Category Archive: Lease Option

Nov 16

Lease Option Failures

Three different Realtors called me this week chatting about deals gone south.  Each agent had a story where in a large amount of money was forfeited by the “Buyer.”  The three incidents had combined losses of $60,000!  All of the deals were lease options.

Each of the tenant/buyers entered into the lease option because they did not qualify for traditional mortgage financing.  They had large chunks of cash for non-refundable deposits but did not meet the credit guidelines for a regular mortgage.

They did what I call a work-around, trying to work around the rules that actually protect them.  I believe most buyers that have an issue ask a mortgage professional how long it will take before they are eligible for a mortgage.  The loan officer gives them the only answer they can which is a minimum timeline.

For example if the borrower recently filed bankruptcy then the minimum timeline might be 2 or three years from the date of discharge depending on the type of loan they get.  That is the best case scenario!

But that is not how the loan is going to be underwritten once the minimum waiting period is over.  The question is asked, “How long after a bankruptcy must I wait until I can get a mortgage?”

But the 2 or 3 year answer only addresses the minimum timeline; nothing in the field of mortgage financing is that simple.  For instance, if the BK included an FHA mortgage and FHA ended up taking the property back from the lender the timeline isn’t based on the BK discharge.  It is based on when FHA paid off the lender and that may not be until years after the BK was discharged.

The borrower thinks they can get another FHA loan 2 years after the BK was discharged because that is the minimum timeline for getting an FHA loan.  But they cannot get approved for another FHA loan until they are eligible for a new CAVIRS number.

This additional $60,000 lost by buyers this week puts the total I have heard about this year in the neighborhood of half a million dollars.  That’s a pile of money!

If you insist on trying to work-around the rules, establish the timeline you think is required then double it.  Double the amount is probably more realistic.

Apr 01

Lease Options – Sellers

Why Sellers Offer Lease Options  

In the previous post we looked at lease options from the buyers’ point of view.

There are two main reasons sellers will entertain a lease option, profit or necessity. Both reasons attempt to exploit the strong desire for homeownership. The number of buyers that can’t qualify for a mortgage is swelling.  The overall economy is not great, unemployment is high, even people that had good credit histories are now being squeezed.

Any shift in the market creates both problems and opportunities. Real estate is no exception.  There is an abundance of properties for sale, the amount of inventory far exceeds the number of qualified buyers.  Many sellers that are unable to sell their homes are leasing them so they can move on.  People relocate for many reasons, jobs, health, family or maybe just to get a better view.  The problems created by the recent meltdown have made it necessary for many sellers to take measures they would never have considered a few years ago.

It has also created a niche that is being exploited by many investors out to make a profit.  There is absolutely nothing wrong with making a profit, our entire financial system is based on the concept of profit.  However, there is a fine line between a legitimate profit and taking advantage of someone’s misfortune.  We can find plenty of evidence that is happening on a daily basis.  

Profit  

Some investors understand the opportunities very well and are able to exploit the circumstances. Since World War II real estate has been oversold.  The downside of homeownership, the liability factor, has been overshadowed by the industry’s sales pitch.  The result is an almost rabid desire for homeownership.  The most common forms of mortgage fraud are for ownership, not profit.  This extreme desire to own a home is the foundation that creates the opportunities to be exploited. People will do anything in order to own a home.

Many people will try to work around the very mortgage system that protects them.  Mortgage underwriting guidelines are actually very liberal in spite of everything you may hear about how hard it is to be approved for a loan.  The actual hard line numbers in the guidelines are more liberal today than they were when I first became a loan officer in 1991.  If you do not qualify for a mortgage it may be a good idea not to circumvent the system that is protecting you.

However, in the real world that isn’t how goes down.  Already mentioned, some people will do anything in order to own a home.  This is why we find plenty of investors willing to offer a lease option.  They can sell a home without really selling it.  

Here is how it works; the investor buys a home at a good price, usually way below market value, makes any needed repairs then offers to lease the property with an option the purchase.  The option will usually be at or often way above the market value.  The “buyer” enters a lease and makes a very sizable non-refundable payment for the option to purchase.  If the buyer does not exercise the option to purchase the investor keeps the money paid for the option.  The investor also receives full market rent, sometimes a little more rent than a market rate.

