Lets look at a couple of ways to make money using options. You will encounter seller situations where, if you know how, you can solve the seller’s problems and make good money yourself. It may be a strait option to purchase, a sandwich lease-option strategy, or an assignment of an option. There are pros and cons to all of them.

You may find yourself creating a hybrid strategy combining the best of a buy and hold strategy with a lease option exit strategy on the sale of the property.  This is a great way to control risk factors and maximize your return on investment (ROI).  We’ve discussed some of the reasons it makes sense to structure a lease-purchase transaction, now let’s review an example. The following example from my portfolio illustrates how you can create multiple paydays using this buying strategy.

Example: House on Twin Loop How I Found the Property:

·    A seller responded to my yellow page ad that stated that I bought houses. I gave him a FREE report, which educated him on how I could help him.
·    Motivation for Selling - Find Out “The Why” The husband had a job transfer 150 miles away and they had already purchased another house.The Realtor had been by and told them they needed to spend $5,000 to fix it up before they could sell it because the basement was not 100 percent completed. It was a nice house in a good area.  Solve the sellers problem.
I told them I would be willing to lease the house for 1 year, for $600 per month, as long as I had at least a one-year extension. Their underlying payment was $750 a month. I told them that in order for me to lease it, I would need them to subsidize the payment at least $150/month, so I could make a profit.

Pay-Day #1: Monthly Payment Spread

You may ask why would they ever do that? Well, there are lots of reasons:
1.    They wanted to sell the house, not just rent it.
2.    A Real Estate agent wouldn’t make the payments while it was listed.
3.    $150 a month payment is a whole lot easier than $750/mo.
4.    They couldn’t do 2 house payments.

I think it also important to say that they “bought” me. We developed instant rapport, and they sensed that I knew what I was doing. They knew that I could solve their problem. People will pay for specialized knowledge. I found out the “Why”, meaning: “Why they needed to sell,” then I solved their problem.

Within a few weeks, I had rented it out to a new buyer, and created a monthly payment spread of a $200 that equaled $2,400 a year.

Payday #2: Front-End Option Consideration This is the difference between the amount of option consideration that you pay the seller, and the option consideration you charge the buyer to get into the deal. In the above example, I only had to make the property payments they owed. Since they were moving, that was $600 due in about 2 weeks.

I immediately began marketing the property as a “Rent to Own.” Within a few weeks, I had found my buyer - a mortgage broker with a few dings on his credit. He figured he would be able to buy in about a year or so, and was willing to give me $5,000 as option consideration, and rent of $800 a month. I had to take the option payments over time.  $2,000 to get in; $500 in 30 days; plus $2,500 in 6 months. I said, “Sure.” Let’s get back to the sellers for a moment. I had determined that the sellers were payment sensitive, and credit sensitive. That was why they were willing to subsidize the payment. They were willing to basically give me their house for their payoff, plus $5,000. That was the equivalent of a purchase price of $85,000. This brings us to the third form of cash flow.

Payday #3: Back-End Spread What I mean by “Back-end spread” is the difference between my contract purchase price ($85,000), and the price that I had sold it to my new buyer ($115,000), less the option consideration to be paid by the new buyer. The reason I call this the back end is because the money is paid to you when your new buyer exercises his offer to purchase.  You basically earn the spread between the two contracts. Before I recap this deal, I want to talk about the buyer. I had sold the property to them for the option consideration of $5,000, paid over time, plus monthly payments of $800. You may ask why would he pay so much to get into a house that he wasn’t sure he wanted to buy? The fact is, most buyers in his situation will do almost anything to buy.

He was a former homeowner. He knew his credit situation would not allow him to get better then an 80 percent loan to value in the near future, which meant he needed at least $20,000 to get a loan.  He didn’t have it, and he had to wait at least a year to get his credit scores up. Besides, when I explained that I would give him a monthly credit of $250 towards the down payment, from his rent payment, it made it a sure thing. The $250 is known as a rent credit. With a monthly rent of $800, I gave him $250/month back, deducted off the option purchase price in the form of a credit. Not bad, huh? Once the buyer realized that he was basically only paying $550/month in rent, and $250/month towards the purchase price, it was a slam-dunk. Structuring a lease/purchase for the buyer this way helps mitigate any concerns they may have about paying a little higher rent payment.

