Sandwich lease options always have a place in the investors’ toolbox. Today’s market is heavily influenced with two of the three elements that make this a very powerful strategy. The three important elements are a seller needing a creative solution, a knowledgeable investor capable of putting the deal together, and a tenant/buyer capable of completing the purchase before the lease period expires. Done correctly, the sandwich lease option is a win-win-win scenario for all three parties.
The two elements that are mostly available today are tenant/buyers likely to be able to complete the purchase sooner rather than later and knowledgeable investors. Less common today are sellers needing a creative sales solution. Still, these sellers always exist in all markets. It could be a landlord that is comfortable with tenants in the house but who wants to be relieved of landlord responsibilities for a few years before completing the sale. Or it could be a seller with very little equity in the house that needs to sell but can’t afford the costs of a traditional sale involving sales commissions. It’s the successful investor that finds these sellers to structure a deal meeting the needs of all parties involved.
As with any creative investing strategy, there are many variations to the basic sandwich lease arrangement. For the investor, the main components of the deal involve three separate income streams or paydays. The first step of the process is for the investor to locate a seller with a suitable house to be sold and assuming control of the property through a lease with an option to purchase at a future date. Sandwich lease options are about controlling properties for a minimum investment by the investor. He or she is not putting down earnest money or a down payment. The investor gains control through a purchase option fee.
Once the investor has control and responsibility for the property, a tenant/buyer is brought in. The best tenant/buyer is a person likely to qualify for a mortgage before the investor’s option period expires. The investor and the tenant/buyer enter into a second lease with option to purchase agreement. A key element of this second agreement is the tenant/buyer pays a higher option fee than the investor paid in the first agreement with the seller. This higher option fee is the investor’s first of three income streams. Another key element of the second agreement is that the tenant/buyer’s option period is slightly shorter than the investor’s option period. This places the investor in the middle of the sandwich lease (the meat in the sandwich). The purpose of the investor’s option period being slightly longer is to assure the investor is still part of the deal when the tenant/buyer completes the purchase.
The second income stream for the investor is the monthly rent collected from the tenant/buyer during the lease period up until the purchase is completed. Clearly, the investor must structure the deal so that he/she is paying the seller less in rent than the tenant/buyer is paying to the investor. The rental income is typically the smallest of the investor’s three income streams but is steady until the purchase is completed. The seller benefits when the rental stream covers the mortgage payment and possibly brings in some positive cash flow. The tenant/buyer benefits because the option fee typically applies to the down payment when the purchase is completed. Also, when the tenant makes reliable rent payments it enhances their credit report to move them closer to qualifying for a mortgage to complete the purchase.
The third income stream for the investor comes when the purchase closes. Typically, the investor’s purchase price and the tenant/buyer’s purchase price are established when the original agreements are signed. For the investor, this payday can be substantial (multiple thousands). The actual amount of the investor’s profit is based on the difference between the sales price negotiated with the seller and the final sales price negotiated with the buyer. Often, this involves the property value appreciation during the option period.
Creative investing strategies are all about having variables to help meet the needs of everyone in the deal. Here, the option fee is important. This can be whatever everyone agrees on but is typically between 2% and 5% of the purchase price for the tenant/buyer. The investor wants to minimize what he/she pays to the seller in exchange for the knowledge and work the investor brings to the deal. The tenant/buyer is asked for a higher option fee so that he/she has more skin in the deal and is more likely to complete the purchase.
The length of the option period (how long the tenant/buyer has to complete the purchase) is another variable to be negotiated. The longer the option period, the higher the option fee. The seller and investor typically want a short option period so that the sale is completed sooner. The tenant/buyer will want a longer option period to assure he/she has plenty of time to qualify for a mortgage. The best agreements will accommodate everyone’s preferences.
The lease with an option to purchase typically involves shifting much of the maintenance and repair responsibilities to the tenant/buyer. Again, how much of this responsibility is shifted is negotiable. Common clauses limit the responsibility to a specific dollar amount per month or event. Major repairs such as a roof blowing off in a storm often remain the responsibility of the homeowner who is covered by insurance. Shifting this responsibility appeals to the seller both financially and from a time involvement point of view. The same is true from the investor’s point of view. For the tenant/buyer, it begins preparing him/her for homeownership as well as adding to their financial commitment to completing the purchase.
As should be clear, there are many variables that can be brought into the lease with an option to purchase deal. This flexibility should be used to make it a win-win-win for all involved.
Please comment with your experiences or views of the lease with option to purchase investing strategy.
Author bio: Brian Kline has been investing in real estate for more than 35 years and writing about real estate investing for 12 years. He also draws upon 30 plus years of business experience including 12 years as a manager at Boeing Aircraft Company. Brian currently lives at Lake Cushman, Washington. A vacation destination, a few short miles from a national forest. With the Pacific Ocean a couple of miles in the opposite direction.