First Lease Option Deal, importance of tenant screening?

[Michael Nathanson]

Hi BP,

I am about to close on my first deal beyond my primary residence which will be converted into a rental next year. This new deal is an off market deal I found on craigslist and was able to negotiate down to a price of $167k for a purchase with 1k in closing costs covered by the seller. Based on my analysis of the market, I determined I could rent the house out for $1500/month without any issues, but based on the equity I thought was already in the deal I decided to also advertise as a lease option. I ended up having the house rented to a lease option tenant but they have a low income compared to the rent and a really bad credit history. They seem very interested in buying the house as soon as possible but I don't think getting the credit score up will be easy due to previous evictions and lots of bad credit card and car loan debt, some of which is being disputed. I decided to take them since I was charging a $5k option fee and $1600 for rent with $100 of that going towards a credit if the option is exercised.

Type: SFR 4bed 2bath

Purchase Price: $167,000

Option Price: $220,000, 2 year term

Closing costs: ~$7,000

Rent:$1,600 with $100 as credit towards purchase

Total Loan value: $125,250 (25% Down)

PITI: ~$750

Maintenance, CapEx, Vacancy: budgeting ~$300/month, though theoretically with a lease option this should be $0

Total out of pocket cost: ~$48,000

Cash Flow: ~$500/month or 12% CoC accounting for all costs with self management

*numbers are rounded and estimates, I do have a spreadsheet to calculate all of this but just obviously the numbers change with all assumptions that go into it

I know if all works out this deal is amazing, but I am worried about this tenant being a problem since there are a lot of evictions in the background check (almost every year it seems). Employment seems steady with a municipal job, but income is about 2x rent. There may be some undocumented income and also $300 in child support. 

The primary reason I was willing to take this tenant is because of the option fee being payed gave me a sense of security, and I like the idea of the tenant having a sense of ownership in the house. My question for the BP community is whether the option fee should give me enough sense of security to deal with any problems that come up. Is taking a less qualified tenant for an increase in cashflow and an opportunity for a large payout worth it to the other investors here, or do you screen just as hard for rent to own tenants. The pandemic and current economic situation is not making me feel any better about this either, but again, $5k in option fee security is worth over 3 months in rent.

The other question I have for more experienced investors is should I be concerned that the appraisal came in right at the purchase price? I know for a fact that they weighted bad comps the most heavily and that similar houses in the area are worth between $210k-$230k. 4 of 5 comps used had a corrected value greater than the purchase price and the one below was well over a mile away in a less desirable neighborhood. Are appraisers just likely to value a property at the purchase price to be safe? I would hate for this all to work out and the tenant qualify to buy the house only to have it fall through on a bad appraisal 2 years from now even though I bought this house with the intention of holding for a long time originally.

This is my first post on BP about a specific deal so please let me know if this is the wrong forum. I have been looking for about a year and this will be my second purchase. If all go well should be building the portfolio some more soon! Hopefully this can be encouragement for newer investors to get out there and make a deal happen, and consider multiple exit strategies in doing so. Let me know what you think of this deal.