I was a salaried employee living off my wages for half of my adult life. Even though I'd tried my hand at several ventures during that period, I couldn't figure out how full-time entrepreneurs could take such risks to earn a living. I didn't have enough money to buy a franchise; and couldn't imagine being able to support a family without a wage-paying job. I confess I was afraid to take the chance to cut loose from my paycheck. Suddenly, with fifteen minutes warning, I got fired. I discovered that I had few career choices. At age 40, these boiled down to working for less pay, or becoming an entrepreneur. I took the plunge.
When I made the decision to work without a net, I sat down and took a hard look at my assets. I had majored in business management in college and had worked management in one capacity or another for several years; so I knew how a business is supposed to run. I was a self-starter, healthy, and was used to working long hours. I had very little money and had to find a way to create an income stream as soon as possible. I had a “hip-pocket” real estate license lodged with a semi-retired broker that I had been carrying around in my pocket for a year or so.
I didn't like the prospect of being a salesman but real estate sales held out several positives; there were very few negatives for someone without a job. (1) I could begin right away without any more classroom time, equipment, or money. (2) I could use my principal broker's office, telephone, and furnishings. (3) Becoming a real estate salesman didn't require additional investment. (4) It had the potential for generating needed income quickly. (5) I already had a license. Once I had weighed all the alternatives, it became clear that the only thing keeping out of the real estate business was my own negative attitude toward “selling”.
I had to confront the fact that my negative attitude was based upon a few past bad experiences and my ignorance about selling techniques. To educate myself on the subject, I signed up for a short course at the local vocational high school that showed me which real estate document to use when listing, selling, and closing a sale. I also read a lot of books about selling from my local library. Gradually, I began to appreciate the skill and craft employed by a good real estate salesman. My attitude changed. I started viewing sales as a challenge to my personal development and my attitude turned from reticence to eagerness to learn new skills.
While I was learning sales skills, I used what experience and ability I already had to begin listing properties for sale. Listing was the key to being able to earn commissions. My broker motivated me by informing me that once a good listing is placed into the Multiple Listing Service, all the other salesmen in town work to sell it. All a lister had to do was to find people who wanted to sell their homes, and fill out a listing contract. This didn't seem to be too hard for a beginner. The only problem I had to overcome was to find people who wanted to sell their homes. My broker took me out one afternoon and showed me how to go down a street where there had been recent sales and knock on doors to solicit listing. All I had to do was show owners how much they could make. From then on I was on my own.
The first thing I noticed was that I had very little competition. Very few experienced real estate salespeople ever go door to door to solicit listings; instead, they rely upon the home-seller to call them. Or they send out cards and letters soliciting business. I couldn't afford mailing costs and I didn't want to wait until someone decided to call me. I wanted to make it as easy as possible for a home-owner to decide to sell, and when they made that decision, I wanted to be standing right in front of them. Walking neighborhoods also gave me a chance to look at every house and to learn something about the people who lived there. I also made it a point to leave my card and to jot down personal information on 3X5 index cards to refer to if I had any future contact with them.
AGENTS WORK FOR TIPS, OWNERS WORK FOR PROFIT . . .
After a couple years of apprenticeship and training — during which time I learned how to sell, exchange, and to manage property — I bought a building, formed an S-corporation, and opened my own real estate brokerage. My business plan was (and remains) simple: No employees and no inventory. I only let one salesman at a time work out of my office, and that person had to have already passed their brokerage test and opted not to open an office. This way I avoided training expense and turnover; and I kept a higher percentage of the fees that the company earned.
I reasoned that buying my own office building would project to the public that I had confidence in myself and in real estate investment itself. I held an open house for homeowners in the surrounding neighborhoods and passed out brochures telling them how my business could serve their needs as a broker, manager, lender, and/or consultant. I leased unused portions of my building to high-traffic businesses for enough rent to pay all my office overhead and mortgage payments. I became a free notary for anybody who needed one. In 1973, years before the public was buying houses for long term investment, I even offered a one-night course on investing in houses. This was an inexpensive way to generate both future customers and good will. This built income and business, but something was missing:
As I began to work with more real estate investors, I found myself earning more fees representing and negotiating for buyers than for sellers. Bear in mind that this was the mid 1970s when buyer's brokerage was considered heresy in real estate circles. I began to understand how investors looked at houses from an income point of view. As I bought highly leveraged houses for investors, and later sold them for huge profits, I realized that investors were making far more money from buying houses than I was. I was earning 10% fees as a buyer's-broker. That's less than a waiter's tip. I decided to find a way to become an investor too.
