There seems to be some excitement around Master Lease Options (MLOs) right now. Honestly, the buzz is coming from people who don’t know what they’re doing and have never done it. I have personally made over 20 offers using this strategy and have successfully completed three. I still have all three properties today. Three is not much but it is enough to understand the strategy and how to use it.
There are many gurus who teach things that they don’t do or have never done. It really is a touchy subject for me. MLO is such a simple thing that a guru will read about it and present himself as the expert. I will briefly describe what an MLO is and explain why it is a bad strategy in today’s market.
Just like a house, you can lease an apartment building with the option to buy it in the future. There are two contracts often combined into one. There is a lease that details the terms of the monthly payments, the responsibilities of each party, etc. There is also an option contract that details the purchase price, the term of the option, how and where the closing will be, etc. If you rent more than one unit in a contract, it is considered in the industry as a master lease. If you have a master lease of, say, 10 units, you control all 10 units during the lease term. So you would most likely sublet each unit separately. The biggest advantage of an MLO is that you can control an apartment building with little to no money. You can even ask the landlord to wire security deposits to you so that you receive a check at the time the deal is structured. It’s a great strategy because you can often pay more for the building if you’re not putting money down and still make a lot of money.
The reason I don’t like this strategy in this market is because you will need the property to increase in value if you plan to make money on the option. If the property declines in value, your option becomes worthless and you would simply let it expire. Unless you have really good cash flow, you would have worked the deal for several years to make little to no money. Now, in a strong market where there is appreciation, this is a great strategy because you will make money on the appreciation of the building just as you actually own it without the risks. As we discussed in my previous article, I believe that the value of commercial real estate will decline in value over the next few years, making this a bad strategy.
Another reason this will prove to be a difficult strategy is the current financing that the owners have. In the past it was easy to renew loans at maturity, but today homeowners may not have that option. If the underlying loan must be repaid in a few years, it will be difficult to structure a long enough lease.
There are three exceptions to my opinion on this:
1. Your cash flow is really strong. If you can generate cash flow of 10% or more of gross income, it may be worth doing the deal for the monthly income alone. Many owners will not do this because it is cheaper to hire a property manager and keep all the benefits of owning the building.
2. His term is REALLY long. If you can trade a long term that gives you time for the market to recover, you can do so from then on. Since we have no idea how long it will take to recover, and considering that it will need to ride out a downturn and then rally long enough to recover the depreciation. You may want to only do deals with terms of 15 years or longer.
3. Lastly, if you are able to negotiate a price well below market value you would since then. My concern here is that if a homeowner is willing to accept a discount, wouldn’t they rather sell to a cash buyer or someone who has the ability to get a loan now?
If you decide to use this strategy, I will spend more time and special attention on the seller’s underlying loan.
I firmly believe that commercial properties will create tremendous opportunities. With that being said, I think there are better strategies to use than MLO at the moment. One thing we will be seeing a lot that you may want to consider is joint ventures and investor collaboration to pay cash and/or get financing.
