“Great spirits have always encountered violent opposition from mediocre minds.” – Albert Einstein
One of the perceived barriers to entry into the commercial real estate arena is the lack of capital. One really interesting tool to negotiate this barrier is the master lease option (MLO). While I am not advocating this as a zero down method, it is certainly a less intensive way to start.
The master lease option is the “Big Brother” to the sandwich lease in residential real estate investing. The principal is the same: you lease the property from the current owner and then turnaround and sub lease the property out. A master lease option is different from seller financing in that the title is not actually transferred. Instead, the lessor (the owner) rents the property to the lessee (you, the investor), and you in turn rent it out to all the tenants in the property.
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So Why Would a Seller Do This Strategy?
The common wisdom on this philosophy is that buyer’s motivation is necessary and is the core lynch pin. If you want to join me in the quest for a master lease deal, check out the advantages we can offer to the seller:
- The management headache will become ours in a very short order. This deal can close very quickly relative to a financed transaction.
- More flexible on option price we can offer more because they are flexible.
- More default protection. Because this is a lease it will be a easier to take the property back – especially with an arbitration provision.
Okay it sounds great right? What are the risk if you’re a seller?
- Counting on the performance of the MLO operator: why will they do a better job than you?
- Forgoing the sales opportunity. The MLO operator then is really who your banking on!
However, there are also some risk to the MLO operator are also at stake:
- How will you know the seller is making the mortgage payment?
- What if you have a large capital expenditure needed? How will that happen?
How a Master Lease Option Works
Now that we have determined the pros and cons for all parties – how will it actually operate? The most common method I have heard of is setting the lease option payment equal to the existing cash flow; the MLO operator is therefore best served by acquiring deals that have a management upside. For example if the property is 60 to 70 percent occupied a great marketer can quickly run this up.
This is where it really benefits to be a skilled operator – because you can raise income or reduce expenses to make more money! Lets break it down in my example and assume we MLO a 15 unit property that has a value of $283,000 at 70% occupancy at 10% Cap.
We have learned some great tips from BiggerPockets and over time we have leased it up to 95% occupied. At a 10% cap rate, we CREATED value of $178,000 with a modest rent increase of $100 per unit over thirty-six months. At that point, it’s probably pretty easy to get a commercial bank loan at favorable rates with that much equity in the deal.
Overall, Master Lease Options are another tool in the tool box for investors. I will definitely report back when I score my first MLO win!
Have you ever used one? What was the experience like?
Photo Credit: Wasfi Akab