How to do a Real Estate Lease Option

WRITTEN BY JAMES GHEEN | UPDATED ON OCT. 21, 2019 | 18 MIN READ

How To Do A Real Estate Lease Option

Want to know what the real estate lease option is?

Do you want to understand the steps to achieve on how to do a real estate lease option?

In this article, you’ll discover how real estate investors perform the real estate lease option strategy.

What is Lease Option Investing?
Problems with Traditional Real Estate Investing
Problem #1 Not Enough Capital
Problem #2 Being Afraid or Risk
Problem #3 Negative Cash Flow
Problem #4 Landlord Trap
What is Creative Real Estate Investing?
Creative Vs. Traditional Real Estate Investing
What is a Lease Option?
Lease Option Benefits for the Owner (Lessor)
Lease Option Benefits for the Lessee (Tenant/Buyer)
Types of Lease Options
Straight Lease Option
Lease Option Sandwich
Contract Expires, Now What?
Master Leases
Final Thoughts

What is lease option investing?

Real estate lease option investing is simply leasing property under a legal agreement that allows the lessor/renter exclusive rights to purchase the property within a predetermined time period and prohibits the lessee from selling the property during this time period.

Problems with Traditional Real Estate Investing

For most, traditional real estate investing is common knowledge. That is, you locate a property that you want to invest in and you pay a large substantial down payment for a loan on the property. In order to obtain a loan for an investment property, your lender will require you to qualify for this loan which may include; a down payment (mostly 20%, perhaps more), good credit, and the proof that you have a good source of income.

If you meet the qualifications of the lenders and close on the property. You now face the challenge of keeping the property rented and maintain the mortgage for the next 30 years. You often may find it challenging where you may need to evict and seek rent collections, as well as other property management hassles.

However, if all successful, in the long-term, you will end up with some great equity and eventually own your investment free and clear. Still, this strategy is better than most, but it still requires the long-haul and it takes commitment. But if you do this with 10 or so properties, you will end up with a very nice portfolio and monthly cash flow.

So, why don’t more people do this? After all, it is a better retirement plan than your stock or mutual fund investments. And like I just said, this is traditional real estate investing. There is so much more to accelerate the growth of these investments, e.g. velocity banking, leveraging, tax benefits, etc. But the reality is most people are just scared to even get started by the traditional way.

Why? Why do people have fears to get started in real estate investing with traditional real estate investing? Although, there can be multiple reasons why. It really comes down to not having enough capital, being afraid of risk, having a concern for negative cash flow, and falling into the trap of being a property manager.

Problem #1 Not Enough Capital

How often do you hear folks say that I need capital or I don’t have any capital? Sadly, too many. People are so afraid to get started without having funds or access to funds to get started in any business or investment endeavor. And if they do manage to get started, they soon find out that their capital dries up quick, which makes them extremely nervous.

However, as the old cliché goes, ‘you need money to make money.’ But the reality is if you can’t make money with no money you can’t make money with money.

Problem # 2 Being afraid or Risk

If you have $100,000 tied up in investment and things start to go sour, you potentially can lose out. And yes, all investments are risky. But there are also exit strategies that will decrease your risk, when or if things start to go south. Yet, the biggest risk is not taking the risk, and those who are not brave to jump in will accomplish nothing.

Problem #3 Negative Cash Flow

Another big problem that people are afraid of is having negative cash flow. Suppose you can’t find a renter or you need to make some big repairs on the property that will eat up your funds and you now have negative cash flow. Yes, it could be a big problem but if you learn techniques like the velocity banking strategy, you will learn how to have emergency funds in case you do run into negative cash flow. There are always solutions to a problem if the investor is willing to think outside the box. This is why it is important to be fully committed and educated before you start playing. You wouldn’t go into law without a law degree, would you? Why on earth would you start playing with investments without understanding the industry?

Problem #4 Landlord Trap

Suppose you started out aggressive and you started to see the potential that real estate investing has on your finances and you accumulate many properties over a few years. Then you wake up one morning realizing that you are spending way too much time on the upkeeping and maintenance of these properties. This is another fear that many have when it comes to renting or property investments. For most, many do not want the anxiety and stress to keep renters in, maintenance up, and the hassles that come along with the traditional way of investing. Therefore, they’d rather not even get started or quickly start downsizing.

