Lease Option Investing

Exactly what is lease option real estate investing? A lease option is basically a rent-to-own contract for a piece of real estate. The buyer signs an exclusive contract to have buying rights to a property after a given amount of time. When the allotted time expires, the buyer can do one of two things: buy at the price agreed on when the contract was signed, or don't buy the property and forfeit down payment.

To make this easier, let's take a look at this from a buyer's eyes.

Buyer

Why would anyone use a lease option for real estate investing? Try risk management. If you were shopping for a home a few years ago (before the market went bad) but were unclear if the area would be hit by recession, you could use a lease option to pay monthly 'rent' and then wait for the contract to expire. The next step would be to get the property appraised. As a buyer, a lease option means you do NOT have to buy the property.

So when you look at the home appraisal after a few years, you compare the current market value to that of the agreed upon purchase price. If the home is worth more than what you agreed, you can purchase and gain instant equity. But, if the property went down in value, then you can leave the deal with no ties and are only lose the down and monthly payments.

How about some real numbers to see how this works? You sign a lease option to buy a home for 100,000 after a 3 year contract. You put 3% down for the contract as you 'good faith', and agree to pay 100$, above current market rents (this excess going toward a future down payment when the real purchase takes place).

When the contract is over you have the home appraised. Luckily the home went up 10% over the last three years! Suddenly you have exclusive rights to buy the home for 10k below the current market value! Since you already put 3% down and can couple that with 100/month (2400) credited for the purchase, you have a total of 5400 (5.4%) toward the real purchase! Now, 10% of 110000 is 11,000 and you now have 5400+10k in equity for a total of 15400 towards buying this property! So, with 3% down and a little thriftiness you have gained a 15.4% down payment!

Yeah, but if the house went down in value? So the appraisal comes in at 90,000. Ordinarily, since the house went down 10k, you would have to shoulder that loss. But since you purchased a lease option, you get to walk away from the property instantly and with no further commitments. However, you do lose the down payment and the extra 100/month. In other words, you lose 5400$. Yes it's a loss. However, if you had bought the home for 100,000, you would be suffering a loss of 10,000 instead of 5400! This is a loss regardless, but you save yourself nearly double the loss by using a lease option.

But how does this benefit the seller?

Seller

During these poor economic times, it's very tough to sell your property since there are many sellers polluting the market and increasing the number of unsold houses. The excessive inventory lowers overall prices. Now, for some reason (personal or financial) you need to sell your property and fast or cover the payments.

Lease options can do both and here is how.

Thanks to the financial education available, many people want to buy a home but do not have the credit or the full down payment needed to buy a home. Seriously, how many people do you personally know that could be identified as one or the other? These people are ready and willing to buy a property but can't get a bank to look in their direction. Hence why a lease option for a low down payment that accepts medium to poor credit has such a strong customer base.

Okay, time for some more real numbers, this time from the seller's perspective. Let's assume you have a home that you paid 200,000 to buy. Then the market plummeted and now your home is worth 190k. You will have a 10,000 loss in combination with realtor fees if you were to sell your house. I doubt this sounds appealing. What about renting it out to cover the payments? Assume local rents for a 3/2 in your area average 1100. This would not cover your approximate $1400 payments. Are you screwed? No.

You jump on craig's list and offer to lease option you home. 'Rent to own this 205k house for as little as 6k down!' Then you detail the extra monthly amount that will go toward the future total down. Notice you asked for MORE than what the property is currently worth. Why? Because those buying the lease option are buying based on an ESTIMATE of what the home will be worth when the contract expires.

Now take a look at the monthly premium. Obviously the regular rents in the area will not cover you payments. So let's break the payments down a bit. Of the $1400, roughly 200 is used to reduce the principle, so you will get it back upon selling. So the1400 is really 1200. That's isn't too far from the1100 regular rent. Since you're doing someone a favor by carrying the contract, asking an extra 100 more should be reasonable. HOWEVER, the buyer will also be paying more to be used as a future down IF they decide to buy. If the buyer does not exercise the option, then you get to keep all the extra money (down and extra monthly payments).

What this means is that your monthly payment would be 1100 plus a 'fee' of 100. In addition, there is the negotiable amount toward the buyer's future down payment. Assume that extra payment is 200/month over the 3 year contract. The buyer could have the mitigated risk purchase of your home IMMEDIATELY for a paltry 6000$ down and modified monthly payments of 1400. Oh, but we aren't finished. That just happens to be the exact same amount you're paying and you have a real bank mortgage!! Hopefully you can see how this could be appealing to potential buyers that are lacking the down payment. And it's all mitigated for risk!

So how does that really benefit you? Well, the buyer agrees to a purchase price that is NOT impacted by the current economic slow down. You adjust the this price as if the property had never lost any value. In other words, you want a 3% annual appreciation on your home so you offer a 1 year purchase price of 200,000+3% or a two year buy price of (200k+3%)+3%. This would be 206k and 212180 respectively.

The 3% is really $6k. But, isn't that the same as the down payment for the option?! So if the buyer does NOT buy the house after 1 year, you STILL get the 3%!! Now, add in the extra monthly 200 and you get another 2400 per year! And if they DO buy the house? You get your 200k+3% anyway! Lease options are a win-win situation.

You get your % regardless of the market value and the buyer gets their purchase mitigated for risk at the same price while getting a potentially substantial gain in equity!