The basics of the deal include a contract to lease the home for a specified period of time for at least the amount of the monthly mortgage payment. This relieves the owner of that monthly payment amount, though not the responsibility for it. The investor has the right, but not the obligation, to purchase the home at some future date. The price can be a set amount, even the loan payoff, or it can be set to some percentage of current value. It's more likely to be a set amount that locks in a profit for the investor. Though some would consider this taking advantage of a family in trouble, a well-executed deal can save them from a foreclosure and credit score damage; even bankruptcy in some cases. Even if there is significant equity lost in the deal, they would have lost it in any case, but now can move on with less financial damage.
Once the real estate investor has the lease purchase in place, they can lease it out at a positive cash flow, flip it to another investor, or live in it for a while, making improvements and readying it for sale at a profit. The profits involved depend on the equity the homeowner had, and the investor's ability to take over the home with that equity moved to their balance sheet. An example would be a home with a loan balance of $165,000, and a current value of $209,000. The homeowner is in trouble, has a mortgage payment of $1150 per month, and needs to get out of the home, as they can no longer make the payments.
- A lease purchase is set up to buy on or before a date 3 years in the future.
- The purchase amount is the current balance on the loan, $165,000, or the balance when the purchase option is exercised, whichever is less.
- The investor takes over the payments of $1150, which include taxes and insurance that are paid through escrow.
- The next phase depends on the strategy this investor is using.
1. The Flip to Another Investor
If this real estate investor keeps a "buyer list" of other investors looking for solid rental property deals, there could be opportunity in this deal. In this case, the successful investor would likely have pitched this home to his list prior to locking it up, and have a buyer ready to look at it and likely to buy it for a long term rental property. Research would have shown that it could be rented out for maybe $1500 - $2000/month, locking in a nice cash flow, even if the buying investor needed to get some financing. An immediate sale at $180,000 would yield a nice cash profit of more than $10,000 to our investor, free the homeowner from the obligation, and give the long term investor what they wanted.
2. Leasing To Another Tenant
This investor, having done their homework, knows that the home could be rented out for $1700/month as an "executive rental," as it's a nice home and close to a major corporation's national headquarters. Rather than flipping it to another real estate investor, it is advertised and rented for a positive cash flow of around $500+ per month. The new tenant is paying down the mortgage for our investor, and the home could be appreciating in value as well. With 3 years to decide what to do with it, our investor can plan their exit strategy based on evolving markets and situations.
Challenges Our Investor May Face
Obviously, the lender holding this mortgage made the loan with the home being the principal residence of the owner, and there's an insurance company involved that is insuring it based on that assumption as well. When the status changes, either party could make an issue of the new status. Generally, the investor tries to keep all existing insurance in place, with payments made out of escrow, and they may have their name added as an "additional insured." As long as payments are made on time, most of these lease purchase deals work their way through to completion without problems. Just be sure to work with an attorney for everyone's protection.