But again, the solution to this problem is learning how to manage property managers not properties. You are as an investor should understand the economic concept of ‘opportunity cost.’ Opportunity cost, simply stated, is the loss of potential benefits when choosing one alternative over another, that is, you know that your time is greater utilizing on making deals in investments and not actually managing the property. So, use your time making deals and hire the property managers to manage the properties.

What is Creative Real Estate Investing?

Introducing creative real estate investing, that is, buying and selling real estate in the non-traditional measures. There are multiple creative real estate strategies or methods, e.g. wholesaling, lease option, short sale, seller finance, tax liens, etc. In creative real estate investing, many do not need to apply for or seek out a bank loan or lending service. In short, it is all about controlling real estate and some strategies don’t require owning property.

However, unlike the traditional method. In many situations, creative real estate investing allows the investor to invest with very little, if not, ‘no money down.’

These strategies can open an investor’s mind wide open and bring back entrepreneurship to anyone who is afraid to get started.

Creative vs. traditional real estate investing

Which is better creative or traditional? It all depends on where you are in your education, financing, how the competition and market is, and how much risk you measure and are willing to take.

Although traditional real estate investing requires some knowledge or education to perform these deals, it really comes down to a down payment, buying property, renting the property, and collecting the rent to produce cash flow.

However, if you implement velocity banking, use proper business entities for your property, and create the right leverage you can grow your real estate business using traditional methods faster.

On the other hand, creative real estate investing requires a bit more knowledge and education and may even require mentorship to walk you through the deals so you can gain the experience, although, these deals can be done alone. It also depends on how much capital you have. You may need to start wholesaling or structure lease option deals to get you going in your business. Later, you can graduate to a fix and flip or get into commercial real estate.

What is a Lease Option?

For most, many people dream of owning their own home. There are many reasons that many pursue this dream but can’t, e.g. terrible credit, self-employed (off the books income, etc.), unstable income, and more. However, as a real estate investor, we can help people achieve this dream through the lease option strategy.

In short, a lease option allows the tenant to rent for a time period and allows them to have the option to buy, once they get their finances in order. In other words, the owner will sell the property at a predetermined agreement and give the tenant the right to buy in a certain time frame. Further, it prohibits the owner from legally selling the property until the lease option agreement is up.

For example; suppose Tom and Jenny want to settle down in your neighborhood, however, they don’t have the finances or funds for a down payment and can’t get approval for a loan. A friend of yours who knew that you are in the real estate investing profession introduces them to you. From there, you explained their options. They were determined to settle down in your neighborhood and you just happen to have a couple of properties that are up for sale.

They looked at one property and both you and the couple agreed on a sale price of $230,000 for a single-family home on the corner block. Therefore, you had them sign a 3-year lease for an agreeable monthly price and another contract with the option to buy. They also agreed to make a down payment (non-refundable) towards the property of 3% to show their commitment to purchase the property. Also known as an option fee.

Lease Option Benefits for the owner (lessor)

Coming from the perspective of a lessor who can either be the seller or owner of the property. There are several benefits that can arise by using the lease option strategy.

Overall Sales Price May be Higher – Eager buyers who want to settle down and are using the rent-to-own strategy to purchase their home are generally not seeking the best price for the home. They are more concerned about the monthly payments that they can afford. Although, the sales price is important and obviously must be within their range.

Rent-to-Own Tenants Have an Owner Mindset – Tenants who choose to purchase their property through the lease option method have a different mindset. After all, they believe they are living in their house. Even though it’s just not theirs, yet. Therefore, rent-to-own tenants tend to look after the house better. In other words, they take care of it. It goes along the line that people just don’t wash a rental car after they get done using it. But if the car is theirs they will wash the car.

Also, in your contract, you can have the tenant make minor repairs if needed. This takes care of the ‘toilet doesn’t flush’ problems in the middle of the night (that apparently happens all the time). However, negotiations are the key to what the tenants need to take care of and what not to take care of. For example; perhaps anything over $1,000 the cost will go to the owner and anything below that will be dealt with by the tenant.

