On Wall Street, the real market mavens who make it from rags to riches do it with stock options, not with actual stocks. CNBC guru, Jim Cramer, made enough money on one option play, Merck in 1986, to leave his job as a broker with Goldman Sachs and start a hundred-million-dollar hedge fund. The rest is history.
But what does this have to do real estate investing? Well, options aren’t just for stocks. You can also buy and sell options on real estate properties, and one of the best strategies is the combination of lease-option. Be aware that lease options work in most states, such as my state Colorado, but have some restrictions in Texas and a few other states so always check your state and local laws regarding these. In addition to lease options, this applies to Owner financing in Colorado, Seller financing a home in Colorado and any seller carry real estate deals.
Terminology – What is a Lease? What is an Option?
First, we need to get some terminology out of the way. A “lease” is an agreement between a lessor (landlord) and lessee (tenant), in which the lessor grants the lessee the right to “possess and enjoy the property.” Most people have leased apartments at one point in their life, and thus are familiar with these terms. Most are also aware of subleasing, by which a “master tenant” (lessee) leases the property to another person called a subtenant. What most people don’t know is that subleasing is always permissible without an express provision in the lease forbidding the lessee from doing so.
Secondly, an “option” is the right, but not the obligation, to buy an underlying asset. In real estate terms, an option is a contract that allows its holder (the optionee) to buy a particular property at a given price (the strike price) within an explicit period of time. For example, John purchases an option to buy Jane’s house in Colorado for $135,000 anytime between now and June. During this time, Jane may not sell her house to anyone but John, although John could sell his option to another interested buyer. While John is not obligated to purchase Jane’s house, he effectively controls it for the duration of the option. For this reason, Jane expects some form of consideration – perhaps $1,000 – in exchange for granting John the option. If for whatever reason John fails to pull the trigger by the expiration date, Jane keeps the $1,000 and is free to sell her house to anyone.
A Simple Equation for Real Estate Riches – Lease + Option = Lease-Option
Just like options are great for stock market investors with comparatively little startup capital, lease-options can be great for savvy newcomers to the real estate investment world. By obtaining a lease at below-market rent, an investor can then sublet the property for positive cash flow. Since he isn’t the owner of the property, the investor is not responsible for property taxes or major repairs. He just sits back and collects the difference between the rent he charges to his subtenant, and the rent he owes his lessor.
But the real profit potential materializes in the second half of the equation, the option. If the investor negotiated for a lease-option, he may have been able to get his landlord to agree to rent credits, which apply a percentage of rent payments to the purchase price of the property. For example, if Peter leased property for $850 per month, and then sublet it to Paul for $1,000 per month, he would have $150 in positive cash flow. Not only that, but Peter’s landlord agreed to apply 25 percent of his rent payments to reduce the $100,000 purchase price of the property, so not only is Peter enjoying the monthly income, he’s also building equity. After two years, Peter is able to qualify for a loan on the property which now appraises at $110,000. His 25 percent rent credit payments have reduced the purchase price from $100,000 to $94,900 ($850 rent payments * 25% rent credits = $212.50 per month * 24 months = $5,100; $100,000 – $5,100 = $94,900) , and he is able to flip the property for $105,000, for a quick profit.
Options are Marketable Securities
In the above example, Peter could have forgone exercising his option and instead, sold it to another investor. For example, the option to buy a $110,000 property at $94,900 ($100,000 strike price – $5,100 in rent credits = $94,900) would have an intrinsic value of $15,100 ($110,000 – $94,900 = $15,100). Peter would probably be able to quickly sell the option for $10,000 and let the new optionee deal with the financing, closing process, etc. While the option may have cost Peter $2,000, to begin with, the $8,000 profit was also complemented by regularly monthly profits of $150 from his subtenant’s rent payments.
Instead of ponying up money for a down payment, Peter paid $2,000 for the option and perhaps a security deposit that would later be returned to him. He received $150 per month and built up $212.50 per month in rent credits, as well as $10,000 in price appreciation over the course of two years. What’s not to love about option deals?
Lease-Option as a Backup Plan
Of course, not every deal can be a sure winner like the example outlined above. Still, the fact remains that lease-options are underutilized by real estate investors, and they offer a great opportunity for beginning investors to get started with little cash. But the advantages of lease-options should not only be viewed from the lessee side – there is a lot to be said for using lease-options as a lessor, as well.
Even the world’s greatest real estate investors occasionally make mistakes. What separates the great ones from the also-rans is the ability to respond to their errors in judgment. Sophisticated real estate investors make the best out of a bad situation by using a lease-option as a bulletproof backup plan.
For example, if you have a property that you’ve rehabbed with the intention of quickly flipping, but the buyers simply don’t materialize, you can attract a quality tenant by offering a lease-option. Young couples starting families and divorcees rebuilding their lives are prime candidates for this strategy. Offer them rent credits in exchange for timely payments, and they will take care of your property as if it were their own. If they fail to exercise their option by the end of its duration, the market will have probably improved. If not, at least you’ve received enough income to cover your mortgage and insurance expenses in the meantime, and you can either renew the option with the current occupants or look for new tenants.
Lease options and alternative financing… many creative real estate strategies rely on alternative financing, but lease-options are, instead, a financing alternative. Rather than paying a hefty down payment, having your credit scrutinized, working with mortgage brokers, and paying costly closing fees, you can control property through a lease-option for a much smaller investment of both time and money. From the lessor side of things, the lease-option is an excellent Plan B even for investors who don’t fancy themselves as landlords. All in all, lease-options are a wonderful tool for real estate investors to leverage their resources and hedge against changing market conditions. Just a reminder that lease options work in most states, such as my state Colorado, but have some restrictions in Texas and a few other states so always check your state and local laws regarding these. And a quick reminder this applies to Owner financing in Colorado, Seller financing a home in Colorado and any seller carry real estate deals.