Lease Options vs. Subject Tos: When to Consider Each Technique

Lease Options vs. Subject Tos
When to consider each technique
By Wendy Patton
Acquiring investment real estate can be handled
with many approaches. Two very popular zero down approaches are lease options
and “Subject To” also referred to as ‘Getting the Deed”.

A lease option is a technique which involves
gaining ‘control’ of a property, but not ownership—just the right to possess a property now and purchase that property at some future date with terms
you define today.

A “Subject To” is getting the deed
to a property without getting a new mortgage. Instead, the seller signs over
the deed to his or her home ‘subject to’ the existing mortgage staying in place.
The buyer in this case makes the mortgage payments on the old loan, but does not
get a mortgage themselves to acquire this home.

Both of these techniques usually
require little or no money down. In both of these techniques it is possible for
the buyer to get money from the seller or the purchaser (or both!) in the
beginning of the transaction. These techniques, when used properly, can provide
for huge profits. They are both awesome strategies, and when used hand-in-hand
by investors are almost an unbeatable pair!

This short article is not meant to
give details of each technique, but rather to show when you should
consider each. If you don’t understand how to document and protect yourself in
each kind of technique, then purchase a course on the technique, or do
additional research. Why Knowing Both Techniques Means More Great Deals For
You!
Unfortunately there are many
people that are teaching that you should only do the subject to – only
get the deed deals. They recommend never buying on an option. I can’t
tell you how many times I have heard, “If I don’t get the deed, I don’t do the
deal”. With 19 year’s of experience (since 1985) doing both types of deals, I
have to disagree with that statement. The more tools and techniques and ways
you have to purchase property or to structure a deal, the more likely you will
be able to work with a motivated seller to come to a potential solution. If you
only buy “Subject To”, you’ll walk away from a LOT of great deals in your real
estate career—but you must know when each technique is appropriate to
use.

Finding a motivated seller is the first step to any
good real estate deal. There are many types of motivated sellers, but we tend
to think of motivated sellers as the ones that are financially distressed. I
like to look at motivation from a much wider range. Let me explain. I like
to divide motivated sellers into two groups:


Situation

Sellers that have Bad Debt
Solution


Get the Deed – NO Lease option!

VS.



Situation

Sellers that have Good Debt



Solution

Lease Option or Deed!

Sellers that have ‘Bad Debt’, are
those in trouble. They might be behind on a mortgage, have lost their job,
acquired an illness, going through a divorce, etc. In these situations, you
need to get the deed either with a subject to or an outright purchase. Your
main concern is that this type of seller will continue to have financial
problems that could affect the title to “your” property if the deed is still in
their name. For example, if this seller gets judgments from creditors, they can
attach to any real estate the sellers own—and they will have to be paid off
before you could exercise your option to buy. That’s why you want to get this
type of seller off of the title.

Sellers that have ‘Good Debt’ are
those NOT “in trouble” in the traditional sense, but they do have a reason
motivating them to sell. Their problem is not financial desperation—it’s simply
a change in their life. They might be transferring to a new location for a
promotion, getting married (each owning their own home), building a new home,
burned out landlords, etc.

Example #1: Here is an example when you MUST get the
deed:

A seller calls you on the phone
and says he is 2 months behind on payments. Do NOT option this home!
This seller is in trouble financially and is not a good risk for an option.
Anyone that is in a bad financial situation is not a good seller for an option.
This is the type of seller that you must get off of the deed so that his
financial situation will not affect the title to the property in the future.

Not every seller who is in
financial trouble will tell you so, which is why you ALWAYS need to do research
on the title before you get the deed or do an option. In this case, you will
need to bring the seller’s mortgage current. Before you do, you will want to
make sure that he/she is the owner of the property and there are no other liens
on the property unknown to you.

Example #2: Here is an example when you COULD get
the deed:

A seller calls you who owes
$135,000 on his home—which is worth $135,000. Since he has no equity at all,
this type of seller might very well be willing to give you the deed. And if
there is high appreciation or a very low payment, you might be able to make a
profit even though there’s no equity.

On the other hand, if the seller’s
payment is too high or the market is slow, you might need to have the seller
pay you to take the deed. Yes, there are sellers who will pay you to take
the deed to their home. Think about it: if this seller sells conventionally—that
is, though a Realtor, he would have to pay up to $10,000 in commission to sell
his home. Plus, he’ll have closing costs, transfer taxes, and will probably pay
points or fees on behalf of his buyer. If he’s willing to pay all this money to
an agent to sell the property—and wait 90-120 days to sell, too--why shouldn’t
he just pay you to take over his payments NOW?

If the seller didn’t have the cash
to give you, an option would be your best strategy. This way, the seller can pay
you the $10,000 over time, or you could arrange for the seller to pay part of
the monthly payment during the option period. This way, if he stops paying his
portion of the payments, you have the choice of surrendering your option and
simply giving the property back to him. When you have the deed, you can’t do
this.

Example #3: Here is an
example where you SHOULD lease option or lease purchase:

A doctor has a new home built for
himself. His old home is worth $200,000 and he owes $125,000. He has $75,000
of equity. He is not behind on payments, and he did not need the $75,000 cash
out to buy the new home. His old home is sitting vacant and the realtor has
not sold it yet. He qualified for both house payments at the bank and he can
technically afford both, but who wants to make an extra house payment?

