Lease-Option: 4 Big Advantages & 4 Big Pitfalls
Lease-option offers several extremely compelling advantages for investors and tenant-buyers alike. But there are some major pitfalls as well that are unique to lease-option. If you want to take advantage of the opportunities and avoid the pitfalls, you must know the realities.
One of the biggest advantages for investors is the ability to make more money by selling a house on lease-option than by flipping the same house. This is due to  a higher non-negotiable sales price,  no seller concessions and  no agent commission. On a $200,000 lease-option, that is already about $20,000 in extra profit versus flipping the same house.
A second big advantage of lease-option relates to taxes. The profit from lease-option is taxed as a long term capital gain (assuming you hold the property with a lease at least one year) instead of short term capital gain if you flipped that same house. That’s another few thousand dollars in tax savings right there. The profit from the lease-option is not subject to self-employment tax whereas the profit from flipping the same house on your Schedule C (still with us after the 2017 tax change) is subject to both sides of FICA at 15.3% tax. That’s another few thousand dollars in money you actually get to keep from a lease-option versus a flip of the same property with equity.
A third advantage in a lease-option is that when compared to a rental, you have the advantage of incentive to the tenants to take care of the house because this will be their home they own one day, not some rental they may feel they can abuse owned by their perceived deep pocketed landlord. Part of the tenant-buyer motivation is the thousands of dollars of non-refundable option consideration they plunked down to get this house when they can’t yet qualify for a mortgage to buy the house. The lease-option investor enjoys this cash injection upfront and can use that money immediately. In contrast, tenants in a standard rental pay a security deposit that is not only much smaller than option consideration, the landlord can’t touch the security deposit until the end of the lease (at least that is true in New Jersey).
An incredible fourth advantage of lease-option is the possibility to do a sandwich lease-option. This strategy consists of "buying" the house in the future on lease-option from a motivated seller, often at a bargain price with great terms, then simultaneously reselling it on lease-option to a motivated buyer at a much higher price, that generates passive cash flow AND thousands of dollars of option consideration. In many sandwich lease-options, you need very little money and you start collecting option consideration and cash flow very quickly! Fantastic!
Wow, these are pretty compelling advantages! There are other advantages of lease-option but these four are enough to ask ‘why doesn’t every investor do lease-option?’
The answer is that there are some realities of lease-option that can put a monkey wrench in to the lease-option machine that can SOMETIMES (certainly not always) can cause it to screech to a grinding halt or worse. I did lease-options nearly exclusively for six years and I developed great scripts, screened tenant-buyers with great care, had all the right contracts from the best landlord-tenant attorney and I bought the right properties with equity. Following are some of the realities that sometimes burst the bubble of ecstasy of doing lease-options.
1. Less than 50% of Tenant-Buyers Exercise Their Option
The reality is that less than 50% of tenant-buyers exercise their option, no matter how well you screen them and no matter how much option consideration they put at risk. I wrote an article about this that explains that the objective circumstances (e.g., medical issue) and/or behaviors (e.g., fiscal irresponsibility or even financial illiteracy) that led the tenant-buyer to fall short of qualifying for a mortgage in the first place, often don’t go away. The result is that less than 50% of tenant-buyers in my area of South Jersey and the Philadelphia area, successfully exercise their option to by the house. I know other investors on the Philadelphia side of the river with a lot of similar experience in lease-option and it is not uncommon for the option exercise rate to be 25% or less, depending to a large degree on how obsessive the investor is about screening tenant-buyers.
If less than 50% of tenant-buyers exercise their options, so what?
If you were planning on a big payday a year or two down the road and roll over that low-tax payday into another investment property to grow your portfolio and net worth on a schedule, then your entire long term plan falls apart. That’s a big deal if you are smart enough to have a written long term plan that crumbles like a house of cards with projections to meet certain measurable goals with deadlines for net worth, passive income, retirement, paying for kids’ college, etc.
I remember my huge disappointment (big monkey wrench in my financial plan) in 2006 when my first lease-option tenant-buyer did NOT exercise their option for my $60,000 payday that was also going to benefit from long term capital gain taxation. My financial planning went out the window that year because I was counting on a $60,000 windfall.
You might think that it was because I chose bad tenant-buyers. Nope, those same people are still in the same house and I just renewed their lease for the 15th year last week. It is now a high cash flow rental and I love the fact that this property is in my rental portfolio with these tenants who are great. In fact, I have a great set of tenants and my vacancy rate is extremely low due to my best practices described in great detail in my lecture “Establish Acceptable Standards of Behavior with Tenants, Tenant-Buyers, Other People’s Children and Other Humanoid Life Forms.”
