A lease-option is essentially a two part contract: a traditional lease or rental agreement for a real estate property, with an option for the renter to purchase that property within a certain time period.  As with most property contracts, there is no standard structure with lease-options; rather, it is up to the buyer and seller to reach agreeable terms.  Most lease-options have a few characteristics in common, however—a fixed price for the future purchase of the property, and an increase in price to cover the “option” (this can either be an upfront payment, or an increased monthly rental rate).  The lease-option framework holds a few real advantages for a buyer, but it comes with inherent risks as well.

It should be noted for prospective buyers that the majority of lease-option contracts do not result in a sale.  This is because buyers who enter into this structure of contract (as opposed to those who simply make a purchase outright) tend to be unable to purchase the real estate at the time the contract is signed, whether the reason is a denied home loan, poor credit, lack of income or savings, or anything else.  Generally the attitude of the buyer is that their circumstances will improve and they will be able to purchase in the near future—this is often not the case.

That being said, if it is impossible to make an outright purchase, a lease-option can secure a buyer the rights to a piece of real estate while they try to accumulate the funds necessary to make the purchase, at a price they know well in advance.  This assurance comes with a few drawbacks, but most can be overcome with good planning.  In the contract, the option must always be paid for—sometimes there is an upfront payment to secure the renter’s right to eventually make a purchase, but more often the monthly rent is increased to pay for the option over a period of time.  In many cases, it can be worked out so that the upfront payment can be used as a down payment on the eventual purchase, and the same can be done with the marginal increase in rent.  Therefore, if the buyer makes use of the option, the rent is no more expensive than if it had been a simple lease, and the renter’s guarantee to be able to purchase is free.  A lease-option only tends to be more expensive when the renter does not actually exercise the option, and therefore loses the upfront payment or any additional rent paid toward the purchase of the real estate.

As far as the fixed price for purchase goes, whether or not the buyer stands to profit depends entirely upon the real estate market.  Generally sellers revert to lease-options when the housing market is poor, because they can list the sale price of the house at a higher rate than could be earned in the market.  On the other hand, if the buyer enters into such an agreement, and while they are renting the real estate market turns and strengthens, then they have a guaranteed purchase price which may very well be surpassed by the market value.  Both the buyer and seller in a lease-option stand to either gain or lose profits based on the conditions of the market, and thorough research should be done accordingly.

A land contract goes by other names, including a contract for deed and an installation sale agreement.  The basic principle of these contracts is that a piece of real estate is being sold, and the seller provides the financing for the initial purchase, while it is the buyer’s responsibility to pay back the seller in a series of payment installations.  This is a unique structure in the scheme of real estate contracts, as it is the seller who provides the loan, rather than a conventional third party such as a bank.  Generally speaking, if the buyer cannot make a full payment, he will acquire a traditional bank loan or mortgage for the property.  A land contract, on the other hand, allows for the buyer to “purchase” the property and commence using it immediately, without legally owning the property.  Rather, the seller maintains ownership of the title until the buyer has paid the agreed-upon sale price (and any interest) in full, at which point the title switches ownership to the buyer.

Generally speaking, land contracts tend to be expensive for the buyer.  The benefits of avoiding bank loans are obvious for someone with unestablished or poor credit who cannot acquire such a loan, and so the seller can demand large upfront and final balloon payments for the purchase of the real estate.  This means that although the buyer does not have to own the value of the property in capital, he does have to make a substantial down payment, and eventually he will have to make a large payment at the end of the time window specified in the contract for the remainder of the purchase price.  With poor planning this can be crippling for the buyer, who may need to acquire a more conventional loan or mortgage simply to keep up with the balloon payment at the end of the land contract.

The upfront and final balloon payments mean that the seller receives compensation in full long before the regular amortization schedule calls for.  In other words, since the seller does not have to wait for a monthly payment schedule to take its slow and natural course, the process of acquiring full funding for the sale of the real estate can be completed relatively quickly if it is written (and adhered to) properly in the contract.  There is no standard here, however; because the terms of these contracts are agreed upon by the buyer and seller themselves, there is no shortage of variety in the style and duration of repayment plans.

Land contracts often come from a place of desperation on the part of the seller, to sell a piece of real estate in a bad market.  The land contract allows a seller to set up a relative short-term purchase plan when the real estate otherwise may not have sold, and it allows the buyer to make a purchase despite having insufficient starting funds.  Perhaps the greatest advantage to this structure is the exclusion of the third party lender (most often a bank).  Once a bank is involved, through mortgage or otherwise, they must protect their interests by ensuring the value of the property in question.  This requires appraisers, lawyers, title searches, transaction fees, and myriad other costs which eventually the buyer and seller are expected to cover for the bank.  Keeping the contract and the loan between two parties—the buyer and the seller—simplifies the process enormously and eliminates extraneous spending.

Many people use the money in their individual retirement accounts, or IRAs, to invest in the stock market while taking advantage of the tax benefits of the IRA account.  It is also legal, with some limitations, to invest IRA money in real estate while still enjoying the benefits of the IRA account.  Although there are many different tax structures for various accounts, most IRAs offer tax-free withdrawals as well as other financial benefits that make it easier for the investors to put their retirement money to use.

Investing IRA money in unconventional commodities such as real estate generally requires having a Self Directed IRA; most other IRAs tend to be managed by a trustee or custodian and invested primarily in stocks, bonds, and mutual funds.  A Self Directed IRA, on the other hand, allows the investor to manage and invest the money directly; furthermore, there are usually no limitations on how this money is invested, inside of the regular IRS-permitted investment types (which is an effectively all-inclusive list).  That means retirement money can be withdrawn and invested in anything from a parking lot to a house to a foreign hotel while deferring the usual transaction taxes.