We all know that the bulk of a typical mortgage payment (99 percent or more) during the first few years goes to interest. Only a very small percentage goes to principle. I just show them an amortization chart vs. a rent credit for a lease purchase, where ½ or a 1/3 of the payment goes to principle reduction. It’s easy. Finding the buyers, if you have the right properties, just isn’t that hard. 

Now, let’s review....

To avoid potential pitfalls between parties it is a good idea to lock in the purchase price at the time the lease option contract is executed. I have seen people do transactions and tie the purchase price to the appraised value at the time the option is exercised. In our opinion, this approach is asking for trouble because appraisals can vary widely.  Agree to the price at the beginning and then stick to it.

If you are the seller and are concerned about giving away equity, you might tie the purchase price to a modest appreciation rate. The buyer needs to feel like there is a reason for them to stay in the deal. Building equity is a good strong reason to complete the purchase.

Be willing to give something up. If you are getting above market rent on the property be willing to let the buyer participate in some appreciation, even if only for a period of time. For instance in a 3 year lease option contract, you may hold the purchase price fixed for two years, but the price starts going up if they haven’t exercised after the second year.  During those first two years, the renter/owner can earn good dividends if they exercise their option.



This works well because the buyer is able to lock in appreciation without actually owning the property.  Make sure the buyer realizes that any appreciation is lost and forfeited, along with any option money paid, if they don’t exercise their option and buy the property in the allotted time.
Sometimes buyers may be a little skittish on taking any risk for fear they can’t get a loan when they need to exercise their option. A safe way for them to recoup any money paid out is to sell their interest to another buyer. Just make sure any assignment on the buyer’s part requires your approval.  You want to make sure you aren’t renting to criminals, or you may need to adjust the numbers because of changing market conditions.  Surprisingly, I have seen home buyers just walk even if they have equity. That’s ok because I can just re-lease the home to someone else and get option money all over again. Remember, the option money is forfeited if the buyer doesn’t buy. Tenant buyers moving out are a strong argument

for getting sufficient option consideration up front, when they move in. In our experience, you go through more than one set of tenant buyers on a property from 20-40 percent of the time. You want to make sure you get enough option money up front so you can get it cleaned up if they move out.  In the beginning of this chapter, I mentioned three or more paydays.

Here are a few more possibilities. 

Create “Paper” with Lease-Purchases You can use this technique a few ways. One-way is to take back part of your back-end profits from your new buyer is in the form of a note. In the previous example, I could have carried a note for $10,000 or $15,000. If the Buyer was still going to have a hard time qualifying for the new loan, I would have actually increased my return, and monthly cash flow, by earning additional interest.  Once you have a note and it has seasoned for a time (6 months or more payment), you may be able to sell it for a discount for cash. Other factors like loan to value, borrower credit, and others come into play here, but it is an option. I know of an attorney who likes to buy this kind of paper for his retirement account. He knows how to collect on them if the buyers default and has his own little note buying system.

The second way to earn paper on a lease purchase, once you get good at creating the deal, is to assign the whole agreement to another investor for a flat fee, and/or take back a promissory note.  This gets you out of the deal entirely, but earns you some monthly cash flow. Certain situations may make this an attractive way to go. When you acquire the skills to do a deal like this by utilizing this course, you can use your knowledge to assist people in solving their problems. Just remember if you collect consulting fees you may need to be licensed as a Realtor in some instances, so check your state laws.

Lease Purchase for Cash Flow Done correctly, lease purchase transactions are on autopilot. As I mentioned earlier, it is a good idea to use an escrow company to collect the payment from the buyer. Use an escrow company to pay the underlying payment on the seller’s mortgage directly, so you know it gets paid. I feel a little stupid saying this, but the one time that I allowed the seller to pay it themselves, it didn’t get paid. They just pocketed the money. It is critical that you have the control in these transaction, or don’t do the deal.

