How to Survive a Recession

LESSON 32: Lease Option Your Real Estate

Many investors that own rental properties see their vacancy rates increase significantly during recessions as tenants lose their jobs and businesses go under or seek cheaper rent. This can cause a significant cash crunch, and can put the property at risk of foreclosure.

The first step when this situation occurs is to refinance any debt on the property to reduce mortgage payments. If this does not eliminate the cash problem, or you simply would like to reduce your leverage but continue to generate current income, then lease-optioning the property might be a good bet.

A lease-option is a contract with a potential purchaser where the buyer agrees to rent the property for a fixed period (usually 1 to 2 years) for above-market rent, and the owner credits a portion of the rent against a pre-agreed sale price at the end of the lease. The tenant is normally responsible for all maintenance and insurance costs, creating a strong incentive to take care of the property. Lease-options are popular for first-time homeowners or buyers with past credit history who cannot obtain standard mortgage financing at reasonable rates. They can also work for business purchasers that lack the collateral to obtain financing for an outright purchase, and who plan to remain at the location for an extended time.

A large percentage of tenants in lease-option deals fail to carry through with the purchase, which means the owner gets to keep all rent proceeds, including the above-market portion. The owner can then continue to rent the property if the rental market has improved, enter into another lease-option, or sell the property. If the property goes up in value and the tenant completes the full term, the owner may lose out on some price premium, but higher-than-normal rental cash flows offset this risk. If the property falls in value and the tenant completes the full term, the sale price usually occurs at an above-market price (the price is always set at market or above at the beginning of the lease-option period). If done correctly, a lease-option can be beneficial for both the buyer who could not otherwise purchase property and the seller who receives positive cash flow and protection against default.

There are two caveats when deciding whether to lease-option a property:

First, a lease-option might trigger a “Mortgage Due on Sale” clause common in many mortgage loan agreements. These clauses state that any transfer of the legal rights of ownership in the property automatically gives the lender the right to call the loan. This gives the lender the opportunity to ascertain whether the tenant (and therefore the owner) is likely to default on mortgage payments. In practice, the lender may require compensation of some sort to approve the lease-option. It is therefore critical to obtain legal advice before lease-optioning a property.

The second caveat relates to the tax deductibility of interest payments. Since the owner continues to maintain legal ownership of the property, the owner gets the tax benefit of interest paid during the lease-option period. This means that a lease-option tenant will not receive any tax benefit of home ownership during the initial lease period. This reduces the value of the investment for the lease-option tenant, which may call for a reduced sale price or reduced payments. The owner might reasonably counter this argument by pointing out that the lease-option tenant would have no tax benefit in a normal residential lease either, so no price adjustment is merited.

As an owner, there are two financial reasons to lease-option a property. First, you believe the property value will fall or stay flat during the lease period. Second, you need to generate greater short-term cash flow and believe that it would be difficult to simply sell the property and get out of your current obligation. As an owner, you would not lease-option a property if its value were clearly increasing, since it would be relatively easy to simply sell it and get your money out. Nor would you lease-option a property if you could not lease it for higher than normal rental rates, as you not solve your cash flow problem and would end up with a new liability to the tenant in addition to your obligation to the mortgage lender.

As a tenant, there are also two financial reasons to lease-option a property. First, your credit is such that you cannot obtain a loan at a reasonable rate to buy the property, yet you have sufficient cash flow to make higher than normal payments for rent, insurance, and maintenance. Second, you believe the property will increase in value during the lease term so your lease payments turn into a down payment on successful investment. You would not lease-option a property if you had the credit and income to buy one, since you do not achieve the tax savings as a tenant. Nor would you lease-option as a tenant if you believed the property value was falling. Rather, you would simply rent under a normal lease and wait until the property value stops dropping, then either buy it or lease-option it then. In the meantime you would be building your credit and increasing your likelihood of buying.