the Right Way
As an experienced investor I am often asked about lease options and rent to own programs. First, let me say that I believe these are excellent programs – but in a limited number of circumstances. I am frequently asked what percentage of my lease option tenant-buyers actually end up buying the house. When I tell people that my average right now is greater than 90% of them DO eventually buy, I am looked at as if I must be from another planet, at which time I'm reminded that this ratio is much, much higher than the national average and therefore it cannot be right. This leads me to the point of this article – to discuss how I believe lease options SHOULD be approached as opposed to how most investors approach this investment strategy.
I saw in a recent article of Forbes magazine discussing the Top Ten Rip-Offs of real estate some comments regarding lease options which prompted me to write this article. Indeed, I agreed with much of what this article had to say. It is an unfortunate trend, but usually when you have a hot market as real estate has been in much of the US in recent years, coupled with the 'gurus' out there pushing questionable tactics to make a quick buck, you have people who either knowingly or unknowingly cross the line of what is fair and ethical in pursuit of the pot of gold.
Let me briefly review the lease option, at least the way it is properly structured here in North Carolina. The lease option is really two agreements. First, you agree to lease to the tenant. Then you grant the tenant an option to buy the property provided they fulfill a certain set of terms and conditions. Much like a stock option, the option is granted by the owner, or "optionor," in exchange for a price which is paid by the buyer of the option, or "optionee." The fee paid for the option is known as the "option fee." The option is valid for a specific timeframe, after which it expires. If the optionee wishes to buy under the terms of the option, the option must be exercised prior to expiration. Often a percentage of each monthly rental payment is also credited to the tenant's future purchase, this credit being known as a "rent credit". Provided the tenant exercises his or her option before the option's expiration, the original option fee and the accumulated rent credits are given back to the buyer, typically at closing of the purchase transaction at which time the amount returned will typically become a part of the buyer's down payment.
In a lease-option situation there will be three documents. The lease, the option, and an exhibit to the option which details the purchase and sale transaction terms should the option be exercised. The option should be recorded but the lease and the exhibit are usually not recorded unless the lease is for a period of three years or more in which case it must be recorded, at least here in N.C.
- The tenant buyer knows the price in advance as well as the time frame over which funds must be saved. This provides a structured approach that helps with budgeting.
- The tenant buyer is able to occupy a home they can really call 'home' well before actually purchasing the property since the option does give them some equitable interest in the property.
- At the time of option exercise, and provided the tenant has an account in good standing, the landlord can provide a solid reference to the tenant-buyer's lender.
- At the time of purchase by the tenant-buyer, some lenders may treat the lease option more favorably than a typical purchase transaction.
- The landlord may get a slightly higher than market cash flow for the property since a portion is being credited back to the buyer as a rent credit (the straight rental portion can be at market level)
- Tenant-buyers may take better care of the property as they are more likely to have the "buy mentality" and as they plan to own the property in the future
- Tenant buyers are more likely to pay their rent on time as often this is a criteria for the option to remain valid and default would result in loss of more than just a security deposit
- Some of the typical maintenance a landlord performs may be shifted to the tenant-buyer (this usually does NOT include maintenance required to maintain the property in "fit and habitable" condition).
- The landlord may be able to lock in the sale of the property easier than with an open market listing and may get a slightly higher price since there is usually little or no negotiating on price in a lease-option situation – note, the property should NEVER be sold at more than market value and the tenant-buyer should always have a clause to allow them to get out with their money if the appraisal doesn't come in and the seller doesn't agree to sell at the true market value.
There are downsides to lease-options, a few of which are noted below.
- The tenant-buyer must be in a position to buy before option exercise or they lose the option.
- With most options, once the tenant-buyers feel they can buy they exercise their option, and then the purchase contract kicks in. If they cannot close the option is gone unless the optionor agrees to renew.
- The total monthly outlay of cash may be more than just a straight rental would require, possibly putting a financial burden on the tenant-buyer.
- If the option is improperly structured it can be very difficult to get a tenant-buyer out of the house if they default (since they have equitable interest in the property)
- Property values may increase due to some unexpected change, or may increase faster than anticipated and the landlord may end up selling at below market value.
- The sale of the property while an option is outstanding will be more difficult then if free and clear title was in place.
The proper way to enter into a lease option with a tenant buyer is to assess the tenant buyer's credit and financial situation up front. Find out if the tenant buyers have a realistic chance of exercising the option and buying the house and if they do consider whether it be affordable for them so they don't experience further challenges by going bankrupt or being foreclosed upon once they buy. It is harder to find a lease-option tenant buyer who fits the criteria but if you wish to conduct your business in an ethical and morally sound way, this is the ONLY way to do it! During the lease-option period, send information to your tenant-buyer to educate them on what they need to be doing to clean their credit up, encourage them to not spend their money frivolously but to save for the additional down payment they'll need, etc. In other words, do what you can to HELP your tenant-buyer live up to their end of the agreement and expect that they will exercise the option. That should be BOTH of your goals. Never ever do things to hurt your tenant-buyer such that they won't be able to buy in order to "recycle" the option.
If you intentionally induce a couple with dreams of home ownership to enter into a lease option agreement when you know they will have little hope of buying, just so you can keep their money in the end if they can't exercise their option successfully, you're playing the lowest game in town and your hopes of long term success in real estate are slim indeed. Those who succeed long term realize that they provide a valuable service, and they provide it honestly and with morally and ethically sound business practices. These are the investors who will never want for business and who will be standing when the "get rich quick at all costs" investors have fallen by the wayside.
Now, understand that when I carefully screen a lease-option candidate, accurately and carefully explain the program, with its ups and downs to the candidate tenant-buyer, when I work to educate them during the option period, and then they go out and do something stupid that ruins their credit further, or they fail to work to save more down payment money, then when they cannot successfully exercise their option, and it is clearly of their own fault, I DO keep the rent credits AND the original option fee, as agreed. I explain to them that this is MY compensation for taking the property off the market, for my trying to help them along the way, and so forth. But this is a rare occurrence for me so far, happening less than 10% of the time.
Lease options are a good thing if approached correctly. Sadly most investors
approach them the wrong way and as a result they leave behind them financially
shattered people who once again dreamed of the American dream of home
ownership, and once again the dream ended in tears. Don't be one of the
investors contributing to the heartache. Be one that brings smiles to
the faces of those to whom you lease option and indeed who buy in the
end. It's a great feeling when you help make another person's dreams come
We hope that you have found this article useful and we welcome your comments and suggestions.
Copyright © 2006 by Ron D. Pate. All rights reserved.