CHAPTER 5

THE LEASE OPTION

The Leveraged Approach

Most people view real estate investments with the traditional purchase procedure in mind: Locate a property, make an offer, combine a down payment with financing, and hold the property for the long term. This is the usual method of making real estate investments, but it is not the only method. One creative alternative is the lease option.

THE LEASE-OPTION CONTRACT

This strategy has two parts. The lease is a rental contract between the current owner and a tenant. The option provides the tenant with the right to purchase the property at some point in the future. The option includes several important provisions:

1.A specific expiration date. The option must be exercised by this date; failing that, it expires and becomes worthless.

2.A fixed price for the property. The agreement includes a specific purchase price for the property. The option is exercised at that price, regardless of the market value of the property. So if the value rises significantly, the seller is contractually committed to the fixed option price. If the property value does not increase enough, the tenant does not have to exercise the option.

3.A monthly payment amount and breakdown. A monthly payment will contain two parts: the payment of rent and payments toward the option. The second part may be a periodic option payment, or it may also apply toward a down payment if and when the option is exercised. The lease-option contract breaks down the payment and specifies how much of the total payment will be applied toward the purchase or, if the option is not exercised, returned to the tenant.

4.A right of assignment. The tenant has the right to assign the option to another person. For example, instead of purchasing the property, the tenant may decide to sell either the option or the property itself.

The lease option is a creative way for tenants (possibly future buyers) to control real estate without buying it. This is the ultimate form of leverage. If property values rise, there are several choices the tenant can make.

1.Exercise. The first possible outcome is the obvious: exercise of the option. For example, a lease option specified that the tenant could purchase a house for $150,000 within the next two years. Near the end of the option term, the tenant estimates that the property value has risen to about $200,000. By exercising the option, the tenant purchases the house at the fixed price of $150,000, which is $50,000 below the current market value.

2.Expiration. If the property value has not risen substantially, the tenant may simply let the option expire. The lease portion may be renegotiated or also allowed to expire, depending on whether the tenant wants to continue living there.

3.Sale of the option. Under the right of assignment, the tenant can sell the option to someone else. For example, if the option has fixed the price of the house at $150,000, but it is currently worth $200,000, the option has an added value of $50,000. Upon exercise, the house can be purchased well below current market value. However, if the tenant does not want to actually exercise the option (or may not be in a position to afford the purchase), that lease option can be sold to a third party. Given that it has a value of $50,000 in potential equity, it would be attractive to someone else at a discount. If the seller were to offer the option to someone for $30,000, for example, it would be a great incentive. If the tenant had lived in the house for two years and paid $1,250 per month in combined lease and option payments, a sale for $30,000 would repay the entire two years’ rental cost.

4.Sale of the property. The tenant can put the property on the market. How is this possible without actually owning the property? Because the tenant has the right of assignment, it is legal for the tenant to offer the house for sale and to accept an offer, contingent on exercising the option. This strategy is called contract flipping. For example, the tenant may advertise the house for sale for $200,000 and accept an offer for $195,000. As part of the closing of the sale, the option is exercised and the tenant realizes a profit on the option of $45,000 (sale price of $195,000 less option value on the house of $150,000), before closing costs and taxes.

5.Cancellation of the option. The tenant may want to continue living in the property without selling it and without exercising the option. However, the option has value, and if it is not exercised by the deadline, it will expire worthless. One alternative is to negotiate with the current owner. For example, the tenant may tell the owner, “The property is worth $200,000, and the option provides me the right to acquire it at $150,000. I am willing to cancel the option if you pay me $20,000.”

Would the owner accept these terms? It depends on the owner’s desires and motivations. At this point, the owner will realize that if a deal is not struck, the tenant will acquire the house in one way or another for $50,000 below current market value. By agreeing to pay $20,000, the owner can get out of the option and retain the right to sell, refinance, or hold the property. The math makes the point:

This illustration provides a view of the option from the buyer’s perspective. This example shows that the seller also has a point of view about lease options. To the buyer, the risk is that property values will not rise enough to justify exercise; in that event, the option turns out to be an expensive mistake. For the seller, the appreciation in value of the property and the option present a problem. If the seller had anticipated this course of events, it is unlikely that the option would have been entered into. The choice now is to lose $20,000 in order to preserve control over the property that has appreciated by $50,000, or to simply take the $150,000 fixed price and lose the appreciated value.

6.Renegotiation with the current owner. The tenant may present a different scenario to the current owner: renegotiation of the lease option. Because the appreciated value of the property gives value to the option, the tenant is in a position to enter into an even better deal. The terms are all negotiable. For example, the tenant may propose using the appreciated $50,000 in equity to offset rental costs over a period of time (free rent in exchange for nonexercise of the option). The existing option could also be replaced with a new lease option with changed rent, option payments, exercise date, and exercise price. Given that the property has appreciated in value, the renegotiation could include a lower price upon exercise, less cost for a new and extended option, or a combination of terms.