Non-Refundable Down payment – There is a principle that the more you put into it the more you want to get out. In other words, when a rent-to-own buyer chooses to purchase the property they laydown option money. This later can be used as a down payment for them if they close on the deal. However, because this option fee may be in the thousands and possibly tens of thousands (usually 3-5% of the sales price). The buyer’s mindset is locked in for the long term. And if they choose to not to purchase the property at the end of the lease. The owner keeps the option fee even if the tenant moves out.

Turnover – A rent-to-own buyer is different than a regular tenant. They have visions of owning the property. They give a heavy down payment (option fee) on the property. This means they are far less likely to move out, damage, or stop making monthly rent payments. For the lessor, it means they have a very good tenant for a few years.

Lease Option Benefits for the Lessee (Tenant/Buyer)

Owner Mindset – As previously mentioned, many people dream of owning a home. However, for whatever reasons they may be hindered for a time period. The lease option allows them to live in the home that they will eventually purchase. And many owners give their tenant buyers to freely choose what they want to do with their home, e.g. paint, upgrades, etc. Of course, this is still done within reason, e.g. you can’t just knock down walls. But if it generally improves the value of the home. Most owners will probably allow the tenant to do what they want during the lease period.

Sales Price is Locked In – When the tenant signs a lease option agreement one good benefit is the sales price. That is, from the day tenant signs the contract it becomes locked in. Therefore, if the rent-to-own buyer stays in the property for a couple of years and the value goes up the owner still must sell the property at the initial agreement price. If the value goes down in price, the tenant-buyer has the option to leave at the end of the lease.

Stability – One of the biggest benefits for the rent-to-own buyer is to lock in the number of years to lease the property. Most lease agreements are 2-3 years, however, this is flexible. When a tenant locks in a lease the owner cannot legally sell the property from underneath them. This gives security to the tenant.

Types of Lease Options

Straight Lease Option

The most popular use for a lease option is the straight lease. The concept is quite straightforward, in which, the real estate investor finds a rent-to-own buyer and leases the property with the option to buy.

For example; David works for NASA and got a new job in Texas as a Senior-level engineer. He needs to relocate from Florida to Texas within a few weeks. David read an article from the BiggerInvesting.com website about how to do a real estate lease option. He decided to lease option his house instead of hiring a realtor to sell the home. He put an ad on Craigslist to seek a tenant-buyer for a rent-to-own purchase. Within a few days, he received a call from an eager family desiring to purchase the property and make an agreement to lease option the house.

Both David and the tenant-buyers agreed on a sales price of $120,000 and a 3-year lease option agreement. Also, they agreed on a 3% option fee, $850 security deposit and the first month rent of $850 totaling at $5,300 due on signing.

David now has $3,600 that is non-refundable to use for his relocation expenses. And since his mortgage is $600 per month he now has $250 cash flow coming in every month since the new tenant-buyers rent is $850 per month. Over the course of 3 years he cash-flows $9,000 and the original tenant-buyers purchased the house in full at the end of the lease.

Both David and the buyers had a win-win. David eventually sold the house and made extra money all the while avoiding the cost of hiring a realtor. The buyers were able to get settled in their new home before they had the credit to get approved for a loan.

Furthermore, this strategy can be used from the investor side. In other words, a real estate investor can lease options from an owner, especially, if the owner is having trouble selling the house or the house is upside down.

Lease Option Sandwich

The sandwich lease option is basically when there is two lease option at once. That is, as an investor you will simply lease option from a buyer and then turn it around and lease option it to a rent-to-own buyer. Although, a bit more creative. However, a powerful strategy to start controlling property with practically no money of your own.

For example; let’s go back to David who needs to sell his house and relocate to Texas from Florida. This time, however, he is unable to sell his house for months. Tom the real estate investor comes along and works with David and negotiates his options. Together David and Tom decided on a 4-year lease option agreement for $120,000 purchase price and a $700 monthly payment. Tom also worked with David and told him that he has buyers willing and ready to lease option the option contract from him.

A few weeks later, Sarah, was eager to purchase the property on a 3-year lease option agreement with a purchase price of $130,000, an option fee of 5%, a security deposit, and the first-month rent at $850. Although, the house has a current market value of $120,000 Sarah believes the value of the property will steadily climb over the next 3-years and has no concern of paying $130,000 in a few years. She can always opt-out later if she chooses.

