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Tip #3
This is the third post in a mini series on how to turn a negative cash flowing property in to one that is cash flow positive. Many people get into real estate without fully understanding how cash flow works. For more information on calculating cash flow, please read my other blogs on the subject. If, however, you are in a place where things aren't going well for you and your property and you need to think of something that will help you right now, this may be the place to start.
Lease/Option Contracts
Rent to own deals are made up of two contracts. The first is a regular lease (or rental agreement) contract and the second is an option contract. A lease agreement is something you should already have in place if you are renting out a place and this contract can stay the same if it is strong. A rental/lease agreement should always be run past your real estate lawyer so that it is both strong and protects both you and your tenant. The option contract is extremely simply when well understood. An option is simply a contract that gives the purchaser of the contract the legal right to purchase the property within a certain period of time for a set amount of money. So, I chat with my tenant and we decide and agree that we will exchange the property for X amount of dollars at any time within the next X amount of months. I typically like having options no longer than 24-36 months for multiple reasons (maybe that'll be another post at some point). This should be of benefit to both the purchaser and the vendor/seller. The vendor doesn't want the property and the purchaser does but cannot qualify for or afford it just yet. A good rent to own contract and deal should benefit both parties and I cannot emphasize this enough. If you ever take advantage of someone's situation and hurt them in the process please get out of the real estate investing industry because you give a bad name to all of those who are providing a basic human need in a reasonable way to families.
These deals have a significant strength as well as a potential disadvantage. The greatest strength is that you can turn a cash flow negative property into a cash flow positive property. In a typically rent to own contract I will be actually charging more, per month, for a family to live in the property. The way it works is the family will be the normal market rent for a property, and then will pay an extra amount of rent that is being put toward the eventual down payment. I find that it really does help families to pay the entire down payment before the end of the deal comes around because it helps them save money (which is often one reason they haven't been able to purchase a home in the past). So, if they are purchasing a $200,000 house and the down payment is going to be 5%, they will need $10,000 by the end of the deal. They pay this in two forms. The first is an up front cost (often called the option consideration because it is money used to purchase the option contract, which gives them legal rights to the property). This option consideration should be enough to cover some risk and give up some of your rights to the property (with this 200k deal I would probably ask for at least $5,000 up front so that the family doesn't simply leave the deal in the next few months; they have skin in the game). They can pay the other $5,000 spread out over the next 24 months ($208 of rental credit per month).
This type of deal is providing two things for you, the investor. The first is a lump sum of cash up front and the second is an extra $200+ of cash each month while the deal lasts. This solves your cash flow negative problem.
The Potential Drawback
The weakness to this strategy is that you now need to sell the property when the family exercises the option contract and purchases the house from you. If you had wanted to keep the property you may want to read my first two posts on the subject. This drawback can actually be a blessing for an owner who wants to get out of a property but the property may not be worth what you need out of it just yet. In an up trending market, you can gain an increase in cash flow now and still sell the property at a future date for the money it is worth then.
A Caution
Rent to own deals aren't the simplest of all real estate transactions. It is best to speak with your mortgage broker as well as a good real estate lawyer to learn what to be careful with in your own community and the potential difficulties in these deals. A rule of thumb is that you need to be structuring this deal to help both yourself and the tenant family. If you have fantastic intentions and you are willing to learn and receive help from a lawyer you can truly create a win-win situation. Another note I will mention here is that if you are unsure how to move forward but this is the deal that best fits your situation... find a real estate investor who specializes in these deals in your community. Often they are willing to help you out for a commission. You can pay them for a few hours of their time to review your documents and how you are going about the deal or you can pay them to advertise and market the property for you. While this will cost some of the option consideration (the up front money), it could make the difference between a good deal and something you wish you had never entered into. Always take your time and make sure due diligence has been covered before entering real estate transactions. I believe real estate is the best investment class on the planet for many reasons (again, look at the series I put together on this subject), but like everything you invest money into you need to be aware of what you are getting into as well as how to cover risk.
Here's to your future of risk-averse investing!
If you would like to learn more about investing in real estate please
contact me at the email address listed at the beginning of this article
or go to my website at: www.akerahomes.com/investing-in-real-estate.html
