Hope most of you real estate investors was able to catch Part 1 of Creative Options and 0% Financing last week because we are jumping in right where we left off on covering Options and Alternative Financing options for your real estate deals.
Pure Options & IRA’s
Pure Options can be purchased for cash or for management effort. They can be written to capture all or a portion of any price appreciation as well as loan amortization. The trouble with Roth IRAs is that it is difficult to accumulate much money from contributions and build up in values in any significant amount until several years have elapsed.
Suppose a Roth IRA custodian were to buy an Option on a house that was being rented by a non-related party in order to induce tire seller to lease the property rather than to sell it outright. The seller would receive tax-free Option consideration plus rent. The tenant would be able to enjoy a residence that might otherwise have been unavailable. The Roth IRA would have a highly leveraged investment with no risk. Let’s quantify this:
Assume a Roth IRA paid $10,000 for a 2-year Option to buy a $150,000 house that had recently been received in a property exchange by someone who didn’t like management. The Option would be conditional on an unrelated party, acceptable to the owner, paying $1200 per month rent for two years. Out of the rent, $100 per month would be credited toward the $140,000 Option strike price.
Let’s assume that house prices were rising at about 8% per year during this period. Each year the Roth IRA would see its equity In the Option grow by $1200 by virtue of the rental credit, and by $8000 through property appreciation. At the end of 2 years, the initial $10,000 investment would have grown to $18,400. That represents a 42% annual yield each year for two years.
Negotiating Leases & Options
Negotiating leases and Options require different approaches from buying and selling. When leasing, the best lease targets are people who have been unable to sell, or who are reluctant to place vacated properties on the market because of all the hassle.
A vacant house can be a real burr under the blanket when payments must be made on it. So, the potential lessee would present himself or herself as a desirable, responsible long term tenant who would take good care of the property. One might even agree to pay rent payments annually in advance in return for a high discount.
Using the above $150,000 with a fair market rent of $1200 as an example, in a pure lease situation, the benefit to the lessee is in a cash flow spread between rent that is being receive from a sub¬-tenant and cash that must be paid out on the lease. The benefit to the owner is a hassle free, vacancy free, maintenance-free rental that he can write off while getting all the appreciation.
In a typical situation, the potential tenant would try to get 10% discount for paying the rent one year in advance. It could be pointed out to the owner that he could recover this discount easily in today’s stock market.
Next, perhaps 5% additional discount could be negotiated for signing a five year lease. Just one month’s vacancy each year would be much more than that. Another 3% discount might be negotiated for taking care of all maintenance items under $100 per month, and as an override on any maintenance arranged on larger items. If you add all this up, the tenant winds up renting this house for 18% under market, or $984.00 per month.
Let’s assume that market rents on the sub-lease could be increased by 5% per year; the first years net rental spread would be $2592. The second year the annual rents would rise by $1200 and the spread would increase to $3312. The third year the spread would be $4068; the fourth $4860, and the fifth year, the tenant would be receiving over $475 per month for doing little more than managing one rental house. Do you suppose a person could manage more than one rental house?
Of course, in the real world, none of these number would work out. There would be expenses, vacancies, etc. On the other hand, if, as is spelled out in the rental agreement previously covered, many of these expenses were passed along to the tenant, it would be a very worthwhile endeavor for someone trying to find cash to feed a highly leveraged cash flow property. The monthly cash flow could pay for several Options too.
Mind blowing right? This is just Part 2 of my three-part blog series on how options are a perfect way for investors to be creative in their real estate investing financing and contracts. See you guys next week!