Here are seven tips for making sure that your lease option sandwich goes off without any major issues and that you are able to achieve the most security, income, and fairness for everyone possible.
How to Analyze a Real Estate Deal
Deal analysis is one of the best ways to learn real estate investing and it comes down to fundamental comfort in estimating expenses, rents, and cash flow. This guide will give you the knowledge you need to begin analyzing properties with confidence.
8 Tips for a Successful Lease Option Sandwich
1. The longer your contract is with the homeowner, the better.
Three years is better than one, five is better than three, and ten is better than five. The more time you have, the more options you have. Also, ensure that your contract with your tenant/buyer is shorter than your contract with the owner/seller. You don’t want to o er your tenant/buyer a five-year lease but sign just a three-year lease with the owner.
2. Always let the owner know what you are doing.
This is not a strategy you should ever think of using without having everyone on the same page. Don’t pretend you’ll be living in the home just to get the contract, only to turn around and sublet it to the tenant. Be up front and honest, and make everyone comfortable with the arrangement. Your job as a real estate investor is to solve problems, so do that!
3. Screen well!
Screening your tenant is one of the most important steps you can take to ensure a positive landlording experience, especially with a lease option sandwich. Although tenant-screening practices are beyond the scope of this book, the most important things you can do are as follows:
- Always run a background check on your tenant. Look for evictions, criminal activities, etc.
- Make sure the tenant/buyer has good enough credit. Their credit score doesn’t need to be 800 for them to qualify, but it needs to be reasonable/improvable for them to be able to get a mortgage to cash you out eventually.
- Look for stability. A tenant who moves every six months without reason is probably not a great candidate.
- Don’t discriminate. Doing so could land you in jail, so know your local and federal discrimination laws and adhere to them. For more information on how to do screen tenants, be sure to read the in-depth article “Tenant Screening: The Ultimate Guide” from BiggerPockets.
4. Connect and qualify your tenant/buyer with a mortgage professional, also known as an RMLO—short for residential mortgage lenders and originator.
This individual can sit down with your potential tenant and explain what they need to do to qualify for a loan, to make sure they can reasonably hope to actually qualify. A good mortgage professional can work with your tenant/buyer to create a credit road map to help guide them from where they are now to being able to qualify for a mortgage. Setting up a meeting between the tenant/buyer and your favorite mortgage professional is helpful for both the tenant/buyer and you, and it can also help prove that you are not trying to take advantage of a tenant if you are ever accused of such.
5. Arrange to pay the owner’s mortgage for him.
After all, you don’t want to send the owner a payment each month and suddenly find out the bank is foreclosing on the property because the owner decided to pocket the money rather than passing it on to the bank.
6. Legally record your option contract with the owner at your county administrative department.
By legally recording the option contract, you will put a “cloud” on the title, and the owner will not be able to sell the property until it’s cleared. If you do not record the contract, the owner might decide to sell to another investor or a retail buyer, and your only recourse would be a very expensive and stressful lawsuit. Recording can usually be done for less than $100 and normally requires only that the agreement be signed and notarized.
7. Don’t apply any portion of the rent toward the tenant/buyer’s future down payment.
This was a popular method of doing lease options in the past, but since the SAFE Act and Dodd-Frank legislation were passed, there has been legal concern on the part of many investors that portions of rent applied toward the tenant’s future down payment constitutes a “security,” which means many additional rules and regulations must be followed (ones you don’t want to deal with). Additionally, most banks will not allow this credit anyway, so it’s just best to make the rent the rent.
8. Don’t be a jerk.
Do you remember the scene from Spider-Man where Uncle Ben states, “With great power comes great responsibility”? By this point, you can probably see that there is a lot of potential power in the lease option sandwich, but this same advice that guides Spider-Man should guide you as well, because with lease options, one could very easily be a jerk and take advantage of tenants.
For me, this is one of the biggest concerns for someone looking to engage in a lease option agreement. Because the vast majority of lease option tenants never end up actually purchasing the home, the lessee may be primed for failure from the beginning. Many lease option investors know this and proactively take steps to make it nearly impossible for the lessee to ever close on the deal. They charge huge up-front fees for a totally unqualified tenant to move in, give them a short time frame in which to buy, kick them out, and then repeat the process. The tenant, on the other hand, ends up in a far worse financial position than they were in originally. I believe this kind of unethical behavior is what gives the real estate investing industry a bad name. Don’t add to the problem.
Treat your lease option agreements as a chance to create a win-win-win scenario and help others get what they want as well. Use your power for good, not evil. This means only entering a lease option with tenants who could very reasonably obtain a loan within several years, without charging an exorbitant option fee. I want to be fair and have all parties happy with how things turned out at the end of the transaction, whether the tenant officially buys the property or not.
Finally, the government knows this is a problem and frowns on landlords who take advantage of people. The SAFE Act and Dodd-Frank legislations were enacted, in part, to help deal with these problems. Not only can you give landlords a bad name, but you could wind up in prison. Don’t be a jerk.
[This article is an excerpt from Brandon Turner’s The Book on Investing in Real Estate With No (and Low) Money Down.]
Have you ever used a lease option sandwich?
Let me know your experiences with a comment!