It isn’t unusual for a portion of the rent to be a credit towards the purchase price.  The investor knows the likelihood the buyer will actually close on the purchase is slim so it doesn’t matter. 

It should be obvious once you understand how it is structured that it can be easy to exploit.  The investor can rent a home; collect a huge hunk upfront and “sell” the same house multiple times. 

Why do so few lease options result in a transfer of title to the buyer?  It starts with the beginning motivation; the buyer doesn’t qualify for traditional financing.  Something you may remember from high school a body in motion…

The buyer is overly optimistic and underestimates the seriousness of their original problem.  A well-meaning loan officer may have told them they will be eligible for financing in two years.  They structure the lease option for how long?  Two years of course!

But they didn’t listen closely, the minimum time line was two years, that doesn’t mean “their timeline” is two years.

The profiteer will take advantage of this combination of keen desire and over-optimistic timeline to structure a deal that has a very high probability of not working out for the buyer.  The investor wins either way, they get money up-front, agree to sell the property for more than it was worth in the beginning and also receives hefty rent that doesn’t reflect the big down payment.  If the buyer defaults the investor wins if the buyer exercises the investor wins.

In the next post we will look at sellers that offer lease options out of necessity.

Mar 29

Lease Option or Rent to Own

Two buzz topics these days are lease options and rent-to-own.  A huge number of posts on many of the real estate forums ask questions on these subjects. About once a week I get a call from a prospect wanting to know if I offer one of these types of transactions.  

The explosion of chatter on this topic indicates a need for accurate information for both buyers and seller.  This post will discuss the topic from both sides.  We will begin by looking at the actual structure of the contract.  

 What is a Lease Option?  

Lease options are real estate transactions. A lease option is simply a lease agreement for a property containing a clause that gives the tenant an option to purchase the property at some time for a specific price.  In theory it is a simple agreement.  It can become complicated quickly because people are involved that have different agendas.  

The first part of the agreement is the lease, a contract where the tenant promises to pay rent to the landlord in return for the use of the property. It is a liability that obligates the tenant to make timely payments.  

The second part of the agreement, the option to purchase, may or may not be contained in the lease.  It could actually be a totally separate contract with a different timeline than the lease.  For example, the lease could cover a two year period and the option to purchase could only be valid during the second year of the lease.  The option part of the contract sets out the purchase price the parties have agreed to in addition to the timeline.    

It is easy to see how complicated the contract(s) could become because the combinations are infinite.  Here is an example of how the terms can go sideways; the lease is for a one year period and the tenant has the option to purchase the property every Thursday during the first year with the price increasing by $500 every week.  

Of course that is a silly example but no stranger than what tenants and landlords actually put in writing every day.   

Rent to own is actually a misnomer when used to describe a real estate transaction.  Rent to own contracts are actually rental/purchase agreements for consumer items such as cars, furniture or appliances.  It is easy to confuse the two agreements and landlords may actually draw up a real estate contract and use the words “rent to own” in the body of the agreement.  A seller is willing to call it anything the prospect wants to call it, the results are the same.  The fact that the tenants/prospects are not aware of the difference shows exactly how dangerous this niche can be.       

Why Tenants/Buyers Want to Do This  

The primary reason “buyers” want to do this is because they want to be a homeowner but have been turned down or know they are not eligible to arrange a mortgage to actually purchase the property.  We are going to refer to the tenant in the rest of this post as a Buyer.  They are fairly upfront about why they seek a lease option, they aren’t eligible for financing, usually followed by some excuse as to why they aren’t.  In the typical buyer presentation it is only for a year or two, just a temporary situation beyond their control.  Their proposition may or may not be true because it is based on a set of assumptions a year or two down the road.  Anyone that has watched the news lately should be aware the rules in the mortgage world are changing frequently, it seems like daily to those of us in the industry. The mortgage guidelines in place today will assuredly not be the same next month let alone in a year or two from now. 

 Another reason the buyer is attracted to this type of transaction is because many sellers do not have the ability to run a credit check on the buyer.  Most of the time the buyer has been turned down for a mortgage because of something on their credit report, something the seller won’t see.   

Another reason  some buyers want to use this method is more sinister than keeping the credit report hidden.  They are trying to hide assets.  Sometimes the reason a buyer isn’t eligible for financing from a traditional lender is because they have recently defaulted on their previous mortgage, a strategic default where they hide money from their previous lender.  I frequently get calls from people that have just gone through a foreclosure and have 20% or more for a down payment.  When asked for the source of their down payment it becomes a topic they do not wish to discuss.  