THE LEASE AS A PURCHASE STRATEGY OR SPECULATION

The lease option is one obvious way for potential buyers to control the price of future purchases, a type of contingent strategy. If property values rise, the option is exercised, sold, or renegotiated. If property values do not rise, the tenant has paid expensive rent. The lease option is also a reasonable strategic device for holding onto the right to buy at today’s price when the investor expects values to rise but does not have the funds or credit history to purchase today.

The lease purchase is a variation on the lease-option idea. Under this type of contract, the tenant agrees to buy the property in the future as part of a landlord-tenant lease agreement. This is in many respects an agreement to buy property with a deferred closing date. An earnest-money deposit acts like a down payment, and in most contracts, the tenant will forfeit that deposit if the purchase does not go through. The lease purchase includes a fixed price for the property but is not assignable like the lease option. So for a smaller cost, the tenant is able to tie up the property and fix the price, and the seller has a deal that won’t close for several months.

A potential buyer may get out of a lease purchase by including one or more contingency clauses. Contingencies usually include items like obtaining financing and approval from a lender, going through property inspections and discovering no hidden flaws, or the sale of another property. If any of these contingencies are not met, the potential buyer has the right to cancel the deal and get a refund of the earnest money. However, contingencies must be legitimate; they cannot be included just as deal killers.

If a lease purchase or lease option is to be used as a deferred purchase strategy, these devices can be effective. The risk involved is related to changes in market value. One way to view this risk is to consider the alternative of purchasing property outright. If a sale is completed and property values don’t rise, the value as an investment is minimal, so the payments made via earnest money in a lease purchase, or through option payments within a lease-option agreement, can be seen as the cost of managing risk.

Another reason people use lease options is purely for speculation. The speculator has no interest in holding onto investment properties for the long term, paying mortgages from cash flow, and benefiting from growth in market value over many years. To the speculator, the lease option is a means of creating quick profits in a highly leveraged way. However, as with speculation in all markets, the potentially higher profits come with a corresponding higher risk. In markets where property values rise quickly, the real estate speculator can use lease options to control many properties that would otherwise be unaffordable. However, today’s hot market may change suddenly, and speculators can just as easily lose money, too.

Here are some guidelines for the use of lease-purchase and lease-option contracts:

1.Know what you are trying to accomplish. Everyone who enters into an agreement of this nature should know the potential risks as well as the potential profits. There is a tendency to ignore the risks and focus only on the profit potential, and that is not a balanced view of the lease-purchase or lease-option contract.

2.Use lease options only when they make sense. For a tenant in a lease option, the monthly rent payment is going to be higher than straight rent, because part of the payment is for the cost of the option or goes toward a down payment. So monthly budgeting for rent payments has to take into consideration the contractual requirement to keep up with payments. As with any lease, if the tenant defaults, the option will expire immediately and the potential profits will be lost.

3.Decide on a course of action in various market scenarios. Do you intend to exercise the option, sell the property, or renegotiate with the current owner? Based on the conditions of the local real estate market, you should decide in advance what you intend to do if the market moves up or remains at or below current price levels.

4.If you enter a lease option with the intention of exercising, be sure you want the property. Some investors concentrate on potential profits but forget the all-important step of evaluating the property as a potential investment. Upon exercise of the option, what will the monthly payments be, and how do they compare to market rents? Be sure that the property will also work as a rental investment, in addition to providing potentially attractive option-based profits.

EXERCISING OPTIONS

The great advantage of lease options is the leverage they create. The traditional concept of leverage in real estate—making a relatively small down payment and financing most of the purchase—is, in fact, only a starting point. The lease option enables an investor or speculator to control real estate with no down payment. If the conditions of the lease allow speculators to sublease property, it is conceivable that a number of properties could be 100 percent leveraged using lease-option contracts.

The risk in such a plan arises if and when property values do not increase by the time of an option’s expiration. However, if the investor has managed to find sublease tenants who pay for the entire cost of the lease and the option, there is no financial loss. By diversifying among different areas, it is possible to set up situations in which options could be exercised, sold, assigned, or renegotiated in some cases, with a zero-loss outcome in others. However, this scheme may not be as easy as it sounds; it remains essential that such speculation be accompanied with skillful management, careful tenant selection and supervision, and a clear vision concerning the desired outcomes under various market conditions.

Because leases are very real obligations, there is a natural limit to the number of lease options a speculator will be able to enter into at the same time. In theory, a speculator could commit dozens of properties using subleases and never experience negative cash flow. In practice, the role of landlord is going to involve occasional nonpayment of rent, the need to evict deadbeat tenants, and the need to repair damages to property caused by neglectful tenants. The plan to use lease options as a broad strategy for controlling or acquiring properties is limited by practical constraints as well as by limitations on locating financing, lease-option deals themselves, and responsible tenants.

For those involved in a number of transactions involving lease options, some calculations are useful in judging the relative value of and profits from option activity. One formula compares the cost of the option to the purchase price of property. This is useful in assessing the true cost of entering into the lease option (from a tenant’s point of view) or the profitability of granting options (from the buyer’s point of view).

