Buy and then sell on a lease option - one of 69 Ways To Make Money In Real Estate. Here is an example.
When you sell on a lease option basis, you generally get to collect
higher rent, and sell at a higher price. Then, if the buyer doesn't
exercise the option you may be able to keep the deposit and sell the
home for even more. The downside? Bookkeeping can be tricky, and many
tenants don't complete the purchase (this can be an advantage actually,
but it does mean more work for you).
There are many potential buyers out there who can't buy at the moment.
This is not always due to a bad credit score. They may be uncertain if
they want to stay in an area. They may have good credit, but no money
for a down payment. They may work for a good company, and have great
opportunities for advancement, but not yet have a good salary. There
are many reasons that people look for a rent-to-own or lease-option
situation.
There are also many ways in which these deals are structured. The basic
concept is that buyers rent the home, and have an option to buy it at a
set price by a set date. (An option means they have the right, but not
the obligation, to buy.) This gives them time to save money for a down
payment, to increase their income, and to find financing.
Often there is a non-refundable deposit. It might be $1,000 or $10,000.
This is sometimes called an option fee. It is generally applied towards
the purchase price when the buyer closes the deal. If he decides not to
buy the home, he loses the deposit. As the seller you obviously want to
get a large option fee if you can.
It is also common to apply part of the rent towards the purchase price.
This makes it possible for the buyer to more easily come up with a
sufficient down payment to get reasonable financing terms. Rent is
often higher than normal, to account for this credit, and as the
seller, you benefit from that higher rent if the buyer doesn't buy.
Another interesting aspect of lease-option deals is that, unlike with
normal rentals, it is common to make the tenant responsible for
maintenance. They are buying the home, after all. There are many
variations in how this is done. The tenant might be responsible for the
first $200 of repairs or maintenance in any given month, while you have
to pay for anything beyond that (It really wouldn't be fair to ask the
tenant to pay for a new furnace three weeks after he moves in.)
Pricing is normally higher than market. This is possible because you
are making it easier for a buyer to own a home. It is also because you
may be selling the home to him in two years, so it seems fair that he
pay what it is worth then, which will presumably be higher in most
areas. In other words, if the assumption is that the home will be worth
15% more in two years than it is worth now, that might be the price at
which the buyer can exercise his option - but in the end this is all
negotiable.
A Lease Option Example
Suppose you find a home that needs a little work. Its market value will
be around $200,000 after you clean it up. You buy it for $180,000, with
$18,000 down. Your closing costs are $5,000, and cleaning costs $2,000.
Mortgage payments, taxes, insurance and a water bill run about $1,500
per month, so holding costs for the first two months (Your target for
selling the home) will be $3,000.
You can't make money just buying and selling a home like this. At the
two-month mark you already have $190,000 into it. ($28,000 of your own
cash.) The likely sales price is $200,000 and a sale's commission and
closing costs will eat up at least $10,000 of that.
Then you find that you can only get about $1,350 per month in rent.
Your costs run $1,500, and you didn't get into real estate to lose
money. What do you do? (Other than planning more carefully next time.)
You put an ad in the paper saying, "Beautiful home. Why throw away your
rent when you can rent-to-own? Move in this week." By the way,
"rent-to-own" will usually get more calls than "lease option." You get
a dozen calls, and arrange to show the home to several couples at the
same time, to get a little competition going.
You find a good young couple who both work, and have decent credit
reports. They agree to rent the home for $1,750 per month on a two year
lease with an option to buy the home at $220,000 at any point during
that two years. They pay a $2,000 option fee, to be applied to the
purchase price if they buy. You also agree to apply $450 of each rent
payment towards the purchase price.
Since it will hopefully be their home, they agree to pay for the first
$150 in repairs and maintenance each month. You will cover anything
larger than that if it comes up. This means that in all likelihood, you
will not have to spend any time dealing with backed-up toilets and
such, as landlords normally have to do.
Why are they willing to pay higher than normal rent? First, it is the
only way they can buy this house. Second, since they expect to buy it,
and $450 of it goes towards the purchase price, the other $1,300 is
actually a bit less than normal rent.
Why are they willing to pay $220,000 for the home? Because you are
making it easier for them to own a home. Also, it may be reasonable to
assume that if they buy it in two years, it will already be worth more
than that (it is only 4.9% annual appreciation).
Your Profit? Let's look at two possible scenarios.
First, if they walk away at the end of the two years, you keep the
$2,000 option fee, and you had $6,000 in positive cash flow over the
two years. Ignoring any gains from appreciation or loan pay-down, you
made $8,000 on the $28,000 you have invested - not too bad for two
years. Now just do another lease option.
If they do buy the home, you have avoided the necessity of paying a
real estate sale's commission. That cuts your costs down. Here's how it
works out:
Sales price : + $220,000
Initial costs, including closing cleaning and purchase price: - $190,000
Positive cash flow: + $6,000
Equity gain from loan pay-down: + $3,500
Costs associated with selling: - $3,500
Option fee: + $2,000
Application of option fee and rent credit to purchase price: - $12,800
Total profit: $25,200
(On a cash investment of $28,000.)
Notice that the buyers have a $12,800 credit towards the down payment
($2,000 fee and the rent credit - 24 months times $450). Not many
buyers would have saved that much in two years. This is part of the
reason that lease options are so attractive. As for the price, if they
had rented for two years and saved for the down payment, the home might
cost $230,000 by the time they were ready to buy.
