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 [1] a higher non-negotiable sales price, [2] no seller concessions and [3] 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 “