Lease-option is one of the four primary real estate investment strategies. Investors choose to use lease-option for a variety of reasons that include significantly higher net profit after taxes when extracting the equity from a good deal on a house, relative to just flipping the house. The tax advantage component of lease-option versus flipping survived the tax bill signed into law at the end of 2017. There are other reasons for the increased profit such as not paying sales commissions and not having to negotiate sales price since tenant-buyers for lease-option are typically motivated buyers. The advantages and disadvantages of lease-option are explained in my lecture "Should I Flip? Rent? Wholesale? Lease-Option?" that every new real estate investor should watch when deciding what is the most efficient path to transform their financial lives from where they are now to where they want to be in the future.
The majority of the best tenant-buyer candidates for lease-option are people who have a strong desire to buy a house, have the income to buy a house, have the down payment to buy a house but just don't have the credit score to qualify for a mortgage loan.
One of the key aspects of lease-option is that the tenant-buyer pays a sizable amount of money for the option to give them the exclusive right to buy the house that is converted into down payment when they exercise the option to the buy the house while usually locking in the price of the house for the future purchase. The amount of this money, called "option consideration," is usually MUCH more than the amount of the security deposit the tenant-buyer would pay if they were simply a standard tenant in a standard rental.
Lease-option was my primary real estate investment strategy in the first 6 years after I started becoming a serious part-time real estate investor. I developed an excellent script to screen tenant-buyers (that you can learn in my lecture) and I became very skilled in setting up tenant-buyers for success.
Despite all my effort and skill, the reality was that most tenant-buyers did not exercise the option to buy the house and I stopped offering lease-option despite it's many advantages.
Recently, a new investor asked me, 'Why don't all tenant-buyers exercise their option? Aren't the extra thousands of dollars of option consideration enough incentive to not walk away from the house?' These are VERY reasonable questions.
The main reason that tenant-buyers do not exercise the option is that the same behaviors and underlying mindsets that led them to not qualify for a mortgage in the first place, most often do not go away.
It’s like expecting a drug addict who hit rock bottom and who decides to become sober, self-cure from the addiction without a professional rehabilitation program.
Behavior modification for financial responsibility can only be achieved if the tenant-buyer can reverse an ingrained lack of fiscal discipline, often compounded by financial illiteracy. This is a monumental mountain that cannot be climbed by most people with credit scores that already plummeted into the 500’s for reasons other than medical. When this happens, handing over $5,000, $10,000, $20,000 or more in cash as non-refundable option consideration “surprisingly” usually isn’t enough incentive to make the change in the underlying fundamental pre-conditioned behavior.
Some people change. Most do not.
That’s just reality.
In my self-image tune-up lecture, I ask “how many psychologists does it take to change a lightbulb?” The answer is “One, but the light bulb has to really want to change!”
The same concept applies to making personal changes to financial performance, marital fidelity, recidivism after being released from incarceration and any other behavior or performance that has been lacking in track record in the life of an individual who has not measured up to the conventional standard in question.
When the reason for the low credit score is medical expenses, the percentage of tenant-buyers who exercise the option to buy the house, is high. That is because the tenant-buyer did not make bad financial choices. Medical expenses are typically forced upon people unwillingly, so no change in financial responsibility is required. If the debt from medical expenses is too big and was not wiped out in a bankruptcy that was discharged, the tenant-buyer still may not be able to qualify for a mortgage loan. But at least the underlying problem is not irresponsible behavior.
Summary: Do some tenant-buyers exercise their option to buy the house? Yes. Do most? No. Why? Because most (not all) tenant-buyers are not disciplined enough to change their previous behaviors of lack of fiscal responsibility, even though it means losing thousands of dollars of option consideration. If it sounds like illogical self-sabotage, it is.
I'm not saying that you should refrain from considering lease-option for your real estate investment portfolio. I'm saying that you should heightened awareness to detect highly motivated tenant-buyers who explicitly exhibit a strong desire or track record of financial discipline.