How To Sell On Lease Option

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 $1500, 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 $1750 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.