•Formula: Option to Exercise Ratio

O ÷ S = R

where:

•Excel Program: Option to Exercise Ratio

For example, an option is entered between owner and tenant providing that the property’s price will be fixed at $150,000 and that the option must be exercised within the next 24 months. Total rent is $1,200 per month, of which $200 is identified as the option cost and $1,000 is rent. Over a two-year period, the option will cost $4,800 ($200 * 24 months). The option-to-exercise value is:

$4,800 ÷ $150,000 = 3.2%

Another method for comparing lease options is on the basis of the return generated through exercise. For example, if an option fixes the price of a property at $150,000 and that option costs $4,800, what is the exercise return? That depends on the market value at the time of exercise.

•Formula: Exercise Return (to Tenant)

O ÷ (M – P) = R

where:

•Excel Program: Exercise Return (to Tenant)

For example, if an option on a property with an option price of $150,000 is exercised when the market value is $200,000 and the option cost was $4,800, the exercise return is:

$4,800 ÷ ($200,000 – $150,000) = 9.6%

This is a profit to the tenant and a cost to the owner, in one respect. However, the real cost to the owner of the property would be calculated as the net difference between the lost market value and the option premium.

•Formula: Exercise Cost (to Owner)

[(M-P)-O] ÷ P = C

where:

•Excel Program: Exercise Cost (to Owner)

If you look once more at the preceding example and apply this formula, you can view the same outcome from the owner’s point of view. This assumes that the fixed option price of the property (P) was considered to be the current value at the time the lease option was signed. In other words, the owner believed at that time that the price was a fair price. The fact that the property increased in value subsequently was a lost opportunity. Applying the formula:

[($200,000 - $150,000) - $4,800] ÷ $150,000 = 30.1%

Another way to express this outcome from the owner’s perspective is: The cost of granting the option to the tenant was equal to 30.1 percent of the profit on the property.

The calculation of return and cost are performed before calculation of closing costs or capital gains taxes. Because those are variables based on individual circumstances and locations, these formulas do not attempt to calculate the net return or gain. For comparative purposes, preclosing costs and pretax comparisons will be consistent.

TAX RESTRICTIONS WITH LEASE OPTIONS

One consideration in the risk/reward evaluation of lease options is the tax consequences of entering into such a contract. In the straight purchase-and-sale agreement, investors who own real estate are allowed to defer their gains through a like-kind exchange (see Chapter 11). This means that investors may complete a sale and pay taxes later. The provision requires investors to replace the property with like-kind properties (other real estate) that costs at least as much as (or more than) the property being sold.

Other conditions apply as well. A buyer in such an exchange must agree in writing to cooperate with the seller in completing the tax-deferred conditions, and the sale has to be completed within six months from the time a property is found and an offer is made. The specific requirements are explained later. One important point to make now is that tax deferrals are not permitted when properties are sold through a lease-option agreement.

This restriction may have tax ramifications for some investors. The timing of taxable transactions can be critical. For example, if income in a particular year is going to be taxed at a fairly low rate, generating additional income could result in taxes being assessed at a higher rate. So advance tax planning may enable you to minimize your tax liability, even if that means putting off the taxable closing of a deal until the following year.

Some other considerations apply as well. For the owners of property, the option payments received are treated as ordinary income, probably in the year in which the option is scheduled to expire. Because this is a complex area of taxes, owners should consult with their tax advisers regarding the treatment of option payments from tenants.

For tenants, payment of option costs is probably going to be added into the basis of the property. Tenants generally are not allowed to claim a deduction for unexercised option payments or for the option cost upon exercise. It is more likely that those payments will be added to the basis of the property. For example, if a tenant paid $4,800 to fix the price of the property at $150,000, upon exercise the basis would be:

This assumes that the full $4,800 was actually paid. If the option is exercised earlier than the expiration date, the actual payments would be calculated. The basis would be further increased by closing costs the buyer paid.

For those tenants who renegotiate options or assign them to someone else, the net profit on the deal is taxed as ordinary income (usually not as capital gains), with the tax due in the year in which the original option is assigned or replaced.

Once buyers exercise their options, they are free to sell the property, convert it to their own residence, or hold onto it as a rental. All of these decisions have further tax ramifications as well. For example, acquiring a $200,000 property for $150,000 does not allow the new owner to claim higher depreciation. The deduction allowed by law is limited to the actual basis of improvements. In the example used in this chapter, the property’s total basis (before adjustments) would be $150,000. Of that, the portion assigned to land would not be subject to depreciation; only improvements can be depreciated, at actual cost.

So by using a lease option, the real estate speculator may evolve into a landlord. Whether you fall into that role through the lease option or through the more traditional offer on a property, you will need to master the financial aspects of assessing cash flow and profits, occupancy trends, and taxes. Chapter 6 explores the various rental income analyses that landlords need to master and understand.