The road less traveled is that way for a reason. —Fortune Cookie The lease-option strategy is a great way to leverage your real estate investments because it requires very little cash. The lease-option method is more of a financing alternative than a financing strategy because you don’t own the property. The basic lease-option strategy involves two legal documents, a lease agreement and an option. A lease gives you the right to possess the property, or, as an investor, to have someone else occupy it. If you can obtain a lease on a property at below market rent, you can profit by subleasing it at market rent. An option is the right to buy a property.

It is a unilateral or oneway agreement wherein the seller obligates himself or herself to sell you the property, but you are not obligated to buy it. By obtaining the right to buy, you control the property. You can market the property and sell it for a profit. The longer you can control the property in an appreciating market, the more value you create for yourself. By combining a lease and an option, you create a lease option. Financing Alternative The two primary objectives of the real estate investor are cash f low and appreciation. You don’t need to own a property to create cash f low or benefit from appreciation. Because a lease entitles you to possession, it allows you to create cash f low. An option gives you the right to buy at a set price, allowing you to benefit from future appreciation. Lease—The

Right to Possession

Under a lease agreement, the lessor (landlord) gives the lessee (tenant) the right to possess and enjoy the property, one of the most important benefits of real estate ownership. The lessee is usually not responsible for property taxes and major repairs. Once you have the right to obtain possession of property, you can profit by subletting or assigning your right to possession.

Sublease

A sublease is a lease by a tenant to another person, a subtenant, of a part of the premises held by the tenant under a lease. The sublease can be for part of the premises or part of the time period. For example, if the tenant has a three-year lease agreement with the landlord, the tenant can sublease the rental unit for two years, or sublease part of the unit for three years.

Assignment

An assignment is a transfer to another of the whole of any property or any estate or right therein. As with a sublease, the master tenant is not relieved from liability for obligations under the lease. However, the assignee of a lease is in contract with the landlord, and thus the landlord can collect from the assignee or the master tenant for nonpayment of rent. Assignment and subletting are always permissible without an express provision in the lease forbidding the tenant from doing so. As a tenant/investor, it is imperative that there are no antiassignment or antisubletting clauses in your lease with the owner of the property.

More on Options, the “Right” to Buy

A real estate sales contract is a bilateral, or two-way, agreement. The seller agrees to sell, and the purchaser agrees to buy. Compare this agreement with an option; an option is a unilateral contract in which the seller is obligated to sell, but the purchaser is not obligated to buy. On the other hand, if the purchaser on a bilateral contract refuses to buy, he or she can be held liable for damages. A bilateral contract with contingency is similar to an option. Many contracts contain contingencies, which, if not met, result in the termination of the contract. Essentially, a bilateral contract with a contingency in favor of the purchaser turns a bilateral contract into an option in that it gives the purchaser an “out” if he or she decides not to purchase the property. Though the two are not legally the same, an option and a bilateral purchase contract with a contingency yield the same practical result.

The receiver of the option (optionee) typically pays the giver of the option (optionor) some nonrefundable option consideration, that is, money or other value for the right to buy. If the option is exercised, the relationship between the optionor and optionee becomes a binding, bilateral agreement between seller and buyer. In most cases, the option consideration is credited towards the purchase price of the property. If the option is not exercised, the optionee forfeits the option money. As seen in the following examples, an option can be used to gain control of a property without actually owning it:

• A speculator who is aware of a proposed development can obtain options on farmland and then sell the options to developers.

• To take advantage of appreciation in a hot real estate market, an investor can use a long-term option to purchase property.

• To induce timely rental payments, a landlord can offer the tenant an option to purchase. There are literally hundreds of ways that an option can be structured, and every detail is open for negotiation between the optionor (seller) and optionee (buyer).

An Option Can Be Sold or Exercised

An option, like a real estate purchase agreement, is a personal right that is assignable. If you were able to obtain an option to purchase at favorable terms, you could sell your option. The assignee of the option would then stand in your shoes, having the same right to exercise the option to purchase the property. As with a lease, an option is freely assignable absent an express provision in the option agreement to the contrary.

