Hey there, Peter Vekselman here.
So, ‘round here at Awesomely, I’ve shared info about how to close sandwich lease options and how not to lose your shirt when you’re doing a sandwich lease option deal.
One of the things I’ve realized, though, is that some people don’t even know the basics of a lease option. So, if you’ve got a knowledge gap on the essentials of a lease option deal… that’s what I want to share with you right now — plus some mistakes to watch out for.
See, lease options are a great tool for buying and selling investment real estate. Sellers are quick to make a deal when buyers are scarce, and it gives buyers with credit or down payment problems a way to build equity in their own home.
But, like any real estate transaction, there are pitfalls you need to protect yourself from as an investor — in the option agreement you have with the seller and in the agreement you have with your buyers.
As they say, protect yourself before you wreck yourself…
How Do Lease Options Work?
First, always require a sizable nonrefundable option payment from your tenants. For you, nothing beats making money up front. BUT just as important as getting that substantial financial commitment from your tenant-buyer is… it also increases the probability that they will exercise the purchase option down the road.
Typically, the nonrefundable option purchase is for no more than 3% of the purchase price. On a $150k house, that’s $4,500. You should require all of that to ensure your buyers are motivated.
Next, credit check the tenant-buyer because you want to know as much as possible about the people you’re doing business with. You should always expect to see problems with their credit.
There are a lot of variables in determining what minimum credit ratings will qualify your buyers for a mortgage when they exercise their purchase option…
A general rule of thumb is that they need a maximum score of 620. If they diligently work in improving their score, they can expect it to increase about 100 points over a period of a year. That means you want tenants with a minimum score of 520.
Beware: Never assume a tenant-buyer will increase their score 200 points in 2 years. That is a big stretch for people with questionable credit history.
Finally, set the portion of the rent that applies toward the down payment high enough so that the tenant will have the full down payment when it comes time to close. It’s impossible to say how much will be needed because down payment rules are always changing… but it’s safe to say at least 5% of the purchase cost.
So, a $150,000 house means a $7,500 down payment.
If the buyer already has $4,500 of the lease option applied toward the purchase, they only need another $3k. That means if the market rents are about $1,000 per month, your tenant needs to pay $1,125 per month to make a deal like this work.
Paperwork matters…
Now let’s look at a few things you want to do to protect yourself in the lease option agreement when you are the actual buyer.
As an investor, you always want to make sure your lease option gives you the right to sublease to another tenant. In most states, that is not automatic. You need a specific clause in the lease agreement allowing you to do that.
And, have a preliminary title check done before you sign on the bottom line. You want to be sure the seller can deliver a clean title without any surprise liens or any other encumbrances.
Plus, you want to have a lease option agreement notarized and recorded as a public real estate document with the county clerk or wherever your real estate records are recorded at your location.
This clouds the title by showing that you have equity in the position in the event that the seller has remorse or tries to sell the property again to a higher bidder. If you or the seller or consider the lease option agreement to be confidential, you can file an affidavit or memorandum of agreement affecting the real estate. This has the same title clouding effect without making the details of your transaction public.
Then, open escrow and have escrow instructions written as soon as the agreement is signed. Also, have the seller place the deed in escrow. You are accomplishing two things by doing this:
- It creates a paper trail detailing the transaction you have entered into with the seller.
- It allows you to complete the deal by simply depositing the agreed to sales price into escrow in the event the seller dies or is nowhere to be found. When it’s time to sell to your tenants, you can still easily complete the transaction.
Look…
Taking these self-protection actions sets you apart as an investor and helps you avoid pitfalls in the hugely profitable lease option agreement.
Lease option, anyone? I’d think so.