Why buy an apartment building when you can RENT one? If you are buying an apartment building with the intent of improving and flipping it within a few years, the Master Lease Option for Apartment Building Strategy may be the way to go.
Instead of going under contract, raising the down payment through syndication, and obtaining a large bank loan (which you may have to sign personally on), use a Master Lease to control the property, with an option to purchase it at an agreed upon price for a few years. You then sublease to the existing and new tenants for cash flow.
When you have the building performing at its peak potential, you can either exercise your option to purchase and resell it through a double closing, or simply sell your option to a third party for a profit. There are four main advantages of using the Master Lease Option for Apartment Building Strategy:
- Less Down Out of Pocket
Many investors buy apartment buildings with 20-30% down payments, which is quite a big chunk. On a $2 million building, that’s $400,000 to $600,000 down, plus loan fees, appraisal, and other closing costs. In addition, you will undoubtedly have to come out of pocket more for fix-up costs, negative cash flow, reserves, and other carrying costs. As a general rule, the more money you put down on an investment, the lower your annual return (assuming your carrying costs are reasonable). Conversely, the less money you have to put down, the higher your return on investment. And, the less money you put down for your down payment, the more cash you can allocate towards repairs and improvements.
Also, with less down out of pocket, you may not need partners, or you may get away with having fewer partners. Fewer partners are certainly easier in terms of logistics and the potential “headache” factor.
- Cheaper than Hard Money
Many investors use hard money or “mezzanine” financing to purchase an apartment building, with the intent of refinancing in a year or so. Using a master lease instead of a loan may result in a lower payment than the equivalent temporary loan at a high-interest rate. And, since temporary financing usually means a low loan-to-value ratio, you will undoubtedly have to put up a large down payment if you don’t use the Master Lease Option for Apartment Building Strategy. Furthermore, if you use the Master Lease Option for Apartment Building Strategy you won’t have to pay the typical loan origination points for a temporary loan, which can be three to five percent (3-5%) of the loan up front (ouch!)
- Less Money at Risk
When employing the Master Lease Option for Apartment Building Strategy, your option money may be as little as five to ten percent (5 to 10%) (of the option price. On a $2 million purchase, that’s $100,000 to $200,000, significantly less than if you purchased it with a loan. If the deal goes bad, you don’t have to exercise the option, so your downside risk is limited to your option money, time, and improvement costs. While these amounts are not insignificant, they are certainly less painful than having to walk away from a 25-30% down payment. Furthermore, if you structure the master lease properly, it will be in a single purpose entity with no personal guarantee. If the thought of being on the hook for a multimillion dollar loan scares you, IT SHOULD! Even if the seller insists on a personal guarantee on the Master Lease, at least it’s limited to only a few years.
- No Debt Financed Income Tax on IRA Investments
If you’ve invested with your IRA on property that is debt financed, you may know that income from that investment may be subject to unrelated debt financing income tax (UDFI). A master lease is not a loan (so long as the master lease is not long-term with a declining balance, thus a disguised loan), so the net income to your IRA is not subject to debt financed income tax. However, the downside to the Master Lease Option for Apartment Building Strategy,is that when you exercise your option to buy and simultaneously flip the building, you haven’t been in title long enough to qualify for a long term capital gains tax treatment. Thus, the gains from the sale may be taxed at a higher rate. Selling your option rather than closing on title to the property before flipping it would be to your benefit. Discuss with your tax advisor for more detail.
While there are many advantages to the Master Lease Option for Apartment Building Strategy, there are also some pitfalls. First, the seller could simply renege on the deal when it comes time to exercise your option, leaving you with an expensive litigation option. Second, the seller may end up in bankruptcy or get a lien against the property in the interim. Third, the seller may die or disappear, leaving you with a legal mess that will take time to clean up. While these problems can be mitigated with some good legal paperwork drafted by a good attorney, you should prepare yourself for the risks of any lease/option deal.William Bronchick, Host of Legalwiz.com, is a nationally-known attorney, author, entrepreneur, and public speaker. Mr. William Bronchick has been practicing law and investing in real estate since the early ’90s, having been involved in thousands of real estate transactions. His best-selling book, “Flipping Properties,” was named one of the ten best real estate books of the year by the Chicago Tribune. William Bronchick is also the author of the highly acclaimed books, “Financing Secrets of a Millionaire Real Estate Investor,” “Wealth Protection Secrets of a Millionaire Real Estate Investor,” “Defensive Real Estate Investing,” “How to Sell a House Fast in a Slow Real Estate Market,” and his latest work, “The Business of Flipping Homes.”William is the co-founder and past President of the Colorado Association of Real Estate Investors and the Colorado Landlords Association. He is admitted to practice law before the bars of New York and Colorado.