Need help making this lease option work

General Real Estate Investing
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I have a prospective buyer interested in a Lease-Option on my property but we’re having a hard time coming to terms due to differing goals. He wants to keep payments down and have a long purchase period. I of course want to make it worth my while to enter into a lease option. I’m looking for advice on how we can somehow come together:

My desired terms:
$5k down (applied to down payment if purchased)
$1495/month with $200 rent credit
1-year purchase at $375k

His counter:
$5k down and then an additional $5k down at 12 months and 24 months (all $15k total applied to down payment at purchase)
$1100/month with no rent credit
3-year purchase at $365k

Btw, market rent is $1195-$1295. Home value based on comps is right in the ballpark of where we are (~$370k) and home values in the area are probably still dropping at this time.

My concerns:
(1) The length of the option period. I would like to put in a graduated purchase price depending on how long it takes to exercise but he’s not going for that.
(2) Sub-market monthly rent (low monthly is very important to him).

Any thoughts on how to structure while meeting both of our goals?

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The two offers are very different in dollar value, you can calculate a net present value on both deals to see how they compare monetarily. Your tennant wants to pay submarket rent and to lock-up the property and sale price for three years. Remember the adage, you name the price I name the terms? I would say no way, if he wants submarket rent then he pays more upfront and a higher sale price. I also would not allow a tennant to lock up my property for 36 months. As it stands you would be better off renting the property to a new tennant at market rates and then selling it on the open market in 12 months or 12 years. You control the property, don’t give that up without being compensated for it.

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Let’s review the numbers before we get the big head and start trying to dicate the terms with a my way or the highway attitude.

You want: $5K down, $1495 (why not $1500?) a month, and an option price of $375K for 1 year.

He wants: $5K, $5K every 12 months thereafter for 3 years ($15K total), $1100/month (no rent credit) and a 3-year option price of 365K.

Current market value is about $370K and DROPPING, by your admission.

First, let’s break down just the first year.

Your deal, you collect $5K upfront and $1495/month, for a total of about $23K. If tenant buys, the end price will roughly be about $368K.

His deal, you collect $5K upfront and $1100/month for a total of $18,200. BUT WAIT! You also collect another $5K at the end of the first year for a total of $23,200, or $200 MORE than your way.

At the end of year one your way, you’ve either sold the house (doubtful) or you’ve now have a vacant property.

His way, you get to collect another $18,200 in year 2, and another $11,200 in year 3.

At the end of year three if he buys, end purchase price (assuming each $5k is going toward it) is $350K or about an $18K difference. So adding back in years 2 and 3 rent, you’ve got an end price of $379K.

Don’t forget that you mentioned that you were in a declining market. What is the market value going to be in 1 year? In 3 years?

Personally, if the tenant checks out (ie can actually pay the rent easily, isn’t a felon, etc., etc.), then I’d take his offer and thank him profusely every month.

Raj

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Cooler heads are always prudent in negotiations, sorry if I came across as single-minded. Raj lays out the scenarios clearly but I feel there is one item missing, the time value of money. A dollar due in 12 months has greater value than a dollar due in 36 months. Run the numbers through a net present value calculator and you’ll see the difference.

You note that market prices are declining and that is an important factor to consider. You don’t mention how stable rents and vacancy rates are. If you wrote a one-year lease option and your tennant did not exercise and moved out could you rent the home easily? If you are committed to selling the house remember the sooner it is sold the sooner you can reinvest your equity in a more productive asset.

If finding a qualified buyer is difficult and your tennant checks-out then negotiating a deal satisfactory to both of you seems the prudent path. But remember, you should be compensated for granting a longer term option.

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True, we do not know all of the details of this deal or the wants/needs of each party. However, everything being equal, the time value of money HAS been figured, as there is $11K MORE dollars in the deal with a 3 year lease as opposed to a one year.

If the goal is to sell the house, then sell the house. 75% of lease options to not go to the closing table (without alot of help from the seller), so if getting the house gone is the motivation, then L/Oing isn’t the best strategy.

