Can Lease Options Make You Rich?

The title says it all; can Michigan real estate investors get rich using lease options as their exit strategy?

There’s always a one word answer for every question in real estate, Depends.

Let’s explore the anatomy of a lease option.  First of all a lot of people thing that a lease option is a single transaction.  It’s not.  Although they typically happen at the same times it’s actually 2 separate transactions *IMPORTANT* If and when you have to evict a lease option tenant and go to court, the judge will treat the lease the exact same way as any other lease-if and only of the transactions ar not tied together in one document.  The lease part of the deal is a simple lease agreement.  Depending on what state you’re in you must make sure that you have your lease created or at the very least revised by an attorney.  In Michigan where I do most of my investing there is a specific paragraph that MUST be in big bold letters on the top of every lease agreement, if you don’t have it your tenan t can be granted a 30 day stay of eviction.  Don’t be a cheapskate, how much is that paragraph worth?

The second part of the transaction is the one that most investors or landlords are less knowledgeable about-the option.  It’s very simple; someone gives you consideration (something of value, typically money) for the right to buy a property at a pre-determined price, within a very specific amount of time.  Here’s how it usually goes-LO Tenant gives you $3000 as a non-refundable option fee to be applied toward the purchase of your property.   Usually investors will give their LO Tenants either a 2 or 3 year time frame.  In today’s challenging mortgage market they will need the time to not only save up the down payment required for a mortgage but almost always will need to take care of nagging credit issues.  Don’t let my last statement deter you from using lease options.  The main reason people need to buy using a lease option is because tey can’t qualify for a conventional mortgage, if they could they wouldn’t need us.

There are 3 major benefits to using lease options instead of just renting ou the property;

1. You will get more money upfront and monthly from LO Tenants (if you don’t then you’re spinning your wheels)

2. Your LO Tenant will typically take better care of the property (you should have received a three, five,or even seven thousand dollar option fee upfront, so they have skin in the game)

3. Your LO Tenant will require much less management (if you set the parameters up initially, treat your investing as a business not a hobby)

Here are a few more concrete reasons to use lease options as one of your exit strategies.  If you recently bought the property and sell it in less than one year you’ll pay regular income tax on your gain, if you’re in the 28% tax bracket and make $30,000 that’s $8,400 to Uncle Sam, YUCK!  If you sell on lease option and they close in 18 months you only pay Uncle Sammy $4,500, ahhh that’s better.  Because you’ve owned the property over 1 year you’re taxed at15% long term capital gains. 

Also you can truly take advantage of Michigan’s depressed real estate prices.  If you’re in it for the long haul you can give someone a 5 year option and the price of Michigan real estatemay have not only stabilized by that time, but it may have increased in appraised value.  If you were paying me to help you set up a rock solid lease option deal and your goal was maximum profit here’s how we would do it;

For the sake of sanity we’re using all round numbers.  So you paid $35,000 for a house.  You put $15,000 into it for repairs, closing costs, bla bla bla.  Your basis is $50,000.  At this point you’ve decided to go the lease option route instead of a conventional sale.   Your conventional sales price would be $79,999 minus commissions, closing costs, holding costs, and concessions you should be around $69,999.  that would leave you with basically a $20,000 profit, not bad.  Now take your 28% out for Uncle Sam and your net profit ends up being $14,400 because $5600 went away the tax monster.  Still, $14,000 is nothing to sneeze at.  Now we’ll run similar numbers on a 5 year lease option.

Instead of a $79,999 sale price you sell it on option for $99,999.  How can you hope to get $20,000 more you’re asking, simple.  Your LO Tenant can’t qualify for a traditional mortgage do the sale price means less to them.  Don’t forget on a 30 year after interest YOU ARE PAYING 2.5 times what you bought your house for.  We just lie to ourselves.  Anyway what’s important to a person these days when they are buying a big ticket item-the payment.  So for our example your LO Tenant’s payment will be $900 per month with $100 being applied toward the purchase price if their on time with their payment.  Sip to the end of the 5 years and you’ve diligently helped them repair their credit and they finally qualify for their own mortgage.  This is where it gets fun because your numbers look great

Let’s assume that you only cashflowed $100 per month (which would be practically impossible) over the 5 years.  Your LO Tenant gave you $5000 down as an option fee plus the $6000 in cashflow ($100 per month).   That makes $11,000 in your bank account (even if they don’t exercise their option and they move out).  Don’t forget that they paid their rent on time every month so they’ve built up $6000 plus the $5000 option fee.  Now they have $11,000 down towards the house.  For this example we said that you sold the property at $99,999.  Let’s take out the same amount of closing, concessions, bla blas bla, but wait NO COMMISSIONSbecause you sold the property to your tenant.  There’s a tidy $6000  more in your pocket.  Now lets do the math $99,999 – $5000 c.c.= $94,999 lets take out their $11,000, now you’re at $83,999, not bad.  But now we need to add in $6000 because that’s what you cashflowed, so you’re at $89,999. 

Your purchase price after repairs was $50,000, take that away from your $89,999 your left with$39,999!  What about Uncle Sam the tax monster you’re thinking.  We didn’t forget about him.  But since you owned the property longer than a year you only pay %15 instead of 28% which amounts to $6000. 

Your true net ends up being $33,999 as opposed to $14,000.

That’s how lease options can make Michigan real estate investors rich!

Oh yeah, you’re allowed to do more than one of these at a time.

Change Your Future-REIA of Macomb