3 Risks and Drawbacks of the Real Estate Lease Option

The lease option can be a powerful strategy in real estate—but it also comes with its challenges. Know what you’re getting into by educating yourself.

1. The Due-on-Sale Clause

You’ve probably heard about the dreaded due-on-sale clause before, but just so we’re all on the same page, let me give you a brief description of what it is. In nearly every mortgage paperwork, there is a paragraph that sounds something like this:

“If the trustor shall sell, convey, or alienate said property, or any part thereof, or any interest therein, or shall be divested of his title or any interest therein in any manner of way, whether voluntarily or involuntarily, without the written consent of the beneficiary being first had and obtained, beneficiary shall have the right, at its option, or declare any indebtedness or obligations secured hereby, irrespective of the maturity date specified in any note evidencing the same, immediately due and payable.”

This clause declares that the mortgage holder—the lender—has the legal right to demand to be paid back, in full, if the property is sold. If this happens, and the borrower cannot pay back the entire loan in full, the lender could foreclose and reclaim the property. Not cool.

“But Brandon,” you say, “we never bought or sold the property! This is just a lease with an option to buy.” Very smart, and very true. Nevertheless, some people worry that a lease option could entice a bank to call the note due, based on the due-on-sale clause. In the lender’s mind, they may argue that although the legal title was not transferred with the lease option, “equitable interest” in the property has been transferred.

Furthermore, many due-on-sale clauses specifically note “lease options” as a condition for the due-on-sale to be exercised, in which case it’s pretty black and white (literally). I just took a look at my own primary residence mortgage, and sure enough, it states that a lease option can trigger the due-on-sale clause. I would wager most of my loans have something similar.

Is any of this likely? How fearful of the due-on-sale clause should you be? Will the bank really come and demand payment from you?

At least in the past, banks have generally ignored the issue, and I’ve never even heard of a case where a note was called due because of a lease option. However, the possibility does exist, so I must mention it and make sure you are aware of any potential problems.

Related: 8 Tips for a Successful Lease Option Sandwich

There are additional concerns that by breaking the due-on-sale clause without notifying the bank, you are breaching an ethical code and possibly even breaking mortgage law. So what can you do to prevent this kind of thing from happening? The main way is to have a great deal. If there is a ton of equity in the deal, chances are good that you could sell quickly or try to work something out. Or simply don’t do a deal that involves a due-on-sale clause.

Furthermore, at BiggerPockets, we recommend never going behind your lender’s back. Therefore, if the mortgage paperwork specifically forbids lease options, you probably shouldn’t do one with that property unless you are 100% comfortable with the risk—and you are not putting the seller at any undue risk. Plenty of other strategies in this book could work just as well.

Creative finance is about finding solutions, not forcing them.

While the due-on-sale clause is definitely a concern with lease options, it’s not the only one, so let’s move on to some more risks to keep in mind.

2. Major Repairs the Owner Can’t Cover

A second problem that could arise is repairs, especially if you are the lessor in a lease option scenario and you are renting out a property to tenants. As I mentioned earlier, you could require the tenant to cover repairs under a certain amount, and in theory, this arrangement is great. However, certain issues could come up that you need to be aware of.

For example, what if a large repair is needed that your tenant can’t afford, such as a furnace failure? Who will pay for that? Hopefully, your legal contract with the owner will spell out exactly who is responsible, and you could take legal action if absolutely necessary.

Additionally, a great suggestion from John Jackson, a lease option expert on BiggerPockets.com, is to pay for a home warranty on the property (or have the tenants pay for one) at the start of the lease option, one that covers all major maintenance problems on the home. These policies tend to be less than $500 and can be a life saver when the furnace does blow up.

3. Changing Legislation

Finally, the lease option world is changing, and it’s severely unsettling right now as to where things are headed. Most of the changes and uncertainty have come about because of passing of the SAFE Act and the Dodd-Frank legislation since the housing collapse several years ago. These reforms were enacted to prevent a similar meltdown in our economy, but much of the language designed for big banks and huge corporations also seems to apply to small-time investors like you and me. No one is sure where things will end up or what actually applies to small investors, so the uncertainty also creates a degree of risk.

[This article is an excerpt from Brandon Turner’s The Book on Investing with No (and Low) Money Down.]

What’s your opinion on lease options? Have you ever run into any of these challenges when using them?

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