My second and fifth lease-options are in the same county in which I live and I still own them today as rentals after the tenant-buyers did not exercise their options. One of them has tenants who were the original tenant-buyers 9 years ago. My other lease-options were in the adjacent county and I eventually either sold them after lease options that were not exercised or the tenant-buyers did indeed exercise their options. I had one "almost lease-option" in my county (in my self-directed Roth 401k) and at the last minute the tenant-buyer realized he could buy outright and did. I already approved him for the lease-option and it was in the tenant-buyer approval process that he discovered he could buy instead of rent.
The point is that most lease-options do not end according to plan and if you laid out a well thought-out long term financial plan, it gets messed up big time if instead of getting $60,000 paydays every year or two, you wind up with cash flowing rentals that throw off $300-$500 per month of positive cash flow. Do the math and you will realize that the rinse and repeat lease-option plan is an EXTREMELY different scenario than have a bunch of solid cash flow rentals. That scenario can grind your plan to a halt depending how you financed the purchase of these lease-options.
2. Title May Get Clouded Even if Clear at the Outset
Let’s say you are enamored with the highly tempting concept of sandwich lease-option for which you invest very little money and generate cash flow and big paydays. This is indeed an extremely tempting strategy with huge benefits.
If you did everything right for your sandwich lease-option, you probably ran title on the property and on the seller and found out that there were no liens or judgments against the property or against the owner except for maybe the mortgage. If you are doing everything by the book and being exceptionally prudent, you will be paying the seller’s mortgage, insurance and property taxes to make sure your investment is protected. After all, you are collecting the rent, so you might as well be sure that the PITI is covered by paying the payments yourself.
However, there are reasons that the seller is selling on lease-option and not through a straight sale. Often, though certainly not always, the seller is a motivated seller due to some financial hardship. Similar to motivated tenant-buyers, the circumstances and/or behaviors that led to the financial challenge sometimes do not go away or they get worse. Even though you are paying the mortgage, taxes and insurance, the seller might get into financial trouble with their motorcycle payment, worsening medical situation, job loss, trouble paying their own rent (remember they need somewhere else to live), etc. The continuation of the seller’s financial hardship that caused the seller to consider lease-option might be deteriorating into judgments and liens against the house or even bankruptcy. When such problems attach to the house, you can't sell to the tenant-buyer with clear title unless you have the money from somewhere to pay off those new liens.
None of this would have shown up in the title search when you entered into the sandwich lease-option agreement with the seller. But these liens will shown up when you go to close on the purchase of the house by your tenant-buyer so you can have your payday. Of course, your contracts with your tenant-buyer probably had all kind of disclosures and disclaimers that you don’t own the house, but you really don’t want to be defending those disclaimers in court when the tenant-buyer sues you for breach of contract.
This doesn’t happen often with sandwich lease-option, but one such occurrence is enough to make you regret entering into the sandwich lease-option..
The way to avoid this is what I did which was to get the deed before doing a lease-option and I simply avoided doing sandwich lease-options…as highly tempting as they were.
Do people make a lot of money consistently with sandwich lease-options? Yes! I’m not saying not to do sandwich lease-options. I’m saying to be aware of the pitfall and make your own comfort zone decision.
3. Onset of a Buyer’s Market Can Kill Lease-Option Profit
I learned the details of the lease-option strategy from some outstanding gurus in 2004. At that time, house prices in much of the US were increasing an average of 17% per year, including in my area of South Jersey. Some investors (not me) were buying single family homes at market value of say $200,000, then selling them on lease-option for $290,000 with a 3-year option. The market was accommodating those magnitude of increases without even buying from motivated sellers. The real estate market in many locations stopped appreciating in 2007 followed by depreciation in 2008, then 20%-30% per year value drop in 2009-2011.
Some of those investors did everything PERFECTLY by the lease-option book but the market turned on them. For flips, this is not much of a problem because you are usually in and out of the deal in six months and you can assume as a first approximation that the next six months of market behavior will be similar to the previous six months of market behavior. If the market is dropping by 2% per month in a buyer’s market, you can build a 12% value drop into your maximum allowable offer calculations for a flip assuming a six month turnaround.
