What is a Master Lease?
Dictionary.com defines a master lease as a “controlling lease under which a lessee can sub-lease a property for a period not extending the term of the master lease.”
A master lease conveys rights to the Lessee (Master Lease Investor) that help make this an ideal solution to the investment dilemma. Master Lessee gets two major rights through a master lease:
Right to control the asset for a period of time
Right to sub-lease the asset
These rights allow a Master Lease Investor to acquire cash flow assets with limited cash capital.
Is Now a Good Time for Master Leases?
Let us breakdown today’s investment environment. Owners can’t sell as prices are still depressed from the heights when many of them bought their houses and not all buyers can’t get mortgages yet everyone needs a place to live. This leads to growth in gross rental rates.
Growing rental rates and difficulty selling real estate is a perfect mix for implementing the Master Lease strategy with the right sellers.
Who Should is the Right Seller?
As a master lease investor, you need to get creative on who you can approach with this strategy. The beauty about this strategy is that you can approach any owner with it but there are certain owners who would be more open to the idea:
Free and Clear out of town owners who want to sell for a specific price and cannot achieve that price in the current market. Their motivation is driven to achieve that hurdle number and may not need all the cash today and do not like renting given the headaches associated with the tenants and repairs.
You can target owners who bought their assets at the height of the market and need to sell but cannot due to the market value being less than their original purchase price. These owners maybe motivated to accept a Master Lease contingent on it working for their debt carry costs due to the inability to refinance and not achieving the price that they want for the asset.
Types of Master Leases
The two most prevalent master lease types are:
I. A performance master lease requires the master resident to pay a percentage of the funds he receives from his sub-resident only when he receives those funds.
II. A fixed lease, on the other hand, generally requires the master resident to make payments even if he does not have a sub-resident.
There are many hybrids given that each owners has different needs. As a master lease investor you can negotiate any and all aspects of your master lease – the variable or fixed rent amount, the term, the liability for expenses, escape clauses, etc. The key is to draft your documents by design based upon your negotiations with the owner rather than by default (i.e. using a standard realtor lease).
Fears Associated with This Strategy
Many investors are more fearful of executing a long-term lease as a master lessee than they are of buying an investment property. I think this is an irrational fear since it is easier to terminate a lease than it is to get out of title so the liquidity risk is less with a Master Lease strategy.
Some investors also think that they may have to be licensed under their state’s real estate brokerage law to engage in master leasing. Usually this is not true. Licensing is generally required for property managers (with few state exceptions) because managers have a fiduciary relationship with their principal.
Perspective of a Master Lessee
Long-term secured lease without an option often acts as a stealth option, since the owner must negotiate with you to remove your lease from the property when refinancing or selling. A master lease in many ways allows you to test drive a property before deciding whether or not you might want to buy.
The master lease is a great way to get your foot in the door for future negotiations. A master lease gives you the opportunity to build the relationship that leads to future purchases and often owner financing. Don’t make the mistake of thinking that your master lease is the final negotiation. It should be the first negotiation that can lead to one or more future negotiations.
You have first payment risk to your landlord. This simply means that you still have pay the rent to the owner even if your sub-tenant stops paying rent. This liability is similar to the liability that any owner of cash flow real estate would have to the lender who gives you money to buy the asset.
You can and will have variability in cash flow associated with unexpected repairs that can lead to negative cash flow. You can mitigate this risk by conducting a home inspection prior to master leasing the investment and craving out special repair ceilings within your master lease agreement.
Landlord-Tenant court. This is something that all buy & hold investors have to deal with so welcome to the club Master Lease Investors. You can mitigate this risk by conservatively underwriting your tenants so you can weed out the good from the bad tenants.
Capital Improvements to make the unit rentable. As a master lease investor you may rent the unit that needs to be cosmetically repaired to get top market rent for the asset. Be prepared to have a few months worth of capital reserves built up prior to making a master lease investment.