How to calculate profit for lease options

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Updated: July 21, 2022

How to calculate profit for lease options - get started in minutes

Lease options are a great way to get started in real estate. They allow you to control a property without putting up any money. However, lease options can also be profitable. To calculate your ROI, you need to know how to calculate profit for lease options. That is what you will learn in this blog.

How to calculate profit for lease options1

What are lease options?

Lease options are lease agreements that give you the right to purchase a property at a set price during the lease term. The option fee is typically non-refundable, but it gives you the right to buy the property at a set price, no matter how much the property's market value has increased.

An offer's appraisal and formulation should never be rushed to get a real estate deal started. Many sellers are eager to use lease options, but they must benefit you.

Considerations while creating the real estate offers

Usually, you shouldn't give the numbers to the sellers in excitement. Tell them you need to return to your office and run the figures even if you feel under pressure. 

You might speak a dollar figure in the excitement that leaves out some crucial factors. You will have the opportunity to review your profitability spreadsheet in the privacy of your office and make sure the numbers add up. Spend the time necessary to perform negotiations and offers well.

However, there can be circumstances when you need to react immediately, including in the instance of a subject-to offer on a pre-foreclosure or another situation involving competitive bidding.

By their very nature, lease options rarely call for a prompt response. As a result, you can react according to the rules of each circumstance.

Calculate the profit requirement for a real estate deal

As a real estate investor, you must decide how much profit you need from each deal. Depending on the sort of investment, it could change.

For instance, you will accept less for rehab as you can exit a rehab within a few months as opposed to a lease option, which usually requires 12 to 18 months or more. Do you need $50,000 in profit, $10,000, or something else? 

Your required profit is the bottom line that you need to be able to attain to accept a property deal after you've determined what it is.

For instance, if you need a profit of $20,000 but an opportunity presents itself that will only pay you $18,000, you will either need to negotiate the conditions of the agreement to reach your $20,000 goal or pass on the opportunity. 

Otherwise, neither the vendor nor you will benefit from the circumstance. As an alternative, you might be able to sell the contract wholesale to someone else whose bottom line is lower than yours.

However, it would be best if you learned to reject real estate offers that don't benefit you.

Sometimes a vendor will only agree to X, Y, and Z in terms of price, payment, and duration. To determine if the deal fits your profit criterion, enter those figures into the spreadsheet.

Occasionally, if it doesn't, you can continue negotiating a little bit. You may be able to negotiate the Z because the vendor is frequently only committed to X and Y, not X, Y, and Z.

However, there will be some deals when you have to walk away. Some sellers are unwilling to take the necessary steps to ensure a win-win situation; others lack the drive or cannot lower their asking price sufficiently due to excessive debt.

It would be best if you learned to move on swiftly and hunt for another motivated seller because wasted time costs you money.

How to calculate profit for lease options?

Calculating profit for lease options1

Start by constructing a worksheet to calculate the lease option's profitability. 

You will need to approximate appreciation because it cannot be predicted with precision. Newspapers are a fantastic resource for local appreciation rates. Base your projections on the forecasts made by the real estate boards or local journalists. 

Use 5% when figuring up your option premium in neighborhoods or condo complexes where all the houses are identical in size or model. The comparables should be available for the appraiser when you attempt to sell the home, and you may use up to 10% if the community is quite diverse.

Determine the cash flow or rental values as well. Similar to sales comparables, you may also use rental comparables. Here are three methods for finding comparable rentals:

  1. Read the local paper. Verify all of the nearby rentals. These are your comparables, or "comps."
  2. Consult members of the local landlords' group. The MLS does not list a lot of rentals.
  3. Are the statistics from the first two sources insufficient? Make a trial newspaper ad. Too many phone calls. You might be charging too little. Too few. You might be charging too much. Like fishing, you can try changing the bait to see what occurs.

Worksheet for calculating profits for lease options

Profitability worksheet

Lease Option


Purchase costs


    Purchase Price


    Total Purchase Costs


Income Sources


    Current Value


    Value of lease option premium (5-10%)


    Expected appreciation


    Expected Sale Price


    Expected monthly cash flow


    Total other income


Expected Profit


Profit Calculation Examples for real estate investor

Let's understand the calculation with three different examples. 

Example 1

For $200,000, the seller will sell you the house. At this time, it is valued $205,000. 

The rate of appreciation is 5% annually. The price will increase by 7.5 per cent (5 per cent x 1.5 = 7.5 per cent) because it will be sold with an 18-month option. This results in an appreciation value of $15,375 ($205,000 x 7.5%) over the 18 months. 

Rent will cost you $1,500 to the property owner. You may rent it out for $1,800, generating a $300 monthly income.

This area has a wide variety of distinctive residences. From $180,000 to $300,000 is the price range.

As a result, we can include a more significant option premium of 10%, or $20,500. The home's retail value is increased by $35,875, thanks to the $20,500 option premium and the $15,375 appreciation. What is the projected profit for the next 18 months? Let's look at how you would calculate the deal's profit:

Profitability worksheet

Lease Option

Example 1


Purchase costs



    Purchase Price

$200,000


    Total Purchase Costs

$200,000

$200,000

Income Sources



    Current Value ($5,000 above purchase price)

$205,000


    Value of lease option premium (10%)

$20,500


    Expected appreciation (5% annually, 7.5% over 18 months)

$15,375


    Expected Sale Price

$240,875

$240,875

    Expected monthly cash flow ($300 per month for 18 months)

$5,400


    Total other income

$5,400

$5,400

Expected Profit


$46,275

The resulting profit from this transaction, fewer transfer fees, title insurance, and potential option credits from the investor (you) to the buyer would be about $46,275 if all payments were completed throughout this option period and lasted the whole 18 months.

