6th April 2011

The Lease Option Landlord – Part 2

posted in Real Estate Investing |

Setting a Lease Option Future Sales Price

There are three schools of thought when setting a lease option price:

1.    Use current value

2.    Use estimated value at time when contract is to be exercised

3.    Set the price at future market value

To be quick and easy, you can use option 1 by finding today’s value for a similar property, or by using the positive cash flow with some notion of a current cap rate.

However, option 2 is preferable to maximize your profit, while still retaining a bit of future security.For the landlord, option 2 is preferable because it will likely be a higher number than where the property is today.  The future value is determined in the same way as option 1, except you are using a future estimate of rents. Assuming your rents increase by 3% per year, the cash flow at the end of the lease-option would be accordingly higher, as would the expenses (considering inflation).  If done correctly, rent increases would outpace inflation and the property value would increase.  That increase will be reflected in the higher option price at the end of the lease term. It’s not uncommon for a lease term to be anywhere from three to five years, though they can be as short as a few months or as long as ten years or more.  Those points are negotiable.

Option 3 can go either way.  If the market rises the property could be sold at a higher price point, potentially higher than what you would have estimated using option 2.  However, if the market drops, you could lose some of that ground, and maybe even find yourself selling below today’s price point (option 1).

No matter what the purchase price, you also want to make sure you maximize the monthly option payments.  This makes pricing the monthly option payments so very important.

Setting the Monthly Option Payment

Your goal with the option payment is to set it at a level higher than what you currently receive.  This can only be accomplished if the buyer has positive personal cash flow to divert from their personal finances to pay your option payment since the monthly rents from the property wont be enough to full pay the option.

What usually happens is that you set the option payments at the current level of positive net operating income (rents minus expenses and other fees).  Basically, the buyer collects rent, pays expenses, and the difference comes to you.  This allows you to retain the benefit of the property’s cash flow, while pushing the management off to the buyer. It’s like being a landlord with few of the landlord duties.  The buyer makes positive cash flow himself when he is able to raise rents or cut expenses.

You can also set the monthly option payments equal to, or near, what the buyer would likely be paying if they were to obtain a mortgage.  For instance, if the buyer were purchasing your property for $120,000 using a $20,000 down payment he’d be getting $100,000 of bank financing.  Assume a current interest only payment at 8%, or $8,000 per year, or $667 per month.  You might charge the buyer $800 per month as an option payment because your lease allows him to purchase the property without using financing, which ultimately saves him money.  If your property was already bringing in $1,000 per month positive cash flow, the property generates $200 extra (after buyer gives $800 to you each month).  That leaves $200 in the kitty which can go toward the buyer’s future down payment or into the buyer’s pocket.

Summary

By lease optioning your property you avert the slow pace of sales in the current down market, avoid both a lower sales price for your property and the capital gains on that sale.  You get continued monthly cash flow, and a decent down payment to be applied toward other opportunities, which are being purchased to allow for a much higher rate of return than your currently held properties.  It’s truly a win-win transaction, and a creative way for landlords to open their portfolios to take advantage of opportunities that exist in down markets.

For more real estate and personal finance tips, visit the Direct Lending Solutions credit library at www.directlendingsolutions.com.

About the author, Craig Grella

Craig Grella is an expert writing on real estate and personal finance topics. He has worked for large national banks, and for several Fortune 500 companies.  He invests nationwide, and his articles can be found online at www.directlendingsolutions.com.

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