Why/How would you lease option 0% equity property? - Posted by Tim

Posted by Bill K. (AZ) on May 26, 1999 at 22:15:48:

JohnBoy,

I was trying to alleviate Tim’s fears of getting a bad reputation. He was concerned about getting into the lease/option business and making a seller mad if he walked away from a property at a time when real estate values dropped. So, I laid out a worse case scenario. That’s all.

You’re absolutely right. You’re under no obligation to purchase this property. However, just because you know that you did everything according to contract doesn’t mean that a seller won’t be upset and try to bad mouth you if you walk away without exercising. So, I was trying to show Tim how he could stem any possible anger by the seller. Paying the seller is not something I recommend. I was just trying to show Tim that he really didn’t have to fear a falling real estate market. He can possibly satisfy an angry seller and still make a little money.

Regarding the numbers, you’re right. I’ll give up $2,000 on this second transaction, but I still collected $8,400 over those 2 years. So, you still walk away with a gain of $6,400 in this scenario if the second tenant/buyer exercises.

By the way, I typed $9,400 in one spot and $8,400 in another. The $8,400 figure is what the investor would collect over 2 years with 2 different tenant/buyers.

How does that sound?

Bill K. (AZ)

Why/How would you lease option 0% equity property? - Posted by Tim

Posted by Tim on May 25, 1999 at 16:16:54:

I have just read a few of the posts regarding L/O and it seems that it is OK to L/O a property that has no equity. How does this work? At the end of say a 3 Year option period, if there is littl eor no equity now, there will liekly still be very little then, NO? Are there any of the How-to articles that detail this stategy?

Thanks,

Tim

Re: Why/How would you lease option 0% equity property? - Posted by rayrick

Posted by rayrick on May 25, 1999 at 22:47:36:

Generally speaking, there are two prices for a house: the “all cash” price and the “seller financing” price, the latter being 5-10% higher than the former.

If you can buy a house at the all cash price while getting some sort of seller financing for yourself (say a L/O or buying “subject to”), you’ve got yourself a deal, since you can sell at the higher “seller financing” price and pocket the difference (buying with good terms enables you to sell with good terms).

As Jim Piper once put it, there are two ways to get a deal out there- get a great price, or get great terms. If you can combine the two, so much the better, but if not, one will suffice.

-Ray

Re: Why/How would you lease option 0% equity property? - Posted by NevilleC

Posted by NevilleC on May 25, 1999 at 22:42:34:

One of the ways that it works is if your monthly incomming is greater than your outgoings. If there is a good mortgage in place that has a low interest rate then you could possiably be able to do a higher payment L/O. End result is a monthly positive cash flow. Get a long lease from the seller or one with multiple renewals at the same price. Given enough time the property price could appreciate but in the meantime you have an ongoing positive cash flow.

Buyers Pay a Premium - Posted by Bill K. (AZ)

Posted by Bill K. (AZ) on May 25, 1999 at 16:35:29:

Tim,

A friend of mine just completed such a transaction, and he’s pocketing $4,200; $3,000 of which is up front option consideration. Here’s what happened…

  1. Seller purchased this home 4 months ago for $92,000.
  2. Seller gets transferred (no equity built up).
  3. Seller willing to lease/option for 2 years.
  4. Option price = Seller’s purchase price ($92,000).
  5. Investor runs a “rent-to-own” ad, $875/mo, $96,200.
  6. Investor has tenant/buyer in 2 days.

The trick is to pay no more than today’s FMV, tops, and option at a price that is at, or a little more than, what the property will be worth a year or two later.

People will pay a premium to have an opportunity to get into a home this way.

Check the “How To” articles and “Success Stories” sections for more information on specific deals.

I hope this helps.

Bill K. (AZ)

Additional Questions - Posted by Tim

Posted by Tim on May 26, 1999 at 08:40:36:

Ray:

Bill posted a response to my question. I replied below on the thread with several more questions. Please take a look. I bet my scenario can happen. If it can’t, let me know.

Thanks for your response.

