In the world of real estate investing, making a quick and profitable sale of your property is the ultimate goal. But—more than likely—this picture-perfect ending isn’t always the reality of your situation.
So, when you’re struggling to sell a property, what other options can you consider?
If you don’t have any interest in keeping the property and using it as a long-term rental, a lease with an option to buy might be a good alternative. Because—let’s face it, being a landlord can have its huge disadvantages, and it’s not a good fit for everyone.
HOW DOES A LEASE OPTION WORK?
A lease option (or rent-to-own) is a rental agreement, plus you are giving the buyer the option to buy the property at a pre-agreed upon price in the next 6 to 24 months.
A few things to note:
- The buyer puts non-refundable money down (between 3-5% of the agreed upon purchase price)
- The buyer is responsible for all upkeep, utilities, repairs, and maintenance
- Once the buyer gets approved for a mortgage, they can buy ASAP
Why does this option work so well for many investors? Well, for one, banks are still tight with lending criteria, so there’s an abundance of buyers who are looking for the more flexible situation of a rent-to-own option.
The important thing to remember is that the best potential buyers might have the income needed for a mortgage, but bad credit. Maybe they had a foreclosure or short sale in the past, due to job loss or the market crash. Or maybe they aren’t as choosy as a typical retail buyer.
Regardless, you want to find a buyer who will be reasonably ready for a mortgage in 6-24 months. Have a mortgage lender look over the buyer’s financial situation, and make sure the buyer can pre-qualify for a loan.
SETTING UP THE CONTRACT
As you look for your ideal buyer, provide all potential buyers a property disclosure document. This is required by real estate law and will essentially list everything that’s wrong with the property (if anything).
After you choose a buyer, they will sign a Letter of Intent (basically, a pre-contract) and write a $1,000 earnest money check—this is separate from the down payment/option money. You will then hand off the Letter of Intent to a closing attorney, who will create the rental agreement and option-to-purchase agreement.
In a nutshell, make sure that all of this is covered in writing:
- Rental agreement: usually for 1 year, with a 1-year option to continue; utilities are paid by the buyer; a 10% late fee applies if rent is paid after the 5th of the month
- Option money: typically $5,000 or 5% of the purchase price (whichever is higher)
- Future purchase price
- Rent credits (optional): offer 10% off the typical rent rate in your area; this serves as an incentive for the buyer to pay the rent on time
- Commission: if an agent brings you a buyer, you will pay the agent’s commission, which is usually half of the first month’s rent plus 3% when it transfers (attach a broker’s lien)
Now, your buyer is going to write 2 checks—make sure they are paid to a third-party collection company (not you!) This just helps to protect everyone involved.
The first check is the option deposit, to be applied as a down payment when the buyer secures a mortgage.
The second check is for the first month’s rent. Remember, if you decide to use rent credits and your buyer pays their rent on time each month, that 10% monthly credit can be applied in 3 ways:
- To reduce the property sales price or…
- To be applied to the down payment or…
- To be applied to closing costs
When you’re ready to close, hold the closing at a title company or attorney’s office—to protect yourself and the buyer. At closing, the closing attorney will also set up an auto-draft payment system for the buyer to pay your mortgage.
TOP CONCERNS FROM SELLERS
Whenever I talk about lease options with other investors, I heard a few common objections that they (understandably) have. I want to address those quickly before we wrap this up:
- What if the buyer causes major damage to the house? It could happen, but it’s highly unlikely. Remember, the buyer has skin in the game… a large non-refundable down payment. They’re more likely to have an owner’s mindset and will want to improve the home. Plus, you can still have hazard insurance.
- What if the buyer moves out suddenly? Not too many people will be inclined to walk away from a large, non-refundable deposit of several thousand dollars. And, even if they do, you can just re-sell the property.
- What if the buyer doesn’t make their rent payments? In a rent-to-own situation, you usually have a title company or another third party collect the payments (often with the auto-draft technology I mentioned before). You don’t have to worry about playing the landlord role.
DELAYED GRATIFICATION? WORTH IT
One final word… If you’re willing to wait for your payoff, a lease option will probably give you a bigger profit than a typical retail sale, for 2 reasons:
- As long as it’s in a good area, the property will appreciate over the next 6-24 months, meaning you can ask for a slightly higher price than what the home is currently worth
- You will qualify for a lower tax bracket if you own the home for a least a year (so you’ll get capital gains rates vs. ordinary income rates)
So, never rule out a lease option when you’re struggling to sell a property. It may take a little more effort up front to create a rent-to-own agreement, but the payoff could be absolutely worth the wait.