Therefore, the sandwich lease option deal is a win-win-win. David can relax because his mortgage is taking care of for the next 4-years and he also cash-flows on the property of $1,200 per year. Tom the investor, cash flows $1,800 per year from Sarah’s rent. He also receives a lease option fee of 5% ($6,500) for putting the deal together and satisfying David and Sarah. He will also earn an additional $3,500 when Sarah eventually purchases the property.

Contract Expires, Now What?

Moreover, notice that there is a 4-year lease option agreement with David and a 3-year lease option with Sarah. This allows Tom the investor to renegotiate with David or find another buyer if Sarah pulls out of the deal. Most lease option tenant-buyers do not follow through with their purchase. This can be good for an investor because each time the investor receives a new non-refundable lease option fee. However, if the investor filters hard enough and does a good background check the investor should be able to find high-quality rent-to-own buyers.

Also, if Tom couldn’t find another tenant-buyer. Tom could always sell retail or flip it to another investor. Worst case scenario Tom can always decline to purchase the home. Therefore, Tom has very minimal risk in this deal. As a real estate investor, he should have systems in place to be able to accumulate potential tenant-buyers, so it shouldn’t be much of a problem.

Master Leases

This strategy is known as a master lease option (MLO). The MLO basically takes over the entire property, in that, the lessee pays all the expenses, e.g. taxes, insurance, etc. and manages the property, e.g. taking care of rentals, collecting rent, etc. The strategy is similar to that of a seller finance agreement, however, it is still a lease.

In general, an MLO is used on large scale deals, such as apartment complexes and commercial real estate. For instance, Harry Helmsley operated the Empire State Building with a 116-year (1961-2076) MLO. Therefore, an MLO is practically a management contract. In that, the lessee takes control of everything and pays the lessor a predetermined agreement. The lessee has the responsibility of the upkeeping and can also keep the extra profits.

An MLO can be used to seek out poorly managed property or sellers who are eager to get out of managing their own property. For instance, you as a real estate investor spark interest in a 24-unit apartment complex, however, you don’t have the capital nor have the means to arrange for finances. Through, discussion and negotiation the owner and you decided on an MLO. This will allow you as the real estate investor to take over the property and give the owner a steady monthly income.

Upon signing and closing on the deal. You acquired complete control of the 24-unit property with an MLO agreement from 5-20 years with the option to purchase the property as a prearranged price. However, you decided to increase the value of the property, in order to create more revenue from the rentals, that is, you will increase the net operating income (NOI).

Here’s an example of what this looks like;

Before Upgrade
Income at $1,000 per unit$24,000
Vacancy losses at 20%$4,800
Gross Monthly Income$19,200
Maintenance$1,600
Utilities$2,500
Marketing$800
Insurance$600
Property Taxes$1,700
Miscellaneous (bad debts, attorney fees, etc.)$1,300
Total Monthly Expenses$8,500
Net Operating Income (NOI)$10,700
Mortgage Payment$7,500
Lease Payment to Owner$2,000
Cash-Flow$1,200
After Upgrade
Income at $1,300 per unit$31,200
Vacancy losses at 5%$1,560
Gross Monthly Income$29,640
Maintenance$1,300
Utilities$2,800
Marketing$600
Insurance$1,400
Property Taxes$3,300
Miscellaneous (bad debts, attorney fees, etc.)$800
Total Monthly Expenses$9,200
Net Operating Income (NOI)$20,440
Mortgage Payment$7,500
Lease Payment to Owner$2,000
Monthly Cash-Flow$9,940

Obviously, these numbers can vary. But my point is to demonstrate that you can take control over a poorly managed property and make the necessary upgrades and improvements, negotiate better insurance policies, perform efficient marketing, seek better alternatives on utilities, and overall make the property more valuable so renters will want to stay and pay larger rents. It is a lot easier to rent something that is well kept and highly maintained.

Final Thoughts

Real estate lease options are a huge potential source for some great deals. In fact, investors can get started with “no money” and build large cash-flow empires. With lease options, it is about controlling real estate. Start small and grow big with confidence, as Mr. Helmsley says, “Deals get bigger as you have more confidence. All of a sudden you are buying apartment houses as well as office buildings and loft buildings. A deal comes along that looks good, and you are in the hotel business, which you never expected to be in” (Quoted in NY Times).

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Real Estate How To Do A Real Estate Lease Option [Infographic]