Lease Option Pitfall Number One
There are a lot of mistakes that people make when they’re trying to do a lease option as an investor.
Let’s go through things that you can do to avoid problem.
Number one, don’t give the seller too much money.
Many Real Estate Investors pay too much money into a sandwich lease option or a lease option assignment. You should only give $10 to the seller.
You are solving the sellers problem. If they are looking to profit by getting a lot of money down from you the investor, there are other ways to help them think that they’re making more money.
A concept called equity split, where on the back end you offer the seller percentage of the net profit.
Let’s say that the seller wants more money than $10 to get the deal done because in their mind they think that they should get a huge security deposit to protect themselves in case a problem . I have had this happen any times with lease options sellers.
So I’ll make an addendum for an equity split arrangement:
let’s say the numbers on the transaction are the following
- Fair market value is $100,000 today
- Depreciation is unknown could go up could go down
- The outstanding balance to pay off is $50,000 with an equity position thought of from the owner of $50,000.
- That $50,000 is in their head. They think it’s real money.
- As investors we know that there’s cost to sell which is approximately 10% of the value of the house.
- This includes Realtor commissions of 6%, closing costs of 2%, and other holding cost that are another 2%.
- 10% varies a little bit, but it is a good wheel of thumb.
- So whenever I see $100,000 house , I think this house is worth $90,000 MAX, because it cost money to liquidate and cash out.
So we have a $90,000 asset with $50,000 loan payoff with a maximum to the seller of $40,000.
I demonstrate this with the cost to sell seller sheet.
This is not include repairs to get to the hundred thousand dollar mark, you could need paint or carpet or landscaping.
So I tell the seller ”
My job is to get someone in this house that will pay $105,000 for the house. End of story.
But it’s gonna cost money to close. Hopefully they’ll buy it within 12 months.
But it has to appraise.
So what I like to do is to put 105,000 as the sales price. Their fee that they pay me to get the house is not included within your profit.
You were going to be getting a little bit more than the house is worth by doing this.
You’re also going to be getting a tenant that’s gonna take care of the place like an owner.
They’re not gonna make a lot of damage .
A lot of tenants don’t care about landlords too much. We have conditioned our buyers to act like an owner.
They’re working hard on getting their credit better and be able to get a mortgage soon.
They are saving up for 3% FHA loan.
My Tenants really want to be homeowners.
So if I have an owner or seller that wants more money than $10 for the lease purchase arrangement, then I will do some kind of a “back end agreement. an equity split.
Let’s say that my profit is XYZ.
I will give them whatever my profit is after all costs 10% of the net profit, So I do a double close on a sandwich lease option. they have costs to buy and costs to sell because I need to be able to buy it first, own it, and then resell it.
There is another way to do it – reverse assignment
Another way to make money with lease options is to do what’s called reverse assignment.
This is where when the tenant buyer is bank qualified let’s say in 12 months, they are going to get bank qualified for $105,000 ,
and I have a lease with option arrangement with the tenant buyer that’s in the house.
I also have an option to buy for let’s say $95,000 from the seller so the spread there is $10,000,
$105,000 -$95,000 equals $10,000.
A reverse assignment has to do with me assigning my paperwork from the buyer to the seller for an assignment fee.
It can be paid at escrow.
So there is not double closing but single closing. The seller and the buyer are going to have a transaction together versus me buying it first paying the cost to sell, and then selling it to the tenant buyer and paying those cost to sell.
The point of this transaction for me as the investor is to make $10,000 on the backend. This is good for the seller on the reverse assignment because he does not to pay any money out of pocket.
He gets his house sold and he makes the amount of money that I have negotiated on the front end of $95,000 and he is happy.
The tenant buyer is happy because he’s getting a house for $105,000 as agreed in the very beginning .
Now, this might sound a little confusing, but there’s two transactions:
I have a lease with an option with the seller $10 down for option consideration, below market rent for 12 months with extensions, and an exercise price for a $100,000 house, of $95,000.
I also have a separate transaction between the buyer and myself for lease with option, consideration of $3000 or 3%, market, rent spread of at least $200 a month where I’m paying the seller X dollars and whatever the buyer is paying me is at least $200 a month difference, and the backend of $105,000,.
This compares with the price on paying from the seller to me of $95,000.
I hope you can see that you have to be cautious with sandwich lease options to not pay the seller too much money upfront.
There are a lot of costs to pay in a sandwich option.
Good luck!
