The Sandwich Lease Option

The sandwich lease option is an old technique used by real estate entrepreneurs to create cash, cash f low, and equity buildup with literally no money, credit, or bank loans. Let me give you a typical example of how a sandwich lease option works. A seller (soon to be landlord) is transferred out of town and rents his property.

A year later, the tenant vacates (after skipping a few months rent) and leaves a big mess. The owner wants to sell the property for $110,000. It is the middle of the winter, the house is vacant, and the real estate market is a bit slow. The house needs new paint and carpet and therefore looks ugly. The $850 per month mortgage payment is a burden to the owner. He decides to lease it on a month-to-month basis but cannot find a tenant because nobody wants to lease a house for sale when he or she may have to leave within a few months. The owner is a perfect candidate for a lease option. The potential buyer (AKA tenant) filed for bankruptcy two years ago. He just moved to town. Although he has stable income, he cannot yet qualify for a loan. In addition, he still has to sell his old house to raise some cash for the down payment. He doesn’t really want a straight rental, yet he is not ready to buy today. The tenant is a perfect candidate for the other end of a lease option.

Cash Flow

So how do we, as real estate investors, fit in? Find the owner who fits the picture and sign up a lease-option agreement wherein you are the tenant/buyer. You are not going to live in the property but are still considered a “master tenant.” The lease-option agreement will give you the right to sublet the property. If the price you pay is lower than market rent, you can create cash f low by subletting the property to another tenant. Depending on the deal, this can create several hundred dollars per month of cash f low—not bad for a property you don’t even own!

Equity Buildup

After a year or two, you may have accumulated some equity in one of the following ways: • Appreciation of the property due to inf lation • Increase in value from improvements on the property

• Increase in equity from rent credits offered by the landlord/ seller Once your equity, the difference between the market value and your option strike price, reaches around 10 percent, you can obtain lender financing and buy the property. Or, you can offer the property for sale to another investor. Better yet, offer the property for sale to the tenant. In many cases, a tenant/buyer is willing to pay more than the property is worth! When the tenant is ready to exercise his option, you exercise your option from the owner and sell it to the tenant in a backto- back double closing for a profit.

Straight Option without the Lease

A purchase option can be used without a lease to gain control of a property and create a profit. Once you have obtained an option, you can either sell (assign) your option for immediate profit or exercise your option to purchase and simultaneously sell it to a third-party buyer. If you are speculating that a particular area is ripe for development, you can use an option as a long-term investment technique. An option is a leveraged, low-risk investment; you can obtain an option with 1 percent or less of the purchase price in cash. Again, using options in lieu of conventional financing is cheaper and less risky when you are dealing with a real estate market that has an uncertain future.

Case Study: Sandwich Lease Option

I was referred to a woman who had a house she needed to sell in a hurry because she had a job transfer. She had tried to sell the property with a real estate agent, but, at the last minute, the buyer could not qualif y for a new loan. The house was a small two-bedroom ranch that was worth approximately $45,000. The balance of the existing loan was approximately $38,000, with monthly payments of $380 per month (including taxes and insurance escrows). Although the average rents in the neighborhood were about $575, she was not interested in becoming a longdistance landlord. I offered to lease the property for $380 per month, with an option to purchase at $38,000 (the balance owed on her mortgage loan).

I had the right to sublet, but I explained to her that my payments to her were not contingent on occupancy. This alleviated her fear of having to deal with the property if it became vacant. I subletted the property for market rent, which was $575. After about two years, the market value of the property had risen to $75,000, so I exercised my option to buy at $38,000. Based on a $75,000 appraisal, I had no problem obtaining solid, institutional financing for the property. In fact, I even pulled out $4,000 from the refinance to make capital improvements to the property. My payments went up, but so did the rents, based on the improvements and increase in value of the neighborhood. For more information on using lease options, take a look at my home study package, “Big Profits with Lease options,” at <www.legal wiz.com>.

Sale-Leaseback

The sale-leaseback is a financing technique that has been used in the United States since the 1940s. The transaction, in its most basic form, involves the sale of a property to an investor who holds title and leases the property back to the former owner. The lease is typically a long-term net lease with the seller/tenant having the option of repurchasing at a later time. The seller/tenant reaps the benefit of favorable 100 percent “financing” and still retains the use of the property. The buyer/landlord receives the tax benefit of depreciation and a guaranteed long- term rental.

To do this with nothing down, simply sign a contract to purchase the property from the seller, then another contract to sell it to an investor. In a double closing, you purchase the property from the seller and resell it to the investor, who then leases it back to you, giving you an option to repurchase. You can then rent it out for cash f low or sublease it with an option to a tenant/buyer as described previously in this article. The sale- leaseback has its drawbacks. If either party to a saleleaseback

is audited, the IRS may recharacterize the sale-leaseback as a disguised financing arrangement. This will result in an immediate recapture of the buyer/landlord’s depreciation of the property and imputed interest on the seller/tenant’s rental payments. The seller/ tenant will lose the deduction for his or her rental payments because the payments will be reclassified as principal repayment of a loan. The United States Supreme Court, in the landmark case of Frank Lyon Co. v. United States, stated the factors to be considered for recharacterization are

• the economic substance of the transaction based upon the potential risks and gains of the parties, and

• whether there was a purpose other than tax avoidance for the transaction. While the above standards set forth by the court are not crystal clear, following are a few guidelines that we can follow to avoid recharacterization:

• Make certain that the purchase price of the property is for fair market value.

• Make certain the lease payments are for fair market rent, and that the lease arrangement is typical of the area and the intended use.

• Have reasons (other than tax avoidance) for the transaction and state those reasons in the preamble of your agreement.

• If the seller/tenant has an option to repurchase, make certain that it is based upon fair market value and not on a declining basis with unusually large rent credits (i.e., make sure it doesn’t look like a loan payoff). • Make certain that the buyer/landlord has the rights of any typical landlord in a comparable lease arrangement (including the right to have the property back at the end of the lease!). Make certain that there is nothing in the sale-leaseback arrangement that prevents the buyer/landlord from selling, mortgaging, or assigning his or her interest or benefiting from future appreciation of the property.

Case Study: Sale-Leaseback A client of mine (we’ll call him Chris) used a sale- leaseback to profit in a win/win arrangement with a builder. The builder had finished developing the first phase of a new housing project. The builder’s lender wanted to make sure a majority of the houses from the first phase were complete before extending the builder more credit to build the second phase. Chris offered to purchase the model homes the builder used to show to prospective purchasers. Chris and the builder entered into a sale-leaseback agreement, wherein Chris bought the properties at 80 percent of fair market value, then leased the properties back to the builder to use as model homes. Because the builder was able to show his lender that three of the homes in the first phase of the subdivision were sold, the builder was allowed to borrow more money for the next phase of the development. By the time the third phase of the development was complete, the builder no longer needed the model homes. The property values had increased, and Chris sold the homes for a substantial profit.

Key Points

• The lease option is an excellent, high-leverage financing alternative.

• The sandwich lease option is a cash f low generator.

• The sale-leaseback is another excellent financing alternative.