Tim

How do you determine what it will be worht in a year or so? - Posted by Tim

Posted by Tim on May 26, 1999 at 08:36:02:

Thanks, Bill, that helps.

Another question though. How can you be sure what a property will be worth in a year or so? In my area, and it sounds like most areas are this way, the real estate market is very HOT!

With my experience in financial markets, you can almost bet that when a market (any market) is HOTTEST, it is probably near its peak. What happens at the end of the option period, if a property has a market value even less than the strike price less rent and option credit. The T/B would be better off to walk away and buy at market, right? I guess if I first L/O’d the property from another seller, I could do the same, but I think that I might get a bad reputation in my area and the L/O concept would get a bad rap in this and every area. In addition, if this happens to a lot of L/O’d properties, the market would be flooded with properties and the market could be depressed even more.

Bottom line, when you get someone to sell to you on a L/O, they want to get rid of the property. If they get their property back in a year or so because markets are so depressed, I can imagine they would be quite upset and may be forced to take a property that is in worse condition than when they “SOLD” it.

I talked to one seller about L/O his property to me. He said he would be willing to do something like this, he wanted an absolute assurance that at the end of the option period teh property would be sold. Being fairly new, I walked for fear of exactly the scenario I detail above, where the property has a lower market value than the strike price.

Thanks again for you answer.

Tim

Let’s Put Some Numbers to It - Posted by Bill K. (AZ)

Posted by Bill K. (AZ) on May 26, 1999 at 12:38:42:

Tim,

Ray provided some good information. The engineer in me wants to look at it another way. If I could, let me add some numbers to the mix. Now, I haven’t yet completed a lease/option transaction, but here’s where I think you might stand dollar-wise…

Your Option Price: $100,000
Your Rent: $800
Your Tenant/Buyer’s Option Price: $104,200
T/B’s Rent: $900

Now, I intend to collect $3-$5,000 option consideration for each $100,000 of purchase price. Let’s assume we only get $3,000. At the end of the year, the T/B decides NOT to exercise because the market value of the home has dropped 3%. Where do we stand?

The tenant/buyer has provided you with $3,000 non-refundable option money PLUS you had a positive cash flow of $100/month for 12 months. Total in your pocket at the end of the year: $4,200.

If you structured your deal to allow a minimum 2-year lease term, you have time to find another tenant/buyer and collect another $3,000 as non-refundable option consideration. So, what’s the new scenario:

Your Option Price: Still $100,000 (if not renegotiated)
Your Rent: Still $800
Your T/B’s Option Price: $101,000 (market dropped 3%)
Your Rent: Probably still $900

If this tenant/buyer exercises their option, you’ve collected $9,400 on this property in 2 years.

If this tenant/buyer DOES NOT exercise their option, and you’re worried about a good reputation, you can give the house back to the owner and pay them the difference between your option price and what they can sell for today. Here are those numbers:

Your Option Price: $100,000
Current FMV of Home: $94,000 (FMV dropped another 3% in year 2)
Offer Owner the Difference: $6,000 (he’s back where he started from)
You Collected: $8,400
Remainder: $2,400

Now, that’s not a lot of profit for you over a 2 year period, plus you might have had a few minor repairs and re-rental costs involved, but you still don’t lose anything. And, the owner’s got to feel pretty good about getting a $6,000 payday from you. Reputation saved. He can resell the home for $94,000, yet he’s really collected $100,000.

Of course, if you don’t care about your reputation, you can walk away from the house after that second year with the entire $8,400 in your pocket. But, I’m like you. I want to maintain a good reputation.

Of course, the problem with this scenario is being able to come up with the $6,000 to pay off the owner. But, with enough of these lease/options in place, you are, hopefully, making a little more money than you’re spending. Besides, your options won’t all come due at the same time.

I hope this helps.

Bill K. (AZ)

Re: How do you determine what it will be worht in a year or so? - Posted by rayrick

Posted by rayrick on May 26, 1999 at 11:07:52:

Can the market go down during the term of your L/O? You bet. That’s one of the beauties of buying on a L/O- you don’t HAVE to exercise your option.