However, if the goal is to get the most money for the property at some time, then L/Oing is a viable solution, and of the two presented, the 3 year deal makes more money for the seller and is what the buyer wants.

It’s ALWAYS better to negotiate a deal that is satisfactory to both parties. In fact, it’s about the only way to ensure that there is a deal at all.

71tr, you seem real big on being “compensated” for the longer option term. Do you have suggestions for that? Is $11k more not compensation enough? If you’re suggesting a higher option price, then normally I’d agree. However, it’s been noted that the market is declining, so asking for a higher purchase price kinda seems like a mute point, doesn’t it? Heck, you could make the purchase price $450K if you want, but it still has to appraise for the dollar amount at the time of purchase, that is, if you truly intend to sale it. If it doesn’t appraise, then the buyer will not exercise the option, period.

What’s missing?

Raj

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Raj, I beg to differ. I do concede that there is approximately $11k more dollars in the three year deal, however it’s still a three year deal and the bulk of the proceeds (sale) are not realized until month 36. If we can agree that money has value over time and that there is a return to be earned on money in hand then summing the cash flows for each scenario and comparing the totals does not provide a true comparison. You must discount those cash flows to the present to determine which is superior. The one year deal puts the bulk of the cash flow into the seller’s hands far sooner and thus is more valuable on a present value basis. If you are familiar with excel run the numbers through the net present value function and you will see the difference. If I am misunderstanding your post then please tell me.

As far as being compensated for the longer term option, the three year deal effectively cedes control of the property to the lessee over a much longer term. By definition this option should be more valuable to the tennant. This is a tangible benefit being provided by the seller and should be rewarded. As you suggest the form of this reward or compensation can be; a larger option fee, an above market rent, less rent credit, a higher sale price etc. Of course the seller can only charge what the market will bear.

Tkelsch, sorry if we’ve assumed control of your post. I think there are good suggestions and points being made all around and I hope you’ve found the discourse useful.

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Thanks for the thoughtful dialogue! Obviously you don’t have all the facts so I’ll throw out some more to help paint the entire picture.

o Don’t need to sell at all, I’m just leaning toward a Straight Sale, Lease Option, or partial Seller Financing deal because I have almost $200k in equity in this house which I’d like to deploy elsewhere. Taking out a home equity loan to invest elsewhere doesn’t make sense to me since that sends this property’s cashflow into the red. I’m certainly open to other methods for getting at this equity if someone has any ideas.
o The house is very easy to rent so I’m not concerned about vacancy. Good location, great schools, etc. My only reason for wanting to move it either now or in the next couple years is that the cashflow is low and I think my cash is better used elsewhere ($100-$200/month).

Again, my main concern with the terms as presented is the lower than market rent for the 3-year term. Seems like I could just as easily do a straight rental and put it up for sale in 3 years. But of course, as pointed out, the big variable is what will the price be in 3 years and I cannot answer that of course! My gut tells me that Raj is right and the offer is solid GIVEN what my best guess of the Phoenix market will be in the near future.

Btw, my latest counter was to split up each of the $5000 down payments so that $2500 is fully non-refundable while the other $2500 can be applied as down payment. This allows me to get monthly market rent and him to keep his monthly payments low.

I’ll let you know how it goes!

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The FULL option fee is always completely non-refundable whether or not it goes toward the purchase upon exercise of the option.

Raj

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Technically true Raj but I think you get my idea. The net is that if he exercises after 3 years, the purchase price is $365k - $7500 credit = $357,500. Under his initial proposal, the purchase price is $365k - $15k credit = $350k. Of course if he doesn’t exercise, it’s a moot point.

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You can also think of the unexercised lease option as a yield enhancement. This is a common practice in the securities industry to sell options on securities held in portfolio, the option fee is taken into income and thus enhances the yield on the portfolio. Of course if exercised you lose the security or in this case the house, but you get the sale proceeds. It is a good way to improve the performance of your investment if appreciation rates have cooled and rental rates are flat.

Good Luck

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