The underlying motivation for all of this topic is a fear of being out of the market, a fear of not being a homeowner.  

Pitfalls for the Buyer  

The biggest problem, perhaps the root of all that follows is a lack of understanding of how the process actually works.  Buyers assume they understand everything there is to know about the process, when in reality most don’t even read the contract.  I know this is true because buyers don’t read mortgages either.  I have attended a couple thousand real estate closings and only once have I witnessed a buyer actually read the deed and the mortgage.  One out of a couple thousand!  

Most real estate transactions are closed based on trust, not the review and understanding of the actual contracts.  This element of trust works for the most part while dealing with a traditional lender because they are heavily regulated.  Obviously this is not the case when dealing with a seller.    

The buyer becomes so pre-occupied with “the deal” they are unaware their personal level of risk increases when they try to work around the system that provides them protection when dealing with a lender.  If you ask any borrower they will tell you the mortgage guidelines protect only the lender. They believe the rules only restrict them for doing something they want to do, finance a home. 

The mortgage guidelines actually protect the borrower a lot more than they do the lender.  If a mortgage goes in to default the lender will survive, one mortgage represents only a tiny piece of equity for the lender.  But from the borrower’s point of view a default is financial ruin and can be a 100% loss.  From this perspective the guidelines protect the borrower a lot more than they do the lender.

Overpaying

A desperate buyer that is focused solely on putting together a deal while trying to work around the system is far more likely to overpay for a home.  It reminds me of a man I knew that would tell a lie when the truth would have helped more.  So much energy and effort gets spent working on finding and putting together the deal that the important facets like value are pushed aside.  The checks and balances of the mortgage system are not there to protect the buyer.

Seller Stability

The buyer assumes the seller is in better financial condition than they are simply because the seller owns a house. In reality the seller may be in worse shape than the buyer.  Truth be known the buyer has little or no experience in determining the financial strength of the seller.  The seller could be six months behind on the mortgage for all the buyer knows.

How to Protect Yourself as a Buyer  

My first suggestion is to look inward, the real answers are inside all of us if we are willing to listen.  That little voice inside of you is screaming “Don’t do it!”

But the desire is so strong most people won’t listen, so if you head down this road, protect yourself at ever turn.  Look at the deal the same as a lender would.  Lenders weigh four separate segments in every real estate mortgage.   The first section is Credit.  In this case you should evaluate the seller’s credit worthiness.  Not easy to do because you won’t be able to see a credit report.  So do the next best thing, look for public records on the seller, visit the county clerk’s office and see if there are any pending law suits.  Specifically if there are any liens against the property.  Ask the neighbors living on either side of the house what they know about the seller.

The next is Capacity, can you afford the payment.  More importantly, can the seller afford the payment they have against the home?  Tricky, figure out a way to ask the seller if they owe anything against the home.  You should have discovered if there was a mortgage during the visit to the clerk’s office.   Now it is simply a matter of a candid discussion about finances.  If you are open and honest with the seller they are more likely to be honest with you.  Let them know you are concerned if the payment they are making is higher than the one you are paying them.  So from the Capacity view, does the financial proposal make sense?  Can you afford the payments? 

The third section is Collateral, is the house worth what you are paying for it?  This is a lot simpler than you think, order an appraisal just like a lender would require. No one does this when they enter a lease option, it will protect you more than you realize.  Once you have the appraisal, read it, read every word on every line, every number and then read it again.  It would be a very good idea to have a property inspector and a pest inspection as well. 

The second part of the Collateral process preformed by a lender is the title report.  Order a title report.  Read it. 

Lenders also review the purchase contract, in this transaction review the lease and the option agreement.  Make sure you understand it, have it reviewed by an attorney.   Yes, it cost a lot of money, so did the appraisal and inspections.  What will it cost not to do these things? 

The last section is Cash to Close.  Are you betting on the come? Do you have the money to close the deal both now and later?   Will you have a cash reserve after making the down payment?

Act as if you are the lender and determine if your position is safe, does it make sense, what is your exit strategy? 

Check back, the next post will look at this type of transaction for the seller’s perspective.