There seems to be some buzz around Master Lease Options (MLO) at this time. Honestly, the buzz comes from people who don’t know what they are doing and have never done it. I have personally made more than 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 do not or have never done. It really is a sensitive topic for me. The MLO is something so simple that a guru will read it and present himself as an expert. I will briefly describe what an MLO is and explain why it is a bad strategy in today’s market.
Like a house, you can lease an apartment building with the option to buy it in the future. There are two contracts that are often combined into one. There is a lease agreement that spells out 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 on a lease, it is considered a master lease in the industry. If you have a primary lease on, say, 10 units, you control all 10 units for the term of the lease. So you most likely sublease each unit separately. The biggest advantage of an MLO is that you can control an apartment building with little or no money. You can even ask the landlord to wire the security deposits to you so you receive a check at the time the deal is structured. It is a great strategy because you can often pay more for the building if you are not putting in money and still making 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 from the option. If the property decreases in value, your option becomes worthless and you would simply let it expire. Unless your cash flow is really good, you would have worked the deal for several years to earn little or no money. Now, in a strong market where there is appreciation, this is a great strategy because you will make money from appreciating the building as you actually owned it without the risks. As we discussed in my previous article, I believe that the value of commercial real estate will decrease in value in the coming years, which makes this a bad strategy.
Another reason this will be a difficult strategy is the current financing that the owners have. In the past it was easy to roll over loans at maturity, but today homeowners may not have that option. If the underlying loan is to 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 make a cash flow of 10% or more of gross income, it may be worth doing the deal for the monthly income alone. Many homeowners will not do this because it is cheaper to simply hire a property manager and retain all the benefits of owning the building.
2. Your term is REALLY long. If you can trade long-term that gives you time for the market to recover, you can do it ever since. Given that we have no idea how long it will take to recover and considering that you will have to curve down and then go up long enough to recover the depreciation. You may only want to do deals with terms of 15 years or more.
3. Finally, if you can negotiate a price well below market value, you would since then. My concern here is if a homeowner is willing to take a discount, wouldn’t you rather sell it to a cash buyer or someone who has the ability to get a loan now?
If you decide to use this strategy, you would spend more time and special attention on the sellers’ underlying loan.
I firmly believe that commercial properties will create tremendous opportunities. That being said, I think there are better strategies to use than the MLO at the moment. One thing that we are going to see a lot and that you can consider is joint ventures and collaboration between investors to pay in cash and / or obtain financing.