Lease Options as a Tool to Rock Out Your Rental Properties

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Money. We buy rental properties because we want money, right? I do at least. I don’t know what you buy them for.

If I want money, what has to not happen in a rental property? Vacancy and repairs. Vacancy is avoided if you happen to get that lifelong tenant (of which I’ve yet to find). Repairs are unavoidable no matter what. It’s a house, it wears. So maybe these two things aren’t avoidable, but how can you keep their expenses as low as possible? There are probably several ways, but I’ve learned a new one recently that I think is worth sharing. Lease options. Before I elaborate on those though, I need to reemphasize this vacancy and repairs issue.

I have to tell you that before I owned rental properties and started experiencing vacancy and repairs first hand, I truly did not realize how costly both of these can be. You’ve heard my story about the property with back-to-back evictions and the consequent turnover costs. Talk about being in the hole for income! Let’s see, six months of no rent at $975/month, I’ll round that to $1,000, so $6,000 in lost rents. The turnover was $2,400 in repairs. That has me at $8,400. I don’t remember the eviction costs, but I’ll go with $600 to make the numbers even. $9,000! Are you absolutely kidding me? $9,000 lost because of a single vacancy. This is a more dramatic case since it was an eviction, but it’s also very realistic too.

I only give that example so you know the reality of how costly vacancy and repairs can be. I know a Detroit investor who had a property that the tenants stopped paying rent on and it took seven months for them to finally be evicted by the courts. Seven months of no rent payments, and the tenants racked up $7,000 in damages during the time they were there. So probably $14,000 in expenses to the owner in only seven months?

Point is- keeping vacancies and repairs down is your ticket to good income on an investment property. How can you do that? I mentioned Lease Options as one method. I love them. Here’s how it works:

Get a Tenant in Under a Lease Option

1. Advertise “Rent to Own”. This tells a potential tenant that by renting your property, they will have an opportunity to purchase it, with some of their rent money going towards that purchase (only if they actually purchase).
2. Multi-year lease with the option to buy. The standard for these is 3-year leases. The “option price” is decided upfront and put in the contract, which means should the tenant decide to exercise the option to buy, they have agreed to buy the property for a set price.
3. Payment of an “option consideration” in lieu of a security deposit. The tenant puts down a non-refundable amount of money that is essentially a purchase for the right to buy the property later. The amount can vary, but is usually around the same as what a normal security deposit would have been.
4. Exercising the option. At the end of the lease period, the tenant now decides if he wants to go ahead and buy the property. This decision isn’t just about whether the tenants want to buy the house or not, it may likely be more based on whether they qualify to buy or have the money to buy at that time. If they do buy, you sell the house. If they don’t buy, they have the option to renew the Lease Option with the same terms and option to buy again. Or they can continue to rent the property under a normal 1-year lease with no option. Or they can move. Their choice.

Why bother with all of this? Because having tenants in under a Lease Option agreement has some serious benefits!

Benefits of Having Tenants Under Lease Options

• Decreased Vacancy Expenses. A tenant can technically walk out of a 3-year lease as easy as he can a 1-year, but at least the 3-year lease is in place and the tenant plans to own the property later so why would he want to leave anyway?
• Decreased Repairs Expenses. The tenant assumes he is going to own this house eventually. Why would he tear it up?
• Non-Refundable Option Consideration. This is free money for you! You don’t have to ever give it back to the tenant. It says so in the contract. Bonus.
• Potential for a Nice Profit on the Sale. Typically the Option Price is about 40% higher than what you bought it for. So if you sell the house in three years, with a 40% profit, on top of the monthly cash flow you received every month for those three years, uhhhh….hello profit.
• Higher Quality Tenants. Again, not a guarantee, but most often if you are dealing with someone who truly wants to purchase a house and for whatever reason just can’t right now, chances are you are dealing with someone a bit higher on the humanity scale than your average tenant. Not to say all normal tenants are horrible or that all lease option tenants are fantastic, but the odds are in your favor for this one. Having a high-quality person as a tenant can change your life for the better.

None of these benefits are guaranteed except for the Option Consideration payment. However, you are setting yourself up for less risk when it comes to tenant quality, vacancy, and repairs.

What You Need to Be Aware Of

There is a reality that you need to know about ahead of time. That reality is that, on average, 95% of tenants don’t exercise the option to buy at the end of their term. 95% may not be the exact number, but it is in the markets I’m familiar with and represents the bigger fact which is that few tenants end up buying the house.

Then why do it at all? For the reasons I mention above, that’s why. If the tenant doesn’t buy the house, the only of those benefit  I mentioned that you wouldn’t get is the 40% profit from a sale. Who cares! Less vacancy, less repairs expenses, monthly cash flow, you still own the property so you will continue to collect cash flow, and you’ve had significantly less headaches the whole time. Well worth it to me! I hate headaches.

If you know the tenants will doubtfully end up buying, is it ethical to get them in under a Lease Option? Absolutely! They truly do have the right to buy. If they don’t, how is that your fault or problem? It’s not.

The Downside

There is only one. You run the small risk that the tenant may buy your fantastic rental property. If it is a rockstar property, that could actually be a bummer for you. I do know a turnkey provider who does lease option properties and he actually will replace your property with one of equal value should your tenant end up buying. He can offer that because he knows so few tenants will buy, but he will for real replace the property. Outside of him though, you may actually be out your property. Oh well. At least you made bank on it!

Any other downsides you can think of to having tenants under Lease Options? Any other perks I didn’t hit?

Photo:Patrick_Down

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.