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What are the dangers of loving leases in real estate investment?

There are certain dangers in existing leases with existing tenants when contemplating the purchase of a rental or single-family dwelling (SFH) property. While most investors purchase single-family homes wholesale, rehab, or wholesale, many other investors see the income stream from a property as their goal.

In a property purchase without a tenant on the property, closing is easy. Taxes accrue through closing date and any other proration is due at closing. However, in the closing of properties that have tenants, other considerations become very important.

The first is any deposit the tenant has with the previous owner. These deposits are generally required to be placed in a separate escrow account. Some states, counties and cities are very strict about the custody of these funds. New owners often use tenants’ rental deposits as part of their operating capital and assume that when the tenant moves out, they will have the funds available. The fact that some landlords never intend to repay deposits has caused all landlords to be penalized by well-intentioned legislators with restrictive escrow laws.

The second issue is the lease that the previous owner had with the tenant on the property. Some of the most important terms of these leases include the amount of rent, when and how the rent is paid, the length of the lease, reasons for eviction, sublease provisions, cure periods for lease violations, lease and renewable terms. Very important are the specific terms for the return of a tenant’s deposit due to the implications when the lease ends with the new owner and the tenant moves out.

The importance of reading and confirming each tenant’s lease prior to closing is very important. If a tenant does not have a lease, he is potentially a squatter and may need to be evicted by court order. Court-ordered eviction without a lease can be a long and always expensive process.

Often a seller of an income property will tell a prospective buyer that rents can be increased above what they are with current tenants. This may or may not be true, depending on rent controls, the terms of the tenant’s lease, competition in the local area for tenants, and the condition or location of the property. Don’t assume that rent increases can be made automatically with new tenants.

The most onerous problem with existing tenants are those with low rents and long leases. These so-called “boyfriend” leases can be between the landlord and a relative or friend, but the new buyer must abide by these existing leases until they expire or the tenant is evicted for cause. These preferential leases are sometimes re-leased (sub-leased) to other tenants and the differential amount is a profit to the previous tenant.

One way to stop these existing loving leases is an owner buyout. This may sound expensive, but figure out how much you’re losing monthly if you raise rents and make an offer to the current tenant for half of this lost monthly income. The best protection is to carefully read each lease and have the tenant of each unit re-sign the lease that they have been told is theirs. Unfortunately, sometimes a landlord in their rush to sell will fabricate leases for tenants that are not actual leases. His obligation is to honor the tenant’s lease, even if the previous landlord cheated him. This becomes an issue between the previous owner and you and the tenant is not involved.

In short, always close on your purchase with lease deposits paid by the seller separately to your escrow account or as a credit on your HUD-1 closing statement. If the seller credits you on HUD-1, immediately set aside money for these rental deposits as required by law where the property is located. Finally, close your purchase at the end of the month. Any new rent payment will be collected by you and not by the previous owner.

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