In contrast, lease-option is the most market sensitive real estate investment strategy when the option term is 2-3 years. That is because you can’t really predict market valuation in 2-3 years. You can do much better predicting the next six months for a flip and build that into your equation. If you have a rental, you don’t really care much about market value as long as you have strong positive cash flow. In a down rental market, you may reduce your rent and cash flow to keep it occupied but it should not be devastating unless you’re teetering on the edge of positive cash flow (which you shouldn't). With lease-option, you can do everything right and still lose money if the market turns on you during the term of the option.
4. State or Federal Law May Be a Problem
Government regulations and laws are required in order to maintain law and order in society. But sometimes the laws and regulations go overboard and hurt selected groups in society.
A federal law passed that was sponsored Christopher Dodd and Barney Frank (Dodd-Frank) that was intended to protect consumers in all kinds of situations including seller financing of houses. You can argue whether and under what circumstances lease-option is seller financing. Indeed, some have argued that if you offer a house on lease-option and you provide rent credits to the tenant-buyer (a portion of the rent goes to equitable interest), you would be violation of Dodd-Frank unless you are a licensed loan originator. I am not an attorney, so I cannot determine if such a situation is compliant with Dodd-Frank, but depending on how you do your lease-options, you will need to consult with an attorney to be sure you are complaint with the law.
Some states have laws that specifically address lease-option. Here in New Jersey, if you want to file for eviction (for example for non-payment of rent), you must first file a “Landlord Certification Form.” The current form at the time of writing is shown at https://www.njcourts.gov/forms/10512_cert_landlord.pdf?c=MEd.
Now read line C.6. It says "The tenant did not transfer ownership to me and I have not given the tenant an option to buy the property." Even if you do what the gurus say and have the tenant-buyer sign a separate lease and a separate option agreement for a lease-option, you do NOT want to sign this form without some modification provided by an expert landlord-tenant attorney or else you will be committing perjury. What do you think happens when the judge sees that you HAVE given the tenant an option to buy? If you are not 100% sure about what happens, you should be very careful before getting into lease-option in New Jersey.
Our REIA will be hosting an out-of-state speaker in April. This speaker will focus on lease-option. I wonder if he knows that our state requires a landlord filing for eviction to declare that an option was not given to the tenant.
In 2005, I worked with the #1 landlord-tenant attorney in South Jersey on my lease and option agreements. In the late 2000’s I did file for eviction of tenant-buyers for non-payment of rent. I used this attorney for the eviction and I used this attorney’s forms. We won every case, but we had to submit an affidavit written by this expert attorney who also knew the exact words to say to the landlord-tenant judge when challenged and disclosing that there was an option to purchase before the tenant was in default.
The lease-option guru who will be speaking at SJREIA in April wrote a good article for our newsletter shown at https://www.sjreia.org/Misc/MemberFiles/Newsletters/Feb_2019_Web_Newsletter.PDF .
Following is an unedited quote from what he wrote in our newsletter (I did not correct the very humorous typo in the sentence...see if you can catch it!): "...I believe, and am convicted of the fact, that lease option strategies are the absolute best strategies in all of real estate investing for every beginning and seasoned investor to get involved with..."
Wow! That's a powerful statement (even if he is only "convinced" and not actually "convicted")!
I agree that lease-option has HUGE advantages. So do other real estate investment strategies.
That is why I wrote a book published last month, at the request of the Chief Operating Officer of National REIA, that is available for free download on this website as an eBook entitled "Which Real Estate Investment Strategy is Best for YOU?"
The reason I was asked to write this book is that the COO of National REIA recognized, like all objective real estate investors do, that one real estate investment strategy CANNOT fit all.
In my free eBook, I present a comparison of the advantages, disadvantages and keys to success for flipping, rentals, lease-option and wholesaling. Yes, no matter how convinced anyone is that there is one best real estate investment strategy, the fact is that each one has advantages AND disadvantages, not just advantages.
Lease-option has MAJOR advantages. It also has disadvantages. It also does not always work as expected or projected.
Regardless of the real estate investment strategy you choose for your overarching financial life plan, make sure you understand all the advantages and all of the disadvantages for each strategy before you start deploying hundreds of thousands of dollars of your money or other people’s money buying houses, flipping them, renting them or lease-optioning them.
If you want to benefit from my training or coaching services to supplement your thought processes about real estate investing, you can contact me using this form. You should now check out special offers for affordable packages of my training and coaching here.