In a rising market, as we had both then and now, more money is made by high leverage than any other thing. The only problem is that high leverage carries with it high mortgage payments that create negative cash flow. I had to find a way to buy houses without using much money at all, and at the same time, avoid negative cash flow. I had been tying up houses for investors by signing a purchase contract in my own name that more or less said I didn't have to close the sale if the investor didn't like the deal I'd made. This is called a contingent contract. It differs from an Option because the earnest money deposit is returned if any of the contingencies aren't removed. My contingency was that my investor had to agree to the contract price and terms. If he didn't I'd get my earnest money back.
An Option works about the same way, with just a few differences: Since it is a purchased legal right to an interest in real estate, money paid is not given back if the transaction isn't closed. Since it isn't certain whether or not a sale will take place, money paid for the Option is tax-free until the deal either closes or fails to close. Because Option money is given directly to the seller where earnest money is usually held in escrow until settlement, I discovered that sellers preferred selling me an Option rather than signing a contingent contract. The Option “strike price” was a net figure that represented their equity after the mortgage balance was subtracted from the price I negotiated. I set my goals to be able to buy their house at 80% of fair market value within 6 months. This may not seem possible in today's hot markets, but recently I witnessed a nice $169,900 home in ready-to-sell condition being bought for $115,000 because the seller was anxious.
Once price and terms had been set, I found, to my amazement, that I could tie a house up for 6 months with only $100. This was because, as I explained to owners, with a 6-month listing, they only got a scrap of paper and a promise that the lister would try to sell their house. With an Option, I was betting $100 on myself to be able to sell their house. With the purchase of an option to buy at about 80% of FMV, I had a potential highly leveraged built in profit with no negative cash flow and no management responsibilities. In all the years since then, I've never found a better way to buy, fix, and sell houses.
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LEASING GETS YOUR FOOT IN THE DOOR . . .
What I’ve described in the foregoing passages is how I used short-term Options to control properties until I could find a buyer for them. A variation on this theme was to wholesale my Option contract to another salesman for a quick cash profit. For example, if I could buy a house for 80% of market value, sometimes I’d sell my Option contract to an entrepreneur for 90% of market value and take my 10% out in cash right away. I did this anytime that I needed immediate cash more than I needed long term profit, even though it meant giving up a lot of money. I was paid for my ability to find motivated owners and to tie up the property for 20% under fair market value. The other party earned his 10% profit – plus any appreciation or increase in value that he could create through improvements – when he sold the property at 100% of FMV retail to an owner-occupant.
When I sold a house myself, I grossed almost 14 times as much as I would have with a conventional listing arrangement. In most markets, selling and listing brokers divide the fees 50/50 and each broker re-divides it again with salespeople; so they each receive about 25% of the 6% fee, or 1.5%. They’ll each get about $3000 on the sale of a $200,000 house. If I Optioned the same house for $160,000 and sold it for $200,000, my gross profit would have been $40,000. Even if I divided the profit by selling my contract first, I’d still have wound up with $20,000. I could make man times more money than a listing salesman or broker would be paid.
Most homeowners sell houses because their plans require it, not just to make a profit. When sellers must move, they don’t like to make payments on a vacant house in addition to paying for quarters elsewhere. That’s an opening for entrepreneurs who don’t need immediate cash flow and who are willing to manage tenants. When markets slow down, fewer people are willing to buy houses and more people are willing to sell options, but more time elapses between sales. One way to offset this is to buy more Options on more houses and wait for the sellers. Another approach is to buy longer term Options and to combine them with cash flow leases.
While Options can control both loan pay-down and appreciation, leases can control use and possession of a property as they build equity. Owners of vacant houses are susceptible to lease-offers for a simple reason: Rents paid to the owner offset his mortgage and operating expenses. In return for “free” management, the entrepreneur gets a purchase option in addition to a credit toward the Option price for each rent payment paid to the owner. Over time, rents can be gradually raised.
When a fixed-rate lease is in place, increases in net rents accrue to the entrepreneur; thus, without any cash investment at all, a person can control both price appreciation and rising income. Those who are willing, able, and ready to manage houses have virtually no limit as to the numbers of houses they can control through leases and Options. Over time, this can create a fortune as well as providing a comfortable life style funded entirely by rents.