In cases where the seller does not have a lot of equity in the property or if you are curing a default, you will need an “authorization to release information” letter from the seller so the bank with the underlying mortgage will talk to you. You will need to fax it to the lender before they will talk to you about the loan. This is a must in certain situations where you are leaving the financing in place.  I like to have the seller sign a deed as well and have the long-term escrow hold it in escrow with an instruction to record it once certain conditions are met. That way you won’t have to worry about chasing the seller down. An even better way is to have the property transferred to a land trust. I will talk more on that later.

One of the reasons I like a third party escrow company to service the payments is that, when the buyer goes to get their financing, there is an indisputable payment history. Sometimes the lender may rate it like a mortgage in qualifying the buyer.  Having a 12-month or 24-month payment history definitely helps.

Nice Properties in Good Areas Only An important concept for new investors is to only use lease-options in good areas and on clean properties (minimal fix-up required). You will find out that sellers will practically give properties away in bad areas, and there is a reason for it. If you try lease-options outside the nice neighborhoods, you will end up a landlord with problem tenants. I KNOW!!! To keep your business easier and more trouble-free, stay out of the lower and lower-middle class neighborhoods for lease options.  Many experienced investors do very well working in these areas, but they are prepared for the headaches in collecting payments and they are able to move people through when they have problems.  They know that they will have a lot of turnover and are prepared for it. Doing lease option deals in lower priced blue-collar neighborhoods and then expecting no problems is not realistic.  Flips in lower class areas are fine, but as a rule, and for the purposes of this course, lease options work best with higher valued properties. Here are some reasons why:

·    Better quality of tenants. More apt to have a degree of accountability for their finances.
·    Desirable neighborhoods typically don’t have many lease option homes available (supply and demand).
·    Good conditioned properties won’t typically require costly repairs during the option term.
·    Tenant/buyers want to live in good areas and will generally keep the property up.

Protect Your Investment Lease-options are no different than any other real estate transaction when it comes time to protect yourself. You should make sure you follow the same cautions and procedures with lease-options as you do with outright purchases. We mention a few below that we have found useful, but this is by no means a complete list. The desired result is control and protection. You may want to consult an experienced real estate attorney as you structure your first few transactions.

·    Do a Property Inspection

Aside from the obvious need to check property out for repairs when you enter into a lease purchase agreement, you should probably have a contractor or home inspection company look things over. It only takes one bad deal to eat up the profits of a few good ones. All my offers are conditioned upon some type of inspection period. You want to thoroughly examine a property before closing a deal. You won’t catch everything, even in the best of cases, but you want to be aware of structural damage, flooding issues, and other things that can be expensive to repair.

·    Check for Liens on Title

Before you sign the dotted line you need to take the time and check out the title report for any liens that the seller has against them personally and/or the property. Costs for a title search vary from state to state, but it is a nominal fee. Even if you decide not to issue title insurance (I recommend you do), you need to at least see what’s currently recorded against the property, and the seller.  Sometimes you may find that the reason you are getting such a great deal on the property is because it has a ton of liens against it, or the Sellers have a bunch against them. Whenever there is divorce or a failed business on the seller’s end, I am especially careful when I check things out.

·    Record a Memorandum of Option

 I also record a memorandum against the property, once I have it under contract. A memorandum will assist you in case the seller tries to pull a fast one.  He might try to get rid of you and cancel your offer.  Some people do these things when they think you might make a little money. A memorandum will cloud the title and force the seller to deal with you.

The Bottom Line

Lease options are an excellent way to go. You can control staggering amounts of property, and not have your name on one single mortgage. It’s funny.  If I look back at all my deals over the last 16 years, it’s the ones I owned with bank financing that have caused me the most grief. Lease options are by far less stressful when things don’t go your way, and market conditions change.