The Master Lease Option: Minimum Risk, Maximum Reward
One of the most awesome strategies to use as an Apartment Entrepreneur is a Master Lease Option. Lease options are common place in the quick-turn “pretty house” arena, but lease options when used on single family homes don’t reflect anywhere near the profit potential that is really possible using this powerful piece of creative financing. When you move from single family to multi-family in your use of the lease option, the risk/reward tilts dramatically in your favor and your profit potential shoots straight up, in hockey stick style increase.
When applied to a multi-family property, the lease option becomes a “master” lease option. The distinction is you are leasing from an individual party, the Seller, but have the right to sub-lease to multiple parties, the Tenants. Hence you have the “master” right to sub-lease … Master Lease Option.
All of the benefits associated with a lease option you have heard about, apply to the Master Lease Option as well:
- less risk; you are not taking title, the deed, mortgage, and tax bill stay in the Seller’s name.
- less money required down; option consideration is at a maximum 5%, but often closer to zero.
- no qualifying; no 3rd party has to approve you, this financing is between you and the Seller.
- fast close; how long it takes to get a title search done and the agreement drawn is how long it takes to close, anywhere from a few days to a month at the outside.
- easy exit; if after running the property for 6 months or so you realize the deal is not as good as you thought it was and you want out, it is simply a matter of canceling the agreement with the Seller. In case of default, the Seller simply cancels the agreement for you and just keeps the option consideration as his/her sole remedy.
- control; you get all the benefits of managing and profiting from the property as though you own it, by merely controlling it.
- huge profit potential; you get an option to buy the property at a price based on what the property is worth today, that spans years into the future, allowing you to increase the value of the property over time and then sell it based on its new increased future value.
When the lease option becomes a Master Lease Option though, there appears another dimension that adds two or three more zeros to a deal’s profitability.
That is, unlike single family homes, apartment buildings are valued based on the income they produce. The value of a property with 30% vacancy and below market rents is dramatically lower than if it was 90% occupied with tenants paying market rent. For mid-sized apartment properties in the mid-west this difference can be in the hundreds of thousands of dollars. For larger apartment complexes in high dollar markets, the difference can be millions.
And this is the unique opportunity a Master Lease Option opens up for you as an Apartment Entrepreneur. When you control an apartment building with a master lease option agreement, you can control the way the property is managed. You can lower expenses, by renegotiating agreements with vendors, canceling unnecessary services, firing unnecessary personnel, instituting tighter financial controls. You can increase income, by leasing vacant units at market rent, raising the rent on tenants renewing their leases, and ridding the property on non-paying tenants.
Increasing Gross Rents and decreasing Total Operating Expenses results in a higher Net Operating Income. And an increase in Net Operating Income means an increase in the value of the property. How much increase? It depends on the market and the property, but generally you can plug in 10X the increase in NOI and that is the increase in value of the property. The lower the Market Cap Rate the greater the increase in value as a result of the increase in Net Operating Income will be.
All of this is accomplished by the improved property management you bring to the property, and the Master Lease Option gives you the control that allows you to do that.
For the beginning apartment entrepreneur, if you are not sure of yourself yet and are looking to gain some experience, the Master Lease Option is an ideal way to ease into a deal that you may not feel confident committing to fully at the outset. On a mid sized apartment building, say a 40 unit, instead of raising $300,000 from private lenders to cover the cash requirements of the deal, you only need to raise a few thousand dollars to cover closing costs. Sometimes you pay nothing at all. Sometimes the Seller puts up money that is held in escrow and applied to repairs.
Once in control of the property you increase the value of the property by executing value plays. After two years goes by and the property is fully occupied and worth full retail value, now you sell the property to an apartment investor looking for a stabilized property to hold onto for the long term. At closing you take your profit as an assignment fee, only it’s not $5,000 assignment fee, but closer to $500,000.
This is the beauty of using a Master Lease Option with multi-family; minimum up front investment, minimum risk, maximum return, maximum reward. It is the ideal entry point for larger apartment deals.