Podcast Episode 67:
“Coaching Successful Lease-Options.”
When a qualified tenant wants to be a homeowner, but can’t get a mortgage, investors can offer him or her a lease-option. This creative investment strategy is also known as rent-to-own. The trick is doing enough diligence on the tenant to make sure that they will be able to qualify for a mortgage at some point in the (relatively) near future. It also helps to get insurance in case something goes wrong. The tenant pays a non-refundable sum of money for their lease-option, and the whole deal can provide an excellent return-on-investment (ROI) for real estate investors.
How to Use Lease-Options
The lease-option, often referred to as ‘rent-to-own’ or RTO, is a popular creative real estate investment strategy. The essence of this approach is finding and qualifying a tenant who would like to be a homeowner, but for various reasons cannot immediately qualify for a mortgage. This is where the creative part of our strategy comes in. As long as the tenant has the ability to pay a solid chunk of option money (typically not less than 5% of purchase price and better to get more), you can start on the other parts of what we like to refer to as ‘qualifying a tenant.’ Your focus is doing enough diligence to be confident that the tenant will be able to qualify for a mortgage in the future so he or she can buy the property.
Below are the RTO experiences of a graduate from our Deal-Ready Documents Focus Workshop. In his own words:
Here’s a really great story that a colleague shared with me. It brought home a few points I think we can all learn from.
This colleague, I’ll call him Joe, signed a new tenant buyer to a nice clean property in an older neighbourhood. It was a character home in great condition, and the tenant—a single man with a few credit history issues—seemed like a great guy.
Joe exercised his due diligence by checking out the tenant’s credit history, getting him to sign off on a letter stating he understood the parameters of the RTO deal, and making sure there was a good chance he would be able to successfully complete the lease agreement and act on his purchase option.
Over a year went by and all seemed in great order, but then the problems started. It became difficult for the tenant to make his payments on the agreed upon schedule. He just needed a bit of time, he said. Understanding that everyone runs into problems from time to time, Joe agreed to wait for the payment. The waiting stretched out, and the rent fell into arrears. The tenant was warned about the consequences of his actions. Nothing changed.
Joe went over to the house to speak to the tenant and collect a cheque. He says he nearly fell over when he entered the house. It was trashed. A once lovely character home was now like something out of a horror movie: holes in the walls, piles of trash, and filth caked on every conceivable surface. The house was unlivable and the only recourse was to evict the tenant.
The drama didn’t stop there. Although Joe had the non-refunded lease-option monies, they were insufficient to cover the thousands of dollars in repairs. His insurance policy would not cover the repairs.
The house is now repaired, looks fantastic, and has a really great family living there. Even better, a few hard but important lessons were learned.
- Even though a prospective tenant may put down a substantial amount of money toward an option consideration, he or she may not necessarily be a good tenant.
- Make sure you screen your tenant buyer thoroughly in all respects. This includes getting personal and landlord references as well as checking credit history and employment. Don’t deviate from your standard tenant qualification practice (unless you make it more rigorous). 40% of tenant/buyers don’t close and are always a tenant!
- Even though you may follow up on all credit and personal references, and things look OK, trust your gut instinct.
- Make sure you’ve got the right type of insurance. This can save thousands of dollars.
- Check in at least every quarter. Look at how the property is being treated.
- Get to know your tenants; a personal connection will help bring the RTO deal to a successful conclusion.
Does this story turn you off lease-options/RTO? It shouldn’t. The stats say that 60% of RTO deals close (meaning the tenant actually buys the property) with our members achieving 40%-50% ROI over a typical two-year term. This leaves plenty of room to add a joint venture partner and offer an amazing 20% – 25% ROI to them. For deals that don’t close, positive cash flow during the lease term and a solid, non-refundable option payment are still good results.
Contact Barry McGuire now. Alberta real estate needs an Alberta lawyer.