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 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:
1. Less Down Out of Pocket.
Many investors buy apartment buildings with 25-30% down payments, which is quite a big chunk. On a $2 million building, that’s $400,000 to $600,000 down, PLUS loan fees and closing costs. In addition, you will undoubtedly have to come out of pocket more for fix-up costs, negative cash flow, reserves, and other 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.
2. 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 original points for a temporary loan, which can be 3-5% of the loan upfront (ouch!)
3. Less Money at Risk
When employing the Master Lease Option for Apartment Building Strategy, your option money may be as little as 5-10% 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 than a 25-30% down payment. Furthermore, if you structure the master lease properly, it will be in a single purpose entity with no personal guaranty. If the thought of being on the hook for a multi-million dollar loan scares you, IT SHOULD! Even if the seller insists on a personal guaranty on a Master Lease, at least it is limited to only a few years.
4. No Debt-Financed Income Tax on IRA Investments
If you’ve invested with your IRA on a 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 lease), 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.
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 expense 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.
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President and founder of the Colorado Landlords Association, best-selling real estate author and attorney, landlord and real estate investor with 28 years' experience.