renter until they pull the trigger and obtain bank financing. Lease options protect sellers because they stay in an ownership position until it is certain the buyer is ready for a mortgage. If a lessee-buyer stops paying for whatever reason, the seller can evict them; which is much cheaper and much faster than foreclosing on a land contract.
• Because a lease option buyer has a sense of ownership and has put up a nonrefundable down payment, that buyer is less likely to be haphazard with the dwelling as compared to a tenant who knows they’re on borrowed time and will probably have to move at some point in the future. Maintenance is handled by lessee buyers as well, which relieves sellers of this responsibility.
• Also important to note, a nonrefundable down payment often covers the cleaning and touch ups that are needed if the lessee decides to move out. Many vacating lessees leave a dwelling in less desirable condition than when they moved in. A nonrefundable down payment of at least 5% of the home’s value covers vandalism and theft, should there be any, from a non performing lessee buyer.

The cons of a lease option

• Unfortunately for sellers, it takes time to realize profit through a lease option sale as most lessee buyers simply aren’t credit worthy at the time a lease option is initiated. If they were credit worthy, they’d be prequalified for a mortgage and shop for the best deal, capitalizing on instant equity in the process. A lease option is a second choice for most buyers. And because the vast majority of lease option buyers can’t obtain a mortgage right away, they need to be diligent about improving their credit and personal finances. This often requires intervention from sellers who must know the game of home finance and know how to get their lessee buyer in position to buy a home somewhere down the line. This is best done by working with several bank loan officers and mortgage brokers who can offer timely advice and solutions to get the lessee buyer to the finish line.
• For sellers, it is imperative to screen a lease option buyer so that they have the ability to purchase the home later on. It’s one thing to have marginal credit with the hope of improving it through some small steps, but it’s a whole other thing to have wrecked credit and a debt to income ratio that is simply too high to ever qualify for a home. Tax liens, past foreclosures, child support, bankruptcies; the list goes on. This is why it’s crucial to make a loan officer your best friend when screening lessee buyers. It makes no sense to initiate a lease option if the buyer has no hope of closing the deal down the line.
• For buyers, be aware that scams exist. Check to make sure the seller isn’t in foreclosure by pulling public property records down at your county building. Also, make sure the person who says they’re the owner actually is the owner before you put up a down payment. Often times, people use vacant houses as a lure for unsuspecting lessee buyers who put up thousands in down payment money, only to get evicted later on.
• Sellers should be aware of what experienced real estate investors call “professional tenants”. Some lessee buyers out there simply aren’t motivated to close their end of the deal and wind up stalling the deal indefinitely. This isn’t so bad for sellers that owe little or nothing on the subject home and have a cash flow generated by the lessee’s monthly payments. But for sellers that are in “panic mode” and must sell their house at all costs, professional tenants are a nightmare. It is best to work through your attorney before a lessee buyer moves in and structure the lease option agreement with various performance clauses and deadlines. When a deadbeat lessee knows they have to perform by certain deadlines, they may be cast aside before trouble starts.
• If down payment is set too low or is refundable, then you may wind up with a renter on your hands who has no incentive to finalize the deal. Renters usually treat a seller’s house in a much less desirable fashion than a lessee buyer would. Don’t give any potential buyer an inch of wiggle room or you, the seller, will get taken advantage of.
• Most banks and mortgage providers do not like mortgage amounts less than $50,000. Buyers and sellers may be out of luck in low income areas or in areas where houses are very cheap. Why enter into a lease option agreement if there is no hope of ever closing the deal based on standard lender guidelines? It’s wise to check with a loan officer before you consider a lease option.

Attention real estate investors

An individual does not have to own property to profit from a lease option transaction. Referred to as a “sandwich lease option”, real estate entrepreneurs can market themselves to vacant for sale by owner houses (FSBO’s) or vacant but listed homes in which the listings are about to expire. A home’s current state of vacancy indicates that the seller would consider leasing to a buyer while the buyer seeks a mortgage. The sandwich lease option technique also involves marketing to buyers and having a good understanding of mortgage guidelines to verify which buyers can indeed be financed. Be aware that placing a bad tenant can end in a lawsuit directed at the person who structured the deal.

A warning for buyers and sellers

Because of today’s depreciating market, many deals have no hope of closing without guidance from a real estate professional. The success of a lease option thrives on the expertise of a mortgage professional who can steer both buyers and sellers around today’s most common lease option roadblocks such as:

• A seller who owes too much on a house than it is reasonably worth. In a situation like this, the lessee buyer could be qualified to obtain a mortgage and the lender will kill the deal in its final underwriting phase based on a low appraisal. A buyer may be leasing the subject home for years before appreciation or applied payments facilitate the eventual sale. The only immediate fix for a scenario like this would be a short sale which involves the seller’s current mortgage carrier accepting the sale of the house to the lessee buyer for a price short of what is owed by the seller. This unfortunately, is a common scenario in today’s market.
• Tight credit standards of today can keep transactions from closing. A mortgage professional’s knowledge of credit improvement techniques and current lender guidelines really help buyers get in a qualifying position to drive the deal to the closing table.

Lessee buyers and lease option sellers are best served by communicating with one another throughout the process and working together through a highly experienced mortgage professional. Mortgage professionals that work at a particular bank can only offer one viewpoint and few loan products: their bank’s. For a lease option transaction, buyers and sellers should wedge a mortgage broker between each other. A mortgage broker works with many banks and has more financing and buyer credit enhancement solutions than a bank loan officer does for a lease option transaction.