I hear your concern about not getting a bad rep as someone who promises the moon to sellers and then doesn’t deliver. I’m very upfront about the fact that I’m not obligated to buy the house at the end of my term. I just tell them the truth- "I want to be clear that I will not be obligated to buy your house at the end of our term if I haven’t found a buyer by then. At that point, several things can happen: it may make sense for me to buy the place myself at that time, or, if everything’s working out well, we can renew our agreement. Worse case scenario is that you’ve had a great trouble free tenant for three years, you’ve paid down your loan balance some more and you’re essentially where you are now as far as needing to sell the house is concerned. Please understand that I will try my best to find a buyer however, since that is one of the main ways I make my money on this arrangement."
All 100% true.

I don’t think you have to come out and say “the bottom could drop out of this market and then you’ll really be up a creek”. Unless they’re a total idiot, they understand that. There is obviously more risk involved for them then there would be in a conventional sale. That is why you need someone who is more motivated then a typical seller.

One other wrinkle I usually work in is that my exercise price does go down with time. I usually try to get them to agree to a price that is their loan balance at the time plus some number. I find that an easier pitch than trying to frame it as a “rent credit.” What your offering them is that they will take a certain amount of cash away from the sale, whenever it goes through. That lowering exercise price gives you a little more room if the market should turn down slightly. Obviously, it wouldn’t compensate for a precipitous drop in home values.

Hope that helps. My standard caveat: I’m new and the possibility exists that I don’t know what I’m talking about!

-Ray

Re: Let’s Put Some Numbers to It - Posted by JohnBoy

Posted by JohnBoy on May 26, 1999 at 21:44:25:

>>>>If you structured your deal to allow a minimum 2-year lease term, you have time to find another tenant/buyer and collect another $3,000 as non-refundable option consideration. So, what’s the new scenario:

Your Option Price: Still $100,000 (if not renegotiated)
Your Rent: Still $800
Your T/B’s Option Price: $101,000 (market dropped 3%)
Your Rent: Probably still $900

If this tenant/buyer exercises their option, you’ve collected $9,400 on this property in 2 years.<<<<

Under this senerio if your tenant/buyer exercises you will have to come out of pocket $2k. Your tenant/buyers option price is $101k. They gave you $3k as option consideration. If they exercise then you have to deduct the $3k they put down as option consideration from their option price. $101k - $3k = $98k balance due to exercise option. Your option price is still $100k. That leaves you owing $2k more than what your tenant/buyer would owe to exercise.

Also, if at the end of 2 years none of my tenant/buyers exercised I wouldn’t offer to give anything to the seller because the value of their home dropped. I never had the “obligation” to buy or sell their home. I only had the “option” to buy. How would that give me a bad reputation? I paid my rent to them on time for the term of our contract. I can’t control what happens with the market whether home values are going to go up or down. I’m not going to take responsibility for controling the market. If his house goes down in value, so does every house in that neighborhood. Do you think all the lenders on those homes are going to lower the loan balances on their mortgages because the market dropped? Heck no! So why would I pay the seller for difference of what his home dropped in value?

At best I would agree to extend our contract for another 2-3 years and change my option price to the lower value of what the home is now worth. Otherwise the seller is welcome to list it with a realtor and sell it if that’s what he chooses. But just because the home value drops and I decide not to exercise my option or none of the tenant/buyers I had decided not to exercise their option doesn’t mean I’m facing a bad reputation. I did everything I was obligated to do under the terms of our contract. That was to lease the property for x number of years with an “option” to buy IF I decided to buy it. I paid my lease payments as required and decided not to buy which were the terms of the contract. You can’t get a bad reputation for fulfilling your obligations of the contract.

Re: How do you determine what it will be worht in a year or so? - Posted by Tim

Posted by Tim on May 26, 1999 at 12:20:02:

Ray:

Thanks, that helps alot. The rumblings in this area seem to indicate that we are in for a major correction in RE markets, especially in light of talk about raising interest rates. But then again, that’s what they have been saying about the Stock market for the last 4 or 5 years.

Thanks for your input.

Tim