A lease option has the following two components:
A residential lease over a property. The rental charged under the lease is usually slightly above market rates due to the unusual nature of the transaction and, unlike a normal residential lease, the tenant pays all repairs and outgoings; and
A call option that allows (but does not compel) the tenant to purchase the property at a future date for an agreed future price. An initial fee is charged for this option which is then deducted from the purchase price if the option is taken up.
If the call option is exercised then a portion of each rental payment is applied against the purchase price.
If the option lapses then the initial fee is forfeited and all the payments received under the deal are treated as rent.
Andrew secures a 3 bedroom property on a large block just outside of Geelong (Victoria) for $80,000. The property was purchased vacant but previously rented for $170 per week.
Andrew ran a classified ad to attract people who would be interested in the idea of a ‘rent-to-buy’ program.
Sharyn and Adam answered the classified ad and said they’d like to own a home but didn’t have the required deposit and as such couldn’t get finance through a bank. They mentioned that they currently pay $200 per week in rent.
After pre-qualifying them, Andrew presented Sharyn and Adam with the following ‘lease-option’ deal:
- Rent of $192.50 per week
- A lease term of 5 * 5 years (25 years in total)
- $2,000 ‘Option Fee’
- Option price of $96,000
Andrew’s nett costs are:
- Deposit (20%) = $16,000
- Less Option Fee Received = ($2,000)
- Plus Closing costs – inc. legal fees = $5,000
- Total = $19,000
We also need to consider Andrew’s cost of finance too. He would seek a 25-year loan for $64,000 (80% of his purchase price) at let’s assume an initial five-year fixed interest rate of 6.4%. His principal and interest loan reayments would be $5,128 per annum.
The rent that Andrew receives is $10,010 ($192.50 * 52). His cash on cash return is:
= ($10,010 – $5,128) / ($16,000 + $5,000 – $2,000)
= $4,882 / $19,000%
What are the critical success factors?
Lease options are creative real estate strategies that can be quite complex, and they contain many pitfalls for inexperienced investors. Critical success factors include:
Lease options offer hope of achieving the Great Australian Dream to people who would otherwise have little hope of ever owning a home. As such, demand will be great – possibly far higher than what you can cater for.
However, your lease options business success will depend on sorting out quality clients from people, usually with a victim mentality, who feel that life owes them a few favours and will use and abuse your services.
The best way to handle the qualifying process is to use a standard form (like the Due Diligence resource) that every applicant must complete and submit.
You need to then pay careful attention to ensure that you:
- Don’t ‘max out’ your client by placing them in a property that they can only just afford. Remember that they’ll also have to pay for the rates, repairs etc. on top of the rent.
- Check the details of their previous tenancy to see that they don’t trash places and then move on. That is, you don’t want to attract people that have been refused rental accommodation because they’re on the bad tenant database.
- Get an understanding of exactly who is going to be living in your property and what pets, friends, relatives, cars etc. they bring with them.
Your deal will be largely made or broken by the quality of the client that you attract remembering that your relationship may last up to 25 years!
The Right Property
You may not need a five star property, but it’s wise to find a potential home that is structurally sound.
Let your client go for broke with the paintbrush (subject to you agreeing to the renovations), but as far as structural problems go – expensive repairs may mean that your client will just up and leave rather than stay for the long-term.
The numbers that were used in the example earlier are only one of an infinite number of ways that the deal could have been structured. I could have changed any of the variables to ensure that I manufactured a win-win outcome where I make money and my client gets to rent a house that they may one day call their home.
Know The Laws!
It’s critical that you know the ‘lease options laws’ in the area where you invest. For example, in some States you are not allowed to pass on the costs of rates etc. Instead you need to allow for these in the amount of rent that you charge. Be sure to get appropriate legal advice before jumping into the investing deep end.
Where to next?
- Buyer Beware is an excellent resource that will help you to avoid buying a property lemon. Find out how you can protect yourself with the five templates that make the due diligence process easy!
- Have you considered other positive cashflow strategies? These include Buy & Hold, Wraps, Flips and Renovations…
- Return to Property Investment Strategies introduction.