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December 15, 2005

How do lease options work?

  • The most successful real estate developers today use options.
    • By WENDY PATTON
    Special to the Journal

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    Patton
    Lease options are a way to purchase real estate, usually with little or no money down, sometimes even with money back in the investor's pocket.

    Money is made in real estate by controlling property. Owning property is the most obvious way to control it, but it's possible to control it without ownership.

    A lease option involves gaining control of a property, without the added burdens of ownership. It gives an investor the right to lease a home, condo, land, strip center or apartment building, and also the right to purchase it before the end of the lease period.

    An option is a contract. In the case of real estate investing, it gives the optionee (investor) the right to purchase property during a contracted period of time. The most successful real estate developers today use options, in one form or another.

    There are some risks involved, but there are ways to minimize your exposure. Options can be taken on a property without leasing it, this is called an "option to buy," or if you lease the property and have an option to buy, it this is called a "lease option to buy." This article is only discussing the latter.

    It's all about terms

    In every seminar I teach, I ask the students: "Who of you would be willing to purchase a home valued at $200,000 for $100,000?" Of course all hands shoot up. Then I ask if they would still be willing to purchase the same home if the price was $150,000. Most of the hands stay up. I proceed upwards with the price increasing by $10,000 each time. All hands slowly but surely drop. At $180,000 most hands are down. At $190,000, usually, all hands are down.

    Most investors are not willing to pay this close to retail price (nor should they in most cases). I then re-pose the question: "How many of you would be willing to pay $200,000 for that same home 10 years from now in a market that is appreciating at 10 percent per year with nothing down and $1,000 per month?" All the hands go back up. I ask: "Why, now are you willing to pay more for that house that you refused to pay $180,000 to $190,000 for a few minutes ago?"

    They respond in unison: "Because you added some attractive terms!" My response is always the same: "You didn't ask the terms before!" Most investors never ask the seller for any terms. They walk away from a deal before they know if terms are possible based on price alone.

    Terms include price, length of time to pay, monthly payment and other items negotiated with the seller. Most of the time even experienced real estate investors don't ask, "When does the seller need their price?" They are willing to walk away from a deal without exploring terms. They look at the surface but they don't dig deeper.

    Lease options can allow you to negotiate terms that can increase your profits and provide a great investment opportunity. Whenever you can negotiate the terms on real estate, the value of the property goes up. Deals that were out of your reach before now might be possible, such as large apartment complexes, strip malls or other commercial investments.

    With lease options you may be able to pay a higher price on a deal, if you can get reasonable terms.

    Commercial deals

    Here is an example of a lease option on an apartment building from my own portfolio: 42 units in Detroit. Normally, I don't buy inner city projects, however, this was a cash cow, and I could not pass it up. I bought it from the seller for $600,000 with half of the units vacant and needing renovation. It cash flowed at 50 percent occupancy, so the vacancy was not a risk.

    I put $14,000 down as my option fee to purchase this building! My payment to the seller was $4,600/month on a lease option, of which $1,100 per month went towards the purchase. Rents from the 20 occupied units were about $9,000/month. I paid insurance, gas and some expenses each month out of the extra cash flow.

    This building needed a $120,000 renovation. I wanted to make sure my interest in the property was protected before putting that much cash into the property. It is too risky when you are not the person on the title. In this situation, we were able to work it out with the underlying mortgage company and the seller to allow me to go on title and leave the lender underlying — "subject to" the existing mortgage.

    This is called a "subject to" deal — taking the deed without paying off the underlying mortgage. Now I am on title and am proceeding with all of the work to complete the building. The building is now worth approximately $1 million to $1.2 million, so I was able to refinance it and pull most of my cash out. This is all because I asked the seller if they would accept a lease option on their building. I knew they were anxious to sell and the property had been on the market for a while.

    You may be thinking we don't have those types of deals in Seattle, but we do. It also doesn't have to be a huge renovation. I really don't recommend that for a beginner in multifamily or commercial. I recommend finding an apartment building or other strip center or single-family home that doesn't need any work at all.

    How to get started

    A good beginning rule of thumb is; don't put any work into something you don't own. Get a pretty piece of real estate. There are plenty of landlords or real estate investors that are ready to get out of this business and retire. They don't all need to get equity out of their properties now. Many prefer to get a monthly check.

    Remember these tips:

    • Know the market.

    • Look for properties you want to own, areas that are either up and coming or appreciating. Don't assume they don't want to sell it now or in the future.

    • Find out who owns the properties you are interested in. You can find the owner of record at your city assessor's office. Where do they send the tax bill? Write them a letter.

    • Hire a private investigator to find the owner of a property you if you can't.

    • Check with your local REAPS group (Real Estate Association of Puget Sound) for real estate investors. They can be a great resource.

    • Keep working on the owners even if they say no today. One of my colleagues in Seattle bought a waterfront apartment building by writing to the owner for 14 years.

    Wendy Patton is an author, teacher, real estate investor and licensed broker. Her book "Investing in Real Estate with Lease Options and Subject To Deals" can be found on Amazon.com, Barnes & Noble and Borders book stores or at http://www.WendyPatton.com.


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