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Options, Lease-Options, And Seller Financing Agreements, Part 1

Feb 22, 2008
I talk to people all the time who either have bad credit or no money, or both, who want to invest in real estate. The easy answer is to tell them to save their money and pay off their debts. But we all know that's easier said than done. In order to save money they have to earn more than they spend, and since most of them are barely getting by on what they make, they're spending everything they have just surviving and don't have enough left over to save. The ideal answer would be to find a way for them to invest in real estate without money or good credit, so they can save the profits in order to pay off their bad debts. Does this sound too good to be true? It isn't.

Back in 1996 when I started investing in real estate, I had good credit, but very little money. I borrowed money on a boat that I owned and used it as the down payment on my first investment property, which I bought with owner financing. When I sold that property I made a decent profit. I bought my second investment property with bank financing and had to put 10% down. That, along with the closing costs, tapped me out. I put a buyer in that property on a 12 month lease-purchase agreement. I stood to make about 15k over and above what I had invested in the property when the sale closed, but that wouldn't be for another year. Since I wanted to continue doing deals, I had to figure out something creative.

The first deal that I'd done proved to be the answer, with a twist: If I could get people to hold paper on properties - and this is key - without requiring me to put money down, I could continue doing deals. I knew it could be done. I just had to figure out how to do it. So I bought a couple of books on real estate investing and did some reading.

I settled on 3 basic no-money-down techniques: Options, Lease-Options and Seller Financing Agreements. Over the next year, using them exclusively, I made over $80,000 and didn't put more than $10 down on a single property. Keep in mind that this was 11 years ago. Taking inflation into account that would be well over $100,000 of income in today's dollars.

There are multiple variations of the 3 techniques. But if you understand the basics of all of them, you can modify them to suit your needs. I'm going to give you examples of how I've used each technique. Since it would be too lengthy to explain all 3 techniques in 1 article, I'm going to break this up into a 3 artcile series.

Today let's talk about Lease-options:

The definition of a lease-option is simply leasing a house with the option - the choice - of whether to or not to buy it at a predetermined price. You might get a credit from each monthly payment toward a down payment. Or you might not. It all depends on the situation, and how you structure the deal. In most cases, if the seller is willing to work with you at all, they will do what you want them to do so long as it makes sense for them.

The great thing about lease-options is you can take control of a property and at the same time put very little money down. You're not taking deed, so you won't trigger the acceleration clause in the seller's mortgage. In a buyer's market like the one we're currently experiencing, properties you can buy with lease-options are far more readily available because there is just so much inventory on the market. The key to doing lease-options is buying properties needing little, if any repairs. You don't want to be dumping thousands of dollars into a property you don't own. You want to do business in decent neighborhoods. Stay out of the slums and war zones. The types of buyers you'll attract in those areas are nothing but trouble. Believe me - I'm speaking from experience.

The type of seller you'll run across will most often have very little equity. That's why he will consider a lease-option, because he can't afford to hire a RealtorŪ to sell his house and oftentimes he's already tried selling it himself without any luck. Perhaps a job transfer took him out of town, or he's bought another house and is making two payments. Whatever the situation, you're his savior because you're taking that unwanted mortgage payment off of his hands.

You'll be dealing with nice properties in good areas, so you're not going to buy them on lease-options for drastically under value. Most times you'll pay the seller what the property is worth, but that's okay if the terms are right. By that I mean, very little money down (I've done many lease options with $1 dollar down), monthly payments that are no more than the seller's debt service, a contract that is a minimum of 12 months - with at least one 6 month renewal clause, the ability to sublet the property (so of course the property must be vacant), and the ability to assign the contract. If you can get the seller to wait 30 to 60 days before the first payment is due, all the better.

Now that you've taken control of the property, you can do two things:

1.Sell the property on a second lease-option to a tenant-buyer. You charge them a hefty Option Fee - 5% to 10% of the purchase price - and if possible mark up the sales price as much as you think the property will appraise for at the end of the lease term. If you're dealing in good areas you can more readily attract good buyers. The reasons people would lease-option a property rather than buying it outright are manifold. One reason would be that they're just coming out of a bankruptcy and need 6 to 12 months to rebuild their credit. You need to judge the story on its own merits and confirm your buyer's ability to obtain a mortgage at the end of the contract by having a mortgage professional pre-qualify them.

You're charging an "Option Fee", not a down payment. The Option Fee is what the tenant-buyer is paying you for the right to purchase the property for a predetermined price at the end of the lease. So theoretically, you can charge the tenant-buyer a 10% Option Fee on a house that you're buying on a lease-option for $100,000 that is only worth $100,000. You don't think the property will appreciate that much, so you do a second lease-option with the tenant-buyer for $100,000. On the sale you're not making anything on the back end, but up front you made $10,000 because you charged a 10% Option Fee. Another good thing I've found about Option Fees is that when I've had to evict a delinquent tenant-buyer, the Option Fee was not considered a down payment. That's a BIG deal. If I had collected a down payment rather than an Option Fee, the tenant-buyer would have had an equitable interest in the property. The lease-option agreement could be construed as a Sales Agreement and I would have been forced to foreclose - a much more lengthy and expensive process than eviction. I can't say if that would be the case in your state. You should check with an attorney before entering into an agreement to make sure.

Throughout the term of the lease-option with the tenant-buyer, they are making payments to you that are equal to or greater than the payments you're making to your seller. They're maintaining the property and paying the utilities. This all works great so long as they hold up their end of the deal. And that's the downside. In the event that the tenant buyer defaults, you still have to make payments to your seller and deal with any repairs needing to be made on the property. Then, depending upon how much time is left on your lease-option agreement with the seller, you might or might not be able to put a second tenant-buyer in the property for a sufficient period of time for them to obtain financing. By the time it's all said and done, if your seller is unwilling to extend the term of your contract, you could end up giving the property back to him at the end of the lease term and losing money. (Remember, this is a lease-option, meaning you have the Option to buy or not buy the property at the end of the contract.)

That's where course of action number two comes into play...

2.Assign the contract to another buyer in return for a hefty assignment fee. They're in effect buying the contract from you. If you compose the assignment clause in your lease-option contract correctly, as well as the assignment agreement with your assignee, the assignee is responsible for living up to the terms and conditions of the contract from that point onward, not you. So you've made money on the deal up front, and don't have to deal with tenant-buyers and property maintenance. It's pretty sweet. Just make sure to explain the contract thoroughly to your seller - including the assignment clause. And don't just pawn the property off on the first person who waves some cash. Do some due diligence. Make sure they're a viable buyer with a reasonably good shot at obtaining financing at the end of the lease term. If you do lease-options unethically by putting just anyone who can pay into the properties without regard for the consequences, you will gain a bad reputation and eventually your misdeeds will come back to haunt you.

Technique # 2, Option agreements. To be continued...
About the Author
Frank Lawson is the Editor of The Profit Blog, the Online Education Resource for Real Estate Investors and Hard Money Lenders. With 10 plus years of experience in Real Estate Investing and Hard Money Lending, Frank has an expert perspective on today's volatile real estate market.
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