The IRS does provide several prohibited scenarios, such as “self-dealing”.  This is when an investor uses tax-deferred money (such as from an IRA), for immediate benefit, and it is illegal.  For example, you can use your IRA money to purchase a house if it is to be flipped, renovated, rented, etc., for a profit; however, if your plan is to live in the home, it is illegal to use tax-deferred IRA money to make the purchase.  Also, IRA investments cannot, unlike regular capital investments, be combined with “sweat equity”.  This means essentially the investor cannot work himself to increase the value of the investment.  Although you can renovate an investment property for resale at a profit, the investor cannot himself do work on the property.

Despite these regulations and a few others, using an IRA to invest in real estate allows all the same opportunities as a regular capital investment, and there are really no additional hoops to jump through to do so, especially with a Self Directed IRA.  It is an excellent way to put retirement money to work, especially during times when the stock market is weaker than the real estate market (which is not an uncommon condition), and for those investors who are simply more familiar with real estate than with conventional stocks.

Creative financing is a term applied very loosely by real estate investors to describe any scenario where funding for a real estate investment is done by unconventional means.  The creative investor strives to use as little of his own money as possible, rather relying on other people’s money—OPM—as capital for the investment.  This is called leverage, and it allows a real estate investor to make multiple purchases or investments without the limitations imposed by his own bank account.  As the investor tends to be accountable to pay back the loans, there is still a great deal of risk involved; however, the creative investor does not assume quite as much risk of simply emptying his savings account, as he would funding the investment project personally.

The simplest, but not necessarily the cheapest way investors acquire outside funding is by attaining a hard money loan (HML).  This is exactly what it sounds like—the investor finds a private hard money lender who is willing to make a cash loan.  The private investor is either someone with substantial personal wealth, someone with connections to the privately wealthy community, or someone who has established their own line of good credit with a bank.  Ideally, the borrower would like to find a private lender, perhaps a friend who simply has the available cash to lend with no interest or yield collection.  However, since these hard money loans are business transactions, the lender must have financial incentive (which means these loans are more expensive for the borrower).  Generally the hard money lender will charge higher interest rates than banks, adding in 3%-6% in points up front.  Finally, the hard money lender will most often expect to collect yield spread, which means they will profit from the investment’s profit.

Hard money lenders can afford to impose such additional payments on the borrower because the demand for hard money loans is very high.  This is because, although the borrower must still convince the lender of his trustworthiness and of the security of the investment, he no longer has to officially qualify for a more traditional loan through the bank.  Therefore, many people who are rejected for bank loans turn in desperation to hard money lenders, who charge more in exchange for dealing with an inherently less reliable population of investors.

Other ways to secure a loan without working through a bank or government institution is by seeking a private mortgage.  As with hard money loans, these are significantly more expensive than mortgages attained from a bank, but they allow for a wider array of real estate investors to receive funding (those that do not qualify for a mortgage with the bank).  This is possible because private mortgages are asset-based, which means rates and values are determined not by the credit or qualifications of the borrower, but rather for the value of the property to which the mortgage applies.

If no loan can be secured, privately or otherwise, the investor may wish to explore purchases that are “subject-to”.  This means the buyer simply assumes the financial loan and debt structure of the real estate’s previous owner, whether it’s a mortgage, a loan, or anything else.  This allows the buyer to acquire funding immediately (or rather acquire debt for previous funding) without using his own capital for transaction costs and acquiring the documentation necessary to attain a major loan.  This can be profitable, but it is always risky to assume someone else’s debt.  All of these strategies are examples of unconventional methods of accumulating funds, but there are countless other ways to creatively acquire financing for a real estate investment.

Investing in real estate is a good financial plan.  Even with the market downturns, real estate is one of the safest places for your money.  The market always recovers and over the long term, at a minimum, your investment increases.  But, what if you want to make a profit on your investment faster?  There are several ways to do so and one is in purchasing a home in foreclosure.  

The positive to purchasing a foreclosure home is the below market price an investor can pay. Many times, the purchase price can be substantially lower than the market value of the home.  The buyer can make a profit immediately on his/her investment property.  When you purchase a new car, it looses value as soon as it is driven off the lot.  Investing in a foreclosure home has the opposite return on your money.  

With little or no work, the property can be flipped at market price thereby giving the investor an immediate profit.  If the investor wishes to hold on to the home as an investment property for rent, the gap between the purchase price paid for the house and the home’s actual market value will increase even more over time.  Either way, you have made a smart choice. 

The investor should be aware of the downsides to foreclosure homes so he/she can avoid those types of situations. The most important is to ensure there are no other mortgages or liens on the property.  Often, if a borrower can not afford to pay his/her mortgage, they may have other unfulfilled contracts as well.  If they took out a second mortgage, that company will have to release the property before it can be purchased by another party.  Similarly, if a contractor performed work on the house and wasn’t paid in full, they can place a lien on the property which can prohibit the new buyer from possessing the property’s title.  A title search should be done so the new investor has the knowledge he/she needs to determine whether this particular foreclosure home is the best choice. 

Understanding the local market is key in purchasing any home but also in forecasting your potential profit after the investment in a foreclosure.  If the original borrower had little equity in a property and the property’s value was originally inflated, the bank is probably owed more than the actual value of the home. In this case, the bank may try to get more for the property than they would otherwise. As an investor you are looking for a good deal in a foreclosure.  Not to pay a bank that made a poor lending choice.  

Investing in a foreclosure home is a strategic move.  Your profit margin can be substantially larger than a typical home purchase.  As long as the investor is aware of the home’s circumstances and the local market, a foreclosure home can add significant value to your investment portfolio.  

Jay Redding

SuperiorPrivateMoneyReturns.com