Previously, we discussed the first 4 steps of putting together a profitable lease to own deal that is mutually beneficial for the tenant-buyer. Now I’m giving you the rest.
CLICK HERE to read Part 1.
Once you’ve reviewed the first 4 steps, let’s get you acquainted with the rest of the processes.
5. Collect a non-refundable option.
The option fee is non-refundable, so you’re looking for 3% to 7% down. The more the buyer-renter puts down, the more likely they are to purchase the property at the end of the lease term.
6. Set up a rental amount and payment schedule.
Just as if you were renting the property out as a typical rental, you’ll want to structure your rent to cover the mortgage as well as obtain cash flow after other expenses (taxes, insurance, any included utilities, etc.).
Let’s say the lease-to-own property is worth $120,000 and the mortgage payment is $750 per month. You’re going to set the rent at $1,200 to $1,400 per month. Be sure to state when the rent is due and how long the grace period is if you’re going to offer one. Like any other real estate transaction, you want as many guidelines set up front before obtaining all your John Hancocks, so no one is confused if anything comes up.
7. Get all of the paperwork drafted by a real estate attorney.
Because laws concerning lease options vary from state-to-state, I recommend using a real estate attorney to prepare the documents for you. Additionally, there may be local regulations of which you are unaware.
The terms will include the monthly rental amount, the final home purchase price based on the appraised value (adding a stop loss guarantee for your protection). I recommend an appraisal contingency, making sure that you maximize the property value and don’t incentivize them destroying it. An attorney will help you get this right.
Additionally, you’ll want the real estate attorney to draft an allocation of responsibility for maintenance and repair costs, a protection clause allowing the owner to inspect the property periodically, and the specific renovations allowed to the tenant.
8. Collect rent.
Now, you can collect the rent, or even sell your cash flowing property to another investor. It makes a cleanly packaged deal.
My recommendation when collecting rent is to avoid what is called an Equity Interest in the Title. It’s common and taught by a lot of people, but I don’t teach it because it gets people into trouble. Trust me, it’s not a smart play.
The way it works is this: the buyer-renter puts a percentage down on the property before moving in and paying rent. Then, a predetermined portion of the rent is applied to the principle buy down. Let’s say the monthly rent is $2,000, and $1,000 is set to go toward the buyer-renter’s principle. If the lease option is 36 months, $1,000 per month. So if the property is worth $500,000, and they’ve got $36,000 in principle and $20,000 in a deposit, they now owe $444,000.
Sellers think that by giving the tenant a reduction in principle over time, they will get a better tenant, and the tenant thinks the equity build up will come off the purchase price.
But, what happens if the value of the house increases to $800,000 by the end of the lease option? This happened in a 1994 California lawsuit. The owner wanted to get the tenant out ASAP to sell the house and pocket the difference, waiting until they were late on just one payment as to evict them, and the tenant sued the landlord for the Equitable Interest in the Title. The courts awarded the tenant any proceeds about $444,000 when the property was sold and the landlord lost.
I recommend that you use a third party escrow to have the purchase and sale agreement, as well as the lease agreement held in escrow. Close at the title company with your new tenant and hold the documents you had an attorney draft for you in escrow as earnest. The escrow company (or a servicing company) can even collect the rents and send billing statements (we do this at Lake City Servicing)
This way, you have a nice, clean deal. Everything is automated, and you just collect!
If done right, a lease option can be profitable. It’s a viable exit strategy for selling rental properties, and it’s a step I recommend if you’ve flipped a house that isn’t selling on the retail market. Like anything else in real estate, do your research first, get the help you need, and solicit the advice of professionals to assure the most comprehensive, fair, and profitable deal possible.
If you’d like more information on putting together a lease option, or what educational services I provide that can bolster your real estate game, call one of my business consultants at 800-533-1622 for details on what program would best suit you.
To Your Success;
Lee A. Arnold
The Lee Arnold System of Real Estate Investing