If principal and interest payments would have totaled about $1995 per month, and taxes and insurance another $500, his rents would have needed to be in the range of $3000 per month in order to cover the normal operating expenses of a self-managed new property. But would they have been? Not in most areas of the country. For a house in the $315,000 range, rents might average around $1400 per month year around. That means that the speculator would be faced with about $19,200 per house per year in out of pocket costs. Twenty houses would have brought this to $384,000.
With prices raging out of control and increasing at 25% per year, WHO CARES? Twenty houses costing $315,000 would be increasing in value at $1,575,000 per year. Each year the $384,000 could be borrowed against the properties because that only represented a little over ¼ of the measured appreciation. But when those loans became scarce, no one had the income to be able to support such a monster outpouring of cash to support something which had slowed way down in its appreciation.
Slow learners continued to pour cash into their sinking investments. Or they came up with exotic equity sharing plans to snare others into bad investments to help them keep afloat. Compare this to Option techniques:
THERE IS NO NEED FOR NEGATIVE CASH FLOW WITH OPTIONS. No loans have been signed. There is no promise to pay! There is no continuing obligation to make payments. There is no inversion of rents to property values that the speculator must sustain. In point of fact, there are few areas of the country in which leverage can be combined with institutional loans at today's interest rates where massive negative cash flow isn't the result. At the same time, there is no situation in which an Option doesn't effectively eliminate this negative cash flow problem for the speculator, and thereby, does increase his rewards both in comparison to his risk as well as to his continuing' investment.
That's why the yield from Options surpasses almost every other kind of investment in a rising market. Think of it this way. When you continue to make negative cash flow payments on property, you're actually INCREASING your investment in the property by the amount of each negative cash flow infusion. Assuming the same investment results, you are in effect DELEVERAGING your investment, subtracting from any positive results of appreciation.
Comparing that $7000 per year negative cash flow for our $110,000 house to an Option easily demonstrates my point. The Optionee would have the ability to Option almost one additional house per year over the borrower who financed his acquisitions. That means that at the end of 7 years, even in a rising market, the Mr. Optionee would have between 5 and 6 times as many properties as Mr. Borrower, and a such higher yield per house because Mr. Borrower would be consuming his resources by paying negative cash flow while Mr. Optionee would not have been doing that. As a practical matter, rarely would Mr. Optionee be required to put as much money down as would someone trying to obtain a loan.
Let's stick with our illustration from the “Leveraging Vs Borrowing” Article for a little while longer. Suppose the speculator with his $15,000 down payment obtained a 30 year, level payment loan at just 7%. Most people would agree that this would have been an attractive source of funds and a reasonable price over the past few years. But would it have been good for the speculator?
