Buying with owner financing is my favorite way to purchase real estate because it involves the least amount of risk.
There are many advantages as compared to getting traditional financing. First you don't have to sign personally for the loan. Second you don't have to put much, if any, money down to get into these deals and third there is no qualifying. You don't have to submit your tax returns, pay stubs, bank statements, etc.
The first type of owner financed deal is going to be a lease option.
A lease option is a simple type of deal. It is a great place to start investing because the paperwork is very easy and there is only one document that you need to have signed to have the deal go.
The structure of a lease option is easy to understand. The first part is the lease. Most all of us have leased a property to live in at one time or another. The lease gives you control over the property. You can now occupy the property and sublet it. You want at least 3 years on the term of the lease. If the market is soft then you will want longer.
The second part is the option. The option gives you the option to purchase the property at a certain price. This is where you can lock in your price on the property. If there is appreciation (which there has been for every year except for 2 in the last 40) you will profit by locking in your price. Obviously you want your price to be as low as possible.
OK, so now we have the concept behind the deal, how do we profit with a lease option?
Here is an example with numbers.
- Lease Price to Seller: $1000 month
- Purchase Price to Seller: $180,000
- Term: 5 years
- Down Payment to Seller: $0.00
- Lease Price from Buyer: $1200 month
- Purchase Price from Buyer: $215,000
- Term: 2 years
- Down Payment from Buyer: $5,000
In this transaction you have put no money into the deal and will receive $200 a month cash flow, $5000 up front money and $30,000 as back end profit (the $5,000 gets deducted from the total equity). The profit equals $34,800 for using your specialized knowledge to put this deal together!
- The paperwork for this type of transaction is a lease and an option combined in one document. You can have two separate documents but 1 is better in case the deal ever ends up in court. With everything in one document you will have a stronger case for ownership.
- Memorandum of Option (recorded to cloud the title so the seller doesn't sell it to someone else.)
- A Warranty Deed (Placed in Escrow in case the seller falls off the face of the earth)
- A purchase agreement that spells out any other terms not discussed in the option agreement.
If the seller is in financial distress you do not want to buy on a lease option. I would only buy subject to the existing financing with a financially distressed seller. This way you will be protected at all costs. A lease option provides you with the least amount of security if the seller decides he doesn't want to sell or he does something crazy, like let the property go into foreclosure.
The lease option is my least favorite way to buy for the following reasons.
- No protection from sellers that don't do what they promised.
- No tax benefits from owning the property.
- You can pay short term capital gains when you resell the property (there is a way around this but that is a different post)
Even with the negative aspects of a lease option it is still a great way to invest in real estate and as the example shows above you can make some tremendous profit.
