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There are certain dangers in existing leases with existing tenants when you are contemplating purchasing a rental property or Single Family Home (SFH). While most investors buy single-family homes in bulk, rehab, or wholesale, many other investors see an income stream from a property as their goal.
When buying a property without a tenant in the property, closing is straightforward. Taxes are increased until the closing date and any other proration is settled at closing. However, in closing properties that have tenants, other considerations become very important.
The first is any deposit the tenant has with the former landlord. These deposits are generally required to be placed in a separate escrow account. Some states, counties, and cities are very strict with the custody of these funds. New owners often use tenants’ lease deposits as part of their working capital and assume that when the tenant leaves, they will have the funds available. The fact that some homeowners never intend to refund deposits has resulted in all homeowners having to be sanctioned by well-meaning legislators with restrictive custody laws.
The second problem is the lease that the former owner had with the tenant of the property. Some of the most important terms of these leases include the amount of the rent, when and how the rent is paid, the length of the lease, the reasons for eviction, the sublease provisions, the remedy periods for violations of the lease 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 leaves.
The importance of reading and confirming each tenant lease before closing is very important. If a tenant does not have a lease, they are potentially a squatter and may need to be removed by court order. Court-ordered eviction without a lease can be a long and always expensive process.
Often times, a seller of an income property will tell a prospective buyer that rents may increase above what they are with current tenants. This may or may not be true, depending on the rental controls, the terms of the tenant’s lease, the competition in the local area for tenants, and the condition or location of the property. Don’t assume that rent increases can be done automatically with new tenants.
The most burdensome problem with existing tenants are those with low rents and long leases. These so-called “loving” 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 good cause. These leases from the heart are sometimes re-leased (sublet) to other tenants and the differential amount is a gain to the former tenant.
One way to stop these existing grooms leases is by owner buying. This may sound expensive, but do the math on how much you are losing monthly if you increase the rents and make the current tenant an offer for half of this lost monthly income. The best protection is to read each lease carefully and have the tenant of each unit re-sign the lease they have been told is theirs. Unfortunately, sometimes a landlord in a rush to sell makes tenant leases that are not actual leases. Your obligation is to comply with the tenant’s lease, even if the former landlord misled you. This becomes a problem between the previous landlord and you and the tenant is not involved.
In summary, always close your purchase with the lease deposits paid by the seller separately to your escrow account or as a credit on the HUD-1 closing statement. If the seller credits you on the 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 payments will be collected by you and not by the previous owner.
