Master leases are a common tool for companies or individuals that want to invest in real estate. This single tool can help you grow a cash-flowing portfolio, even if you’re just getting started without any money. In this article, I’ll explain how a master lease works, what they can do for your business, and how they can help you scale.
What Is a Master Lease?
A master lease in real estate is an agreement where an investor leases a property as a single tenant, and then subleases the same property to sub-tenants. The master lease can be used for multiple real estate arbitrage properties or just a single property, like Airbnb arbitrage (also referred to as rental arbitrage).
How Does a Master Lease Work?
Although the term “master lease” sounds complex, in reality, this type of lease is very simplistic.
An investor finds an off-market property for sale or a property for lease. Then the investor negotiates with the seller/landlord to try a master lease option. The investor may offer a down payment on the property or get the property for no money down.
Once the lease is signed, the investor has the same rights as the property owner, without legally owning the property. That means you can raise rents, make renovations, or expand as you see fit. In return, you’ll pay the landlord/legal owner rent payments until you purchase the property OR until the master lease expires.
Remember, as the tenant on the master lease, you’ll be responsible for paying the bills. That includes taxes, insurance, maintenance, and more. You essentially own the place!
More often than not an investor tenant (like you) will negotiate a buyout option before signing the lease, allowing you to purchase the property at a certain date or once you have the funds.
So what type of master lease should you sign?
Types of Master Lease Agreements
Most master leases will follow the same type of structure. But, creativity can be your friend when negotiating a potential real estate deal. The two types of master leases you’ll become most familiar with are:
- Fixed Master Lease: This type of lease is far more common, and allows the landlord to act as a regular landlord would. In a fixed master lease, the primary tenant (you) is required to pay a percentage of your rent, EVEN if you haven’t sublet the property or collected any profits yet. This type of lease structure gives the landlord added security when leasing to you.
- Performance Master Leases: This type of master lease requires the primary tenant (you) to pay a percentage of your rent to the landlord after you receive rent payments. This type of lease can help you sweeten the deal by providing the landlord with an opportunity for higher income. If you make more, they make more. Everyone wins!
The type of master lease you choose is entirely based on the landlord/seller and what it takes to close the deal. This is creative financing at its best, so don’t be surprised if the landlord/seller wants some added profit for their troubles.
Why Sellers Love the Master Lease
A master lease is a tool that works for you and the seller. Some sellers will prefer a master lease over a sale for the reduced tax implications. If you do need to convince a seller that the master lease can work for their situation, try offering these reasons:
- Consistent Income: Most sellers do not need a large pile of cash unless they have something in mind to use it on. If you have a seller that isn’t in dire need of direct funds, pitch them on the consistent, passive income side of a master lease.
- Complete Passivity: Once you sign the master lease, the responsibility of the investment property is on your shoulders. This means the seller can focus on other projects or just take time off work!
- Delayed/Limited Capital Gains: A seller may not want to outright pay 15%-20% of their profit in capital gains as soon as they sell. Master leases allow them to still retain consistent income without paying taxes on the “sale.”
- An Assured Price: A seller may have a certain number that they want for a property. When you sign a master lease, there almost always is an option to buy the property at a certain price. This gives the seller peace of mind that they’ll be able to walk away with the price they want.
Why Buyers and Investors Love the Master Lease
For a buyer, especially one without a 20% down payment lying around, the master lease is one of the best ways to creatively finance a deal. Here are some more added benefits:
- Cash Flow: After taking over the property from the former owner, you’ll be the one who gets to raise rents, make improvements, and yes, boost the cash flow. That means you have income-producing real estate without even owning it!
- Equity Entitlement: Upon signing a master lease, you and the seller will negotiate a purchase price when/if you decide to buy the property. This means that if the master lease lasts five years, and the property appreciates $100K in that period, you’ll be entitled to the equity when you close!
- Longer-Term Financing: As opposed to using something like a bridge loan, master leases can last however long you and the seller agree to. So if you need three years to come up with the down payment, you can write the lease to fit your timeline. This is often preferable to a high-interest bridge loan or borrowing private money (also very high interest), both of which may only give you a year of runway.
Cons of a Master Lease Agreement
By this point, you may be feeling the love for master leases. But, before you sign on the dotted line, know that there are some downsides for investors and sellers.
Seller Drawbacks
- Risk: Sellers often have the option to sell and receive immediate payment or sign a master lease with an investor, which delays their closing by years. For the seller who is more risk-averse, a standard sale may sound better than a master lease.
- Difficulty Finding Tenants: A master lease only works for a seller if the investor/tenant is experienced, stable, and knows what they’re doing. Many investors who want no-money-down deals are novices, again raising the risk for the seller.
