A a lot of creative strategy is for an investor to do a lease option contract with the seller of the property and re-lease option it to a perspective buyer at higher terms than he’s paying. This can be cited as a “butterfly lease option” and can be very profitable if all goes as planned since the investor will have very little or no money or risk in the deal.
With all that said, what is so dangerous about lease options?
1. If you are giving a tenant a lease option, it is critical to sign two separate documents, a lease and an option agreement. The reason is that if you have to evict the tenant, the eviction process stands on its own contract and is not clouded by the option contract part.
2. The option consideration is non-refundable and must not be construed as a refundable lease deposit. Unfortunately, courts have had this confusion problem when there is one document (lease-option) versus two documents, lease plus separate option contract).
3. If you are considering a butterfly lease option, make certain the seller uses a single agreement contract, while you must give your tenant two separate contracts. This is protects you on both sides of the transaction if something goes wrong.
4. Make certain that the tenant understands and signs to the effect that all repairs less than some amount ($3,000) are his since he will be becoming the owner and no longer a renter. If you don’t make this threshold high enough, he will be a typical tenant calling you in the middle of the night with his latest plumbing problem.
5. Do not make the terms of the cure period unreasonable for the tenant. For example, if the tenant is one day late, his option contract is zero and void and his option consideration is forfeited. States have passed laws just to control this type of malicious behavior by the landlord.
6. A common problem is that investors charge too low a rent and when the tenant is ready to finance his purchase he realizes that his new rent will be double what he is paying. His pride of ownership becomes a lack of interest and he does not buy the property. Some investors like this because they can re-lease option the property over and over again constantly collecting non-refundable option considerations. The tenant’s rent should be equivalent to what his mortgage payment including principal, interest, taxes and insurance will be when he buys the property.
7. To support a higher lease payment to get the tenant ready to exercise, give him a monthly credit that will be deducted from the principal purchase price or as a seller credit at the closing. If he is evicted or does not exercise his option, his credit is forfeited.
8. The renewal terms of the option contract may not be the same as the tenant’s lease. The renewal of a lease doesn’t cost the tenant another lease deposit, while the tenant should have to pay a non-refundable renewal fee of $1,000 to $2,000 which will be a credit at the closing, if there is a closing. The other possibility is to have the strike price of the option raised each year. Investors should give their tenant a maximum of two years and 3 months to exercise, while they should ask the seller for a minimum of five years and 6 months.
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