How to Convert a Lease Option Into a Subject To Deal
One question I get asked all the time is whether it is better to buy on a lease option or to buy subject to the existing financing. Before I give my answer, lets get clear on what the two buying strategies are. Briefly, when you buy a property on a lease option you are controlling possession of the property through the use of a long term lease and you are controlling all the future appreciation of the property through the use of an option to buy. The seller stays on title until the point in time you exercise your option (either by buying it yourself or finding a new buyer to buy the property for MORE than your option price.)
When you buy a property subject to the existing financing you have the seller deed the property to you and you take over making the payments. You own the property; you are on the deed. You are NOT paying off the seller’s existing loan(s) nor are you formally assuming this debt. Rather you are taking title subject to this debt. Many people wonder if you are allowed to do this and the answer is yes, provided you intelligently lower your risk. (For more information on buying properties subject to the existing financing see Chapter Two of my newest book, Making Big Money Investing In Real Estate Without Tenants, Banks, or Rehab Projects.)
So which is better, a lease option or a subject to deal? On a residential property you are almost always better off buying subject to versus on a lease option. When you buy subject to you never have to worry about whether the seller will honor the agreed upon option price down the road, or if they will go bankrupt, etc. Also, since you will own the property, you will get all the tax benefits. There are no loan costs for you to take over the payments this way so you save several thousand dollars on the financing. This list goes on.
With all the advantages to buying subject to why would you ever buy on a lease option? Because it takes an extremely motivated seller to sell you the property subject to, while it only takes a motivated seller to sell it to you on a lease option. My students and I currently average three or four lease option deals for every one deal we do subject to.
One of the best kept secrets in real estate investing is how to convert a lease option deal INTO a subject to deal.
When you get good at using this technique you will be able to convert one out of three lease option deals into subject to deals. This is probably the single most overlooked source of subject to deals. The reason is that many times by locking up the deal as a lease option will be the first step that gets the seller comfortable with working with you. Then a day or a month or even a year or two later you can convert the deal once the seller is more comfortable with working with you.
So how do you do it? There are three big opportunities to convert your lease option deals. The first comes at the beginning of the deal. Have you ever signed up a lease option and then come to find out a few days or weeks later while doing your due diligence that the seller owes back payments, or that the property is in need of a significant repair? This is the perfect time to trade you putting in that money (which may be a few thousand dollars or more if the numbers in the deal warrant it) for you getting your name on title. I will almost never consent to putting any significant money into a deal unless I get on title. Just what is “significant” will depend on your financial situation. My rule of thumb is that if I’m putting in more than $5,000 up front into any deal I make sure I am on title.
There are times when you aren’t putting any money into the deal, but you still convert the deal up front into a subject to deal because the seller had a few weeks to get used to the idea of working with you and to get to know you. This is especially powerful if the seller really isn’t waiting for any equity out of the property. Think of this as the “foot in the door” technique.
The second chance to convert your lease option deal into a subject to deal comes at the point in time of any major repair. In all my lease option deals the seller is responsible for any cost of repair that exceeds $200 in any one month. So let’s say the roof needs $4,600 of repair work, I say to my seller, “Mr. Seller, I’m not sure my partner would go along with this or not, but what if we were to just buy the property from you now, we’d take over the payments, and at some point before our option to buy would have expired we’ll cash you out of the $15,000 you are waiting for. In the meantime, since we’ll own the property we’ll be responsible for all the maintenance not just the first $200. Is this something we should even talk about or probably not?” In essence you are trading the repair cost and worry over any future repairs that might be needed for the deed.
The final chance to convert your deal comes anytime your seller expresses the desire to just be done with the deal. They will say something like, “Can’t you cash me out now? I just want to be done with this property.” Your response should be, “Mr. Seller, I hadn’t really thought about this before, but if there was a way where my partner and I could just cash you out of the equity you’re waiting for early and then just take over making the payments is that something we should even talk about? Obviously if we are cashing you out early we’d need a discount on the $15,000 that we owe you to make it a good business decision to pay you now instead you having to wait 3 and a half years for your money. What do you think would be a fair discount to get your cash now and just have us buy the property and take over making the payment every month?” I think you see the pattern here.
The bottom line is that where possible you always prefer getting on title. This means that you will keep an eye out for opportunities to convert lease option deals into subject to deals.