Another aspect of leasing eludes many of those who fix-up houses; it enables a person to stretch cash so as to make extra profits each year. Suppose you had $100,000 in cash or credit that enabled you to buy, fix up, and sell a house every four months. If you made a $25,000 net profit with each round trip, you’d earn $100,000 per year. Let’s say that you could lease/Option a house at the same as you might have paid to buy it. Most of your money could be used to fix up houses rather than to buy them. Having the full $100,000 working solely on fixing up houses would enable you to do more each year. If you could fix up and sell just two extra houses per year, your annual gross income would increase by another $50,000.
Sometimes management can also provide lodging. For ten years one retiree worked as an unpaid caretaker for ten fully furnished Florida houses owned by a Chicago corporation for its use during the winter months. Our hero had his choice of any of the houses to live in. His arrangement also allowed him to rent the others for 9 months out of the year. Over the three months of winter, when the corporation needed the houses, he rented a furnished mobile home that I owned.
LONG TERM LEASE/OPTIONS CREATE FORTUNES . . .
Most of us have been enjoying a wonderful ride with appreciating houses for almost a decade, but now things seems to be leveling out. In some areas of the country they’re already looking back with nostalgia at how fast fortunes could be created during the magical decade of low inflation and low interest rates. Now, as seasoning restrictions are being applied by more lenders and speculators are being trapped in properties they can’t sell, the paradigm is shifting from short term profits to long term profits. We need to re-calibrate our strategies to keep pace.
The bad news is that houses will be harder to finance and that they won’t sell as swiftly for as much profit. The good news is that a buyers’ market will prevail. As a result, sellers will be more motivated to accept unconventional financing, and houses will be easier to buy. When a house is held long enough for the business cycle to run its course, part of the time wealth will be created as a result of inflation, It drives up leveraged equity over fixed rate loans whose interest rates are below the inflation rate. At other times, inflation will be negligible, but equity will continue to grow because of loan amortization. The key to winding up on top of the financial heap in both situations is to hold houses for longer periods. This is where long term leases and options shine.
Today, as sales dry up, short-term speculators are taking a huge bath. The next in this line of financial dominos getting set to tumble are highly leveraged builders. One wag said that a builder is a person who files bankruptcy every seven years. This looks like the 7th year! When builders and developers fail, they leave all their troubles with the banks that loaned them money. If the 1970s and 1980s are valid predictors, the banks are next in line for forced liquidations as their reserves are shriveled by defaulted loans. Government will rush in to protect money-center banks, but smaller banks and mortgage companies will have to shift for themselves. When this scenario unfolds, it won’t be a pretty sight, but it’s rife with potential profit for those who want to use leases and Options to build their portfolios.
Institutional lenders who take back too many houses through foreclosure or mortgage insurance companies that guarantee their loans – comprise a lease/Option target that is often missed when sales slow and lender repossessions are on the rise. Very few lenders are equipped by training or temperament to be landlords. They ignore vacant houses they have taken back, allowing them to slowly deteriorate for months, and sometimes years. They are usually amenable to leasing these houses at rates, which will enable an entrepreneur to generate cash flow by sub-leasing them to occupants. HUD in the past has paid a couple of Commonwealth Letter subscribers management fees to manage hundreds of vacant possessions, even though they weren’t rented. This created income, but no equity.
My favorite poster boy for lease/Option techniques was mentioned in the very first edition of this letter. He created a significant net worth solely by getting investors to put up the money for the down payments on “subject to” houses. He then leased these houses to occupants. He didn’t charge management fees but used all net income to pay them off. He gets half the cash flow from about 80 free and clear houses, plus half of the eventual millions of dollars in long term profit when they’re sold. All he did was to trade management skills for an Option.
One last point: An ideal investor in Options is a Roth IRA or any other kind of tax-free entity looking for long term growth. Debt-leveraged investment can be considered to generate taxable Unrelated Business Income, but an Option creates a highly leveraged position without any debt. When it is structured to capture both amortization and appreciation, so long as the loan isn’t defaulted, it can’t fail to compound its value each year regardless of the business cycle. An IRA could easily step in and provide supplementary funding to a distressed investor in return for half of the eventual sale proceeds in excess of the mortgage balance.
Among the possibilities presented in this month’s letter, do any fit you?
