There are certain dangers in existing leases with existing tenants when contemplating the purchase of a single-family home (SFH) or rental property. While most investors buy single-family homes wholesale, rehab, or wholesale, many other investors consider the income stream from a property their goal.
In a property purchase without a tenant on the property, closing is easy. Taxes are increased through the closing date and any other apportionments are settled at closing. However, in closing on properties that have tenants, other considerations loom large.
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 tenant lease deposits as part of their operating capital and assume that when the tenant leaves, they will have the funds available. The fact that some landlords never intend to refund deposits has meant that all landlords have 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 rent is paid, the length of the lease, reasons for eviction, subletting provisions, cure periods for violations of the lease and renewable terms. Very important are the specific terms for the return of a tenant’s deposit because of the implications when the lease ends with the new owner and the tenant leaves.
The importance of reading and confirming each tenant’s lease prior to closing is very important. If a tenant does not have a lease, they are potentially a squatter and may need to be evicted by court order. Court-ordered eviction without a lease can be a lengthy and always expensive process.
Often a seller of an income property will tell a potential buyer that rents can be raised 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 “boyfriends” leases may 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 preferred leases are sometimes re-leased (sub-leased) to other lessees with the differential amount being a gain to the previous lessee.
One way to stop these existing sweetheart leases is an owner buyout. This may sound expensive, but calculate how much you are losing on a monthly basis if you increase 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 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 abide by the tenant’s lease, even if he was misled by the previous landlord. This becomes an issue between you and the previous owner and the tenant is not involved.
In short, always close on your purchase with the 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 rental payments will be collected by you and not by the previous owner.