Although he is motivated to sell
because he’s coming out of pocket every month to own a vacant property, this
type of seller is NOT going to simply give you the deed and let you take over
the mortgage. No way is he going to give up all of his $75,000 in equity, and
no way are you going to pay that much cash out of pocket.

When you lease/option this house,
he gets most of his equity back—although it won’t happen until YOU sell the
property. The deal might work like this: you option the property for $195,000,
and make payments to the seller that equals his total mortgage payments. You
SELL the property on an 18 month lease/option for $228,000 with payments to
match his payments. You get cash flow + $33,000 in profit when your tenant/buyer
buys the property; the seller gets his payments taken care of for a few years,
then gets the bulk of his equity out. And in the meantime, he doesn’t have to
worry about management, vandals, frozen pipes, and all of the other things that
owners of vacant houses have to deal with.

Example #4: Here is an
example where you COULD lease option or lease purchase:

Seller just inherited a property
worth $120,000 from their parents estate. It is owned free and clear and they
don’t want to be paid off. They don’t need the cash, but they would love some
cash flow on this asset. This seller is not going to give you the deed.
Let’s say you can lease option this property for $700 per month with $300 per
month going to the purchase – or the option credit. Your real payment in this
case is only $400. You also could do seller financing on this property.


Let’s examine a seller
financing deal:



A seller financed deal means that the seller will
finance a mortgage for the buyer and the buyer pays their mortgage payment and
interest to the seller versus a bank. This is primarily done when the seller
owns a home free and clear and they do not have a mortgage on it themselves.
Let’s say you negotiate a deal with the seller for a sales price of $110,000 –
if you want your payment to be $700, as in the above lease option example, let’s
see what that really means to a seller for a seller financed deal. First in a
seller financing or mortgage your payment includes taxes and insurance (unless
the buyer pays them themselves). This must be subtracted from the $700. Each
part of the country fluctuates, so I will use an estimate of $250 per month for
taxes and insurance. This leaves $450 for the seller. Now we must subtract
our principal we negotiated above the $300 per month credit. This now leaves
the seller with $150 per month. If this were to be all that is left this would
essentially mean the seller is receiving 1.6-1.7% interest on their money. The
interest rate has to be disclosed on the loan document or seller financed
deal. A very low interest rate is much harder for a seller to accept then a
lease option payment of $700 per month. It is the same thing to the seller, but
it is spelled out differently. They don’t do the subtraction themselves to
calculate the real rate of return. When you do a seller financing deal, you
must calculate and show the interest rate in writing.

Let’s examine the pros and cons of
Subject to vs. Lease Options – primarily as compared to one another.

Subject to Pros:
Subject to Cons:

Title is in your name – Full ownership

You own it and have ethical responsibility to the
seller even if the market changes or you can’t sell the home. You own it! No
changing your mind on this one.

Some sellers will pay you to take the deed.

You will need to keep two insurance policies in place.
One that goes to the lender with the old owner on it – so it won’t trigger
the ‘due on sale’ clause and one policy for you as the real owner. You
must insure it based on the title or you will have no coverage. This
increases your real monthly costs. You can also place it in a Land Trust to
avoid most of the due on sale issues – usually recommended.

Easier to prove ‘seasoning of title’ – when you are the
title holder. Easier to refinance.

In some states mortgage brokers and realtors could be
fined and/or subject to revocation of their license. It could be considered
against their code of ethics to assist a person in violating a clause in a
contract.

If you are on the title you will have long term gains
vs. short term if you hold the home for longer than 12 months.

Sellers with lots of equity will be hesitant or
completely against giving the deed.


Lease Option Pros:



Lease Option Cons:



You don’t have to buy later – if the market drops or there is something wrong with the home. You can get out!

Title is NOT in your name – seller
could screw it up – must be careful to screen the
seller. Only lease option from strong sellers, not those in trouble or
headed for trouble. (unless you put the deed in a Land Trust)

More sellers will do an option vs. giving up a deed –
especially on ‘pretty’ homes.

You will have short term capital gains vs. long term if
you are not on the title. This can be avoided if you finance it with the
12 months of payments (see the pros) and get on the title and hold it for 12
months before closing with your tenant buyer. This is a minimum of a 24
month solution.

After 12 months of payments there are many lenders that
will treat a lease option as a refinance – as if you were on the deed. It
would be treated like a land contract or contract for deed refinance.

Some sellers might feel like an ‘option’ is not closure
on their home. Some sellers will feel better with a deed being transferred
or a lease purchase (which is a guarantee vs. and option).

A way to get nicer homes. It is more likely the
seller that is not behind has taken better care of their home. This type of
seller is also more likely to consider a lease option vs. signing over the
deed.

Seasoning of title will start when you file a
memorandum of option or lien of interest. Most lenders will consider this
adequate and similar to recording a deed. (with the exception of FHA)

Sellers with lots of equity are more likely to give you
the right to buy the home than they are to give you the deed to their home.

Sellers with lots of equity usually want to close and
get their equity out.

Warning: There are many factors to consider
when making an offer with either of these techniques. What is the current
market condition for real estate in your area? Are homes appreciating,
depreciating, or staying flat? What is the financial condition of the seller?
Are they moving up or down financially in their new home? All of these items
make a huge difference on how you will structure a deal. I always say – “Strong
market – make a stronger offer. Weak market – make a weaker offer”.

Do your research, but if you keep your mind open to new
ways of acquiring real estate, you will indeed make more money!!!!!