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Buying Property with Little or No Money Down
Part 5
Sublease Income Property For A Profit
Sometimes you will find a property which would not be suitable for your personal residence and yet would make a good
rental property. What if you find a single-family home that is selling for more than its
fair market value? The property is being offered at $65,000 and its value is about
$60,000. If rented, its fair market rent would be approximately $575 per month.
You could offer the seller a
three year lease option with payments of $550 to $600 per month. You could then sublease
the property to a tenant for $575 per month and have, depending upon the terms of your
lease option, a cash flow of approximately plus or minus $25 per month. If you have to
supplement the rental income with cash out of your pocket, it will probably only be
temporary. Over the next three years, you could reasonably expect rents to go up at least
5% per year. By the end of the first year, you will probably have a positive cash flow.
The benefits to the seller in
this kind of situation are as follows. Not only would the seller receive the asking price
for the property, but all of the tax benefits of owning real estate would be retained
because the property is being leased and is now considered investment property. Untaxed
monthly income would also be received.
The benefits for the buyer are
obvious. While you may have only a very small positive cash flow, you are receiving a $200
per month credit toward the purchase price. You are, in effect, banking money each month,
and the tenant is paying for it.
This technique incidentally can
work with any size property. You could even lease option an eight unit apartment building.
While you may not have a strong positive cash flow during the period of the lease option,
you could be fixing up the property and raising rents.
You might even find an owner who
is currently paying a 10% management fee to an outside management company who would be
willing to lease option the property to you for 10% to 15% less than the current rental
income level. That way you would have a positive cash flow while you are lease optioning
and then subleasing the property. This technique of using lease options and then
subleasing is referred to as a sandwich lease option.
Protecting Yourself With Lease Options
If you enter into a lease option
agreement without taking care to protect yourself, you might find that the specific terms
of the lease option are so binding that it will be almost impossible to exercise. The
following precautions are important:
- Record the Option
Every time you enter into
an option agreement with a seller, you should record the option in the public records of
the county in which the property is located. This protects you , the purchaser, more than
it does a seller. It provides notice to the world that you have an option to buy the
property. If the seller should sell the property to anyone during the option period, the
new purchaser will buy the property with the knowledge that you have an option to buy the
same property. To record the option, it must be notarized and witnessed by two people. If the option agreement is
signed before this notarization takes place, the seller might be reluctant to later sign a
second time in front of a notary public. Make sure it is all done at the same time.
If you consider the terms of the
option confidential, then record and Affidavit and Memorandum of Agreement Affecting Real
Estate. This will put the world on notice that there is a pending sale of at least an
agreement that could affect the real estate in question, without disclosing the terms of
the agreement. As in the case of the option, it should be witnessed and notarized.
- Right to Sublease
Whether you plan to live in the property or not, you should always make certain that your lease option will give
you the right to sublease the property to another tenant. That right is not inherent in a
lease unless specifically spelled out.
- Right to Assign
In some states, the right to assign a contract is protected by law. In other states, it is not. Assignment is the
right to transfer the contract to someone else. To avoid any misunderstanding or
litigation, you should make sure that the right to assign the contract is spelled out in
your lease option contract. If you do not exercise the option yourself, you should have
the right to sell it. Your "equity" in that property is valuable. After all, you
have been paying rent each month, and a portion has been allocated to the option price.
By providing you with the right
to assign the contract, the seller also benefits. The seller does not have to find another
buyer for the property.
- Right to Extend
Some lease option contracts will have a section which spells out the terms under which the option may be
extended, known as an extension clause. Other contracts specifically say that the
extension of the lease option is prohibited. Some contracts may be silent on this point.
Regardless of what your lease option says or does not say, make certain that you have the
right to extend the option period for at least a period for one year.
This right may be expensive. For
example, you may have to pay an additional 5,000 in earnest money, and the option price
may be increased by several percentage points. However, in the end, it will be less costly
than if you were not able to exercise the option when you want to, thereby losing all of
the credits that you have built up.
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