- Costly Maintenance: If an investor/tenant is a poor operator, they could leave the property in shambles, making repairs/maintenance the original owner’s responsibility if the lease becomes broken or an investor/tenant decides to decline their buyout option.
Investor Drawbacks
- Difficulty in Finding Sellers: As with any type of creative financing, it is difficult to find sellers who will trust you enough to sign a master lease. By no means is it impossible, but be aware that it’ll take significantly more work to find the appropriate owner.
- Paying Rent: Because you are on a lease, your monthly payments aren’t going towards a loan, meaning you aren’t participating in principal paydown. This stops you from building equity and forces you to restart the clock once the property is finally yours.
- Inconsistent Cash Flow: For the most part, master lease-type properties are not stellar when you acquire them. They need a lot of time, attention, maintenance, and marketing to get whipped into shape. This means you will not have consistent cash flow for the first year (or years) you manage the property.
Examples of Master Lease Agreements
A simple example of a master lease agreement is Airbnb arbitrage (often called rental arbitrage). This practice is when an investor finds a long-term rental, rents it at market price, and then subleases it to tourists at a (far higher) nightly rate. The investor gets paid the difference between the rent cost and how much they collect from nightly rentals, and the landlord gets their agreed-upon long-term lease amount.
Another common example are properties like shopping malls. The mall may have been built by a builder/investor, who subleases the entire mall to another investor who then rents out each individual storefront to a tenant. The investor then pays the property owner a set rate and makes a profit through the difference between his tenant’s combined rent and what he owes to the owner.
In other words, a master lease can be thought of as real estate arbitrage on someone else’s property for your benefit!
Tips for Structuring a Master Lease
Before you run off to the apartment complex down the street, you should know a few key tips when structuring your master lease.
Always Include a Buyout Option
The buyout option in a master lease is arguably the most important clause to add. This gives you, the investor, the option to buy the property from the seller at a given date in the future, for a set price. This protects both you and the seller from leaving each other high and dry toward the end of the deal.
Make It Long-term
Like any other type of real estate deal, it’s best to know your exit strategies before you start. Understand how long it’ll take you to lease up the property, make repairs, and get it into financeable shape. Set your time horizon so it makes sense for not only you but the deal. This means the master lease could last anywhere from three to ten years, depending on what you and the seller are comfortable with.
Offer to Manage the Property for Free
The seller most likely wants a headache-free transaction. Part of that deal means you doing most (if not all) of the property management. Remember, a master lease gives you the same responsibilities as an owner. So getting repairs done, tenant turnover, and everything else in between is your responsibility. Let the seller know about this and put their mind at ease before the lease is signed.
How to Secure a Master Lease
So now you know what a master lease is, how it works, the benefits, and the drawbacks of it as well. But how do you structure a master lease to fit your perfect deal?
1. Find Your Property
First things first, know what type of property you’re going after. Are you looking for a single-family home, a multi-unit apartment complex, a self-storage facility, or a commercial space? Pick your niche, know your strategy, and start looking for property potential.
Outdated, underpriced, or mismanaged (often messy) properties may be some of the best to try this strategy on. This is because a property like this will often be neglected by an owner who wants out of it.
2. Find Your Seller
If you’ve found a property that meets your above criteria, it’s time to talk to the seller. Be upfront about what your plans would be with the property, how a master lease would benefit the seller and hit home on how this is a low-stress, low-involvement, almost completely passive option for them.
3. Do The Math
If you’ve gotten a verbal commitment from the seller, start running the numbers. How much will this property need to be fixed up? What are the fixed expenses? What variable expenses can you forecast? And finally, ask yourself how long it will take until you can buy the property from the owner (if that’s your prerogative).
4. Get an Inspection
If the math checks out, it’s time to hire an independent inspector. Before you do, let the seller know that you will be doing this. You do not want to catch someone by surprise when sending someone to look through the ins and outs of their property.
5. Hire a Lawyer
Hire a legal professional to draft up a master lease for you and the seller. Be sure to ask them to add a buyout option at the price and date that you and the seller have agreed to. Once this is written up, send it to the seller for review, and get it signed.
Side Note: Lawyers aren’t as expensive as you think. These types of contracts can be drafted for as little as $200. So don’t use some random template from the internet!
6. Negotiate
If your inspection has highlighted some worrying repairs needed, speak to the seller to see where you can meet in the middle. If they aren’t willing to offer repairs, they may be willing to lower the future purchase price, waive a down payment, or offer other consolations.
7. Close
If you’ve made it up ’til here, then you’re ready to sign away. Get the contract finalized, sign, and start making rental property profits!
Conclusion
Master leases can be a useful tool for investors who want to take advantage of the benefits of leasing without sacrificing the flexibility or control that comes with ownership. We hope this guide has given you some insight into what master leases are and how they work. So get out there, find your next real estate investment property, and get that cash flow flowing!