The Lease Option

A lease option is really two transactions: a lease and an option to purchase. Under a lease, a tenant may have the option to buy the property. The option itself can be structured in various ways. For example, the option may be that of a right of first refusal in the event the landlord intends to sell the property. The option may also be an exclusive option for the tenant to buy at a certain price. When combined with a lease, a purchase option may also include rent credits, that is, an agreement that part of the monthly rent payments will be applied to reduce the purchase price of the property. There are literally hundreds of ways that an option or lease option can be structured, and every detail is open for negotiation between the landlord and tenant.

The Lease Purchase

The lease purchase, like a lease option, is two transactions: a lease and a purchase agreement. A regular purchase contract is a bind- ing bilateral agreement; the seller agrees to sell and the buyer agrees to buy. An option binds the seller to sell, but the buyer is not bound to buy. If the buyer on a bilateral contract fails to buy, he or she is in breach of contract. However, a properly drafted agreement will limit the seller’s legal remedy to simply keeping the buyer’s earnest money (called a “liquidated damages clause”). Thus, as a practical matter, the result is the same as if the buyer gave nonrefundable option money and failed to exercise his or her option. In practice, lease purchase and lease option are just buzzwords that mean the same thing. Except as noted, we will use the two terms throughout this article interchangeably.

Lease Option of Your Personal Residence

Pride of ownership is what makes so many Americans obsessed with the idea of owning a home. Once you get over this idea, you will see that you can often rent more home than you can buy.

Why buy when you can rent?

We’ve all seen the ads used by real estate agents: “Why rent when you can buy?” Consider the other side of the coin: “Why buy when you can rent?” In most parts of the country, a typical $100,000 house will rent for about $1,000 per month. Assuming a reasonable down payment and interest rate, the monthly mortgage payments would be less than $1,000 per month. In this case, it makes sense to own the home. However, more expensive homes don’t rent as well as cheaper homes. A typical $500,000 home does not rent for $5,000 per month. The more expensive the home, the cheaper it becomes to rent compared to buy. If you are concerned about the proverbial “throwing away rent,” consider a lease option of your next home.

Case study: lease option builds equity. A student of mine from the Phoenix area (we’ll call her Sharon) was interested in purchasing a home to live in, but she didn’t have much cash. She was at her new job just a short time and could not qualify for a conventional or an FHA low-down-payment loan. Sharon found a seller with a nice property, with little equity but with a low-interest-rate loan. Sharon leased the property from the owner for three years for $1,200 per month, with an option to buy at $162,000.

The agreement provided that the seller give her a 25 percent ($300) credit towards the purchase price for each rent payment made. Sharon put up just $500 as a security deposit that would be credited toward the purchase price when she exercised her option to purchase. After 18 months, the property had appreciated $17,000 in value to $179,000. In addition, Sharon’s “equity” had increased $5,400 because of the $300 per month rent credit. Thus, Sharon’s equity position was almost $23,000:

$162,000 Option price – 5,400 Rent credit – 5,500 Security deposit $156,100 “Strike price” $179,000 Market value –156,100 Strike price $ 22,900 “Equity”

Sharon exercised her option to purchase the property and sold it to a third party, pocketing the cash difference. A few points are worth noting here: First, had Sharon purchased the home 18 months earlier, she would have been required by the lender to put up several thousand dollars for a down payment and loan costs. Because Sharon intended to live in the property for just a few years, she maximized her profit by using a lease option to control the property for 18 months, rather than a mortgage loan. Second, Sharon’s risk is limited to her $500 investment. If Sharon had bought the property with conventional financing and property values had declined over the 18-month period, Sharon would have been stuck with the property. As you can see, using options to lever age real estate is an effective alternative to bank financing when future real estate values are uncertain.