What Are the Dangers of Sweetheart Leases in Real Estate Investing?

There are certain dangers in existing leases with existing tenants when you are contemplating the purchase of a rental or single family home (SFH) property. While the majority of investors buy single family homes to wholesale, rehab or wholetail, many other investors look at an income stream from a property as their goal.

In a purchase of a property without a tenant in the property, the closing is straightforward. The taxes are accrued through the closing date and any other prorations are settled at the 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 former owner. These deposits are usually required to be placed in a separate escrow account. Some states, counties and cities are very strict about the escrowing of these funds. New landlords often use the lease deposits of the tenants as part of their operating capital and assume when the tenant leaves, they will have the funds available. The fact that a few landlords never intend to refund deposits has caused all landlords to have to be penalized by well-meaning legislators with restrictive escrow laws.

The second issue is the lease the former owner had with the tenant in the property. Some of the more 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, sub-lease 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 every tenant lease before the closing is very important. If a tenant does not have a lease, he is potentially a squatter and may have to be removed by court order. Court-ordered eviction without a lease can be a lengthy and always an expensive process.

Often a seller of an income property will tell a perspective buyer that the rents can be increased above what they are with the 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. Do not assume that rent increases can be made automatically with new tenants.

The most onerous issue with existing tenants is those with low rents and long leases. These so called “sweetheart” 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 sweetheart leases are sometimes re-leased (sub-leased) to other tenants and the differential amount is a profit to the former tenant.

One way to stop these existing sweetheart leases is a buy-out by the landlord. 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 ½ of this monthly lost revenue. The best protection is to carefully read each lease and have the tenant of each unit re-sign the lease you have been told is theirs. Unfortunately, sometimes a landlord in his rush to sell will manufacture leases for tenants that are not real leases. Your obligation is to abide by the tenant lease, even if you were misled by the former owner. This becomes an issue between the former owner 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 put money aside for these lease deposits as may be 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 the former landlord.