Check out almost every publication that deals with creative real estate and you'll see myriad approaches to acquisition of properties using both conventional and private financing. Erudite newsletters for many years have dealt with sophisticated strategies for slicing and dicing mortgage instruments and notes to create amazing rates of return. Investors have become fairly sophisticated when it comes to mortgages. Most have a working knowledge of hand-held calculators that can calculate precise rates of return on their investments. But these same people are lost when asked to explain about Leases, or how they can be created and employed to build cash flow and profits. This month, we'll see if we can remedy this.
Let's start with the basics. There are basically three ways in which real estate equity can be made to produce cash flow. The most used cash-generator is sales. That probably surprised you; but when you compare the huge sums of money that change hands annually as a result of new and used real estate transactions, sale proceeds dwarf the other two techniques for converting equity to cash. As a result of the 1986 tax act which penalized capital gains for a decade with high tax rates, borrowing against equities, especially home equities, is another common device for converting real estate appreciation and loan amortization to cash. The third way to create cash flow from equity is through Leases that generate net rents.
Unlike the first two methods, Leasing doesn't require either the loss of possession upon sale, or the risk of debt following borrowing that the other two techniques result in. On the other hand, in the process of conveying to a Lessee the 'quiet possession' of the premises, a Lease does deprive the Lessor of the personal use of his property during the Lease period. Because this letter is dedicated primarily to the single family home owner, entrepreneur, and investor; I'll try to confine my remarks to the application of Leases to residences. Still, even within those narrow limits, there are many ways Leases can be used to build financial independence and security, both from the standpoint of the owner and of the would-be real estate opportunist.
We all know about short term residential leases that our tenants sign. Every year laws and requirements change the duties that landlords owe to tenants; thus over the years, including all the disclaimers and documentation of everyone's rights, my single family house Lease has grown to 16 pages with a 3 page abstract of 'DOs' and 'DON'Ts' plus 6 pages of attachments. This is included in the 'Management Masters' collection of some 400 pages that we sell for $99. It can be ordered by calling toll-free to (888)282-1882. This may seem like over-kill, but it's by no means a record. I've seen a 7/11 store Lease that is over 200 pages long.
Let's talk the length of Leases: The term of what constitutes a Lease is usually set by State law. Usually, when a rental contract extends a year or so, regardless what the instrument is called, most States would deem it to be a Lease. Nonetheless, rental terms can extend from a few hours for things such as meeting rooms to land leases of many hundreds of years. By creating long leases at attractive rates and then subdividing his Lease rights then Leasing all of a portion of these to others, it's possible for a person to create an income stream for years.
When a tenant wants to offset high rents, without specific prohibitions in the Lease, he can sub-Lease all or part of the property to an additional tenant for any term up to the expiration of his own rental agreement. By creating a 'spread' between the rent he pays and the rent he collects, he can build in a cash flow income akin to that created with a 'wrap-around' Note. Or, he can sometimes simply 'sell' his Lease for a cash fee by assigning all his rights under it.