Does this generate the profit you need? Move forward with these terms if that is the case. If not, you can either reject the offer or continue the negotiations.

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Example 2

On a 12-month option, the seller will sell you their house for $155,000. It is valued at $155,000. If the appreciation is 3 per cent annually, there will be an extra $4,650 ($155,000 x 3 per cent) after one year. 

This house is located in a neighborhood where all the houses are identical and cost between $150,000 and $158,000. This yields a more reasonable option premium of only 5%, or $7,750 ($155,000 x 5%). 

($4,650 + $7,750) The appreciation plus the option premium is $12,400. The property owner will receive $1,200 in rent from you, and you'll charge $1,400 for the rental. 

You can also get a $200 monthly credit from the seller toward the purchase of this house. Let's examine your anticipated annual profit:

Profitability worksheet

Lease Option

Example 2


Purchase costs



    Purchase Price

$155,000


    Total Purchase Costs

$155,000

$155,000

Income Sources



    Current Value (same as purchase price)

$155,000


    Value of lease option premium (5%)

$7,750


    Expected appreciation (3% annually)

$4,650


    Expected Sale Price

$167,400

$167,400

    Expected monthly cash flow ($200 per month for 12 months)

$2,400


Option credit from seller ($200 per month for 12 months)

$2,400


    Total other income

$4,800

$4,800

Expected Profit


$17,200

For an investor, this transaction would not be nearly as profitable. Before closing fees, it would only make $17,200, leaving little room for unforeseen issues. This opportunity might falls short of your minimum profit standard. 

There are, however, methods for renegotiating the agreement with the seller. It must be more of a buyer's market with a low appreciation rate. 

You ought to be able to haggle over the cost and the terms. Request a lower price and more monthly financing for the property purchase

You can also request a buy-down of the mortgage's equity during the option period. You would receive the $10,000 credit that was paid on the mortgage balance during the option period since you had been making that mortgage payment during that time. 

For instance, if the seller owes $100,000 on the house at the beginning of this option and only owes $90,000 at the end, you would receive that $10,000 credit.

Allow the transaction to stall if the seller refuses the new conditions until they become sufficiently motivated to accept them and the deal meets your profit criteria. It must achieve your bottom line and produce a win for both the buyer and the seller.

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Factors that can affect your profit

There are a few factors that can affect your profit when it comes to lease options.

  • The first is the purchase price. You will want to make sure that you negotiate a fair purchase price with the seller.
  • The second factor is the length of the lease term. A longer lease term gives you more time to increase the value of the property, which can lead to a higher profit.
  • The last factor is the option fee. This is the fee that you pay for the right to purchase the property at a set price.

Make sure that you negotiate a fair option fee with the seller as well!

Tips to negotiate a better real estate deal

If you want to make a profit with lease options, you need to know how to negotiate a better real estate deal. Here are a few tips:

Tips to negotiate a better real estate deal1

Do your homework

Know the market value of the property and what similar properties have sold for in the area. This will help you negotiate a fair purchase price with the seller.

Get a good real estate agent

A good real estate agent will help you negotiate the best deal possible.

Have a lease option agreement in writing

This will protect your interests and ensure that both parties are clear on the terms of the agreement.

Following these tips, you can make a profit with lease options!

Conclusion

In real estate investing, any sale will always have unforeseen costs; therefore, you want to ensure that any real estate transaction includes a cushion of extra earnings. Always prepare for potential problems, such as nonpayment of rent by a tenant, a broken furnace, a leaky roof, a failing septic system, etc. If you prepare for the worst, you will be secure.

FAQs

How do lease options work?

A lease option (also known as a "lease-to-own" or "rent-to-own") is a type of contract used in residential real estate transactions. It allows the tenant to rent the property for a specified period of time, with the option to purchase it at a later date.

The terms and conditions of a lease option vary from one deal to another, but they usually allow the tenant to purchase the property for a price that is lower than the market value. This can be an attractive option for people who want to own their own home, but don't have enough money saved up for a down payment.

How to calculate expected monthly cash flow

There are a few different ways to calculate expected monthly cash flow, but one of the most straightforward methods is to simply multiply your average monthly sales by your average profit margin. This will give you an approximation of how much cash you can expect to bring in each month.

If you want to get even more specific, you can also break down your expected monthly sales by product line or service and then apply your average profit margin to each one. This will give you a more detailed view of how much money you can expect to make from each individual product or service.

What is the sandwich lease option?

The sandwich lease option is a real estate investing strategy that can be used to purchase property without using any of your own money. The way it works is you find a motivated seller who is willing to sell their property for less than what it’s worth, then you lease the property from the seller with the option to buy it at a set price in the future. Once you have the property under contract, you find an end buyer who is willing to pay more than what you’re paying for the property, and then you sell it to them. This allows you to profit from the difference between what you paid for the property and what the end buyer paid for it, all without having to use any of your own money.

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