February 1992
Vol 15 No 4
The only proof you have that you own property is a recorded deed – a piece of paper! The only evidence that someone owes you money is a Note secured by recorded mortgage – another piece of paper! The only thing you have to show for bank deposits, stocks and bonds are more little pieces of paper! Why spend so much time belaboring the point? To fix in your mind that real estate assets are INTANGIBLE even though they seem to be TANGIBLE. Without our system of law which recognizes those little pieces of paper that denote your ownership, you’d own nothing.
We can see that today in the breakup of the USSR. They’ve had no such system of law for 70 years. There’s no way for anyone to buy or sell any property with any assurance that the sale will be bonafide and the conveyance protected by law. Thus, once you’ve accepted the fragility of real estate title, you may be much more at ease learning how to make money dealing with two of the most productive of all the intangibles: Leases and Options. Let’s take a closer look.
The Lease primarily controls cash flow, possession and use of a property. It’s a contract which, when recorded, acts like a mortgage in that it’s a claim on title. The longer that a lease lasts, the more it begins to resemble real estate. When we define fee simple title to real estate as the entire bundle of rights that accompany ownership, we can see that a 99-year leasehold would be salable, rent-able, develop-able, and mortgage-able, it could be exchanged tax free, and the leasehold would exceed most life spans. Indeed, the IRC treats any lease of 30 years or longer as if it were real estate instead of merely an agreement between the lessee and lessor.
Suppose you had a long term lease with several Options to extend under fixed rental terms. The US Postal System has many of these. So do major retailers and industrial companies. As inflation and demand cause rents to rise, you’d be realizing an increasing spread in your net rental income. In short, you’d be getting inflation protection – something that other kinds of ‘paper’ such as conventional mortgages can’t provide. Considering this growing lease income stream as an investment, you can see that, as the lease term goes up, so does the value of it. Thus you’d theoretically be able to sell your leasehold position to an investor – or to a user – at a higher and higher price which represented the present value of your appreciating income stream.
Conversely, an Option is not a lien on real estate title but rather a right to buy, sell, exchange or lease. Unlike a lease, which takes precedence chronologically in order of filing, an Option is always subordinate to a lien, so it’s prudent to secure title with a recorded mortgage. Alternatively, title to the optioned property could be conveyed into the hands of a third party Trustee in order to protect it against subsequent liens, title clouds or conveyances. Nonetheless, when an Option is recorded against a property, any subsequent title transfer is subject to the optionee’s rights.
A ‘CALL’ Option can control equity growth through appreciation and through loan amortization. A ‘PUT’ Option can hedge against a downturn in property value in much the same way as ‘selling short’ hedges stock values. Because the optionee always has the right NOT to exercise his Option, he can obtain maximum leverage to harvest an upswing, but risks only the amount paid for the Option on collapsing prices.
In most instances Options aren’t mortgaged, therefore, they can be used to control much larger properties and expensive single family houses that would otherwise require the investor to feed high negative cash flows. They enable one to invest in markets situated at considerable distances without the problems associated with remote management. And at the same time, they can generate more profit for owner or tenant.
An Option can transfer profit to either optionor or optionee through its structuring of PRICE, TIMING, CONSIDERATION, FINANCIAL TERMS and TAX BENEFITS. Optioning the EQUITY transfers loan amortization to the optionee while an Option at a set PRICE gives it to the optionor. Thus, an Option primarily controls gain, tax benefits, leverage and amortization when used in a transaction – subject always to agreement of the parties.
Combining Leases with Options gives us the best of all possible worlds. When we array benefits each can control, we see Leases providing CASH FLOW, MANAGEMENT and POSSESSION while Options control GAIN and AMORTIZATION. Together they are a formidable structure for generating TAX BENEFITS and low risk LEVERAGE while acting as a double edged economic HEDGE. In view of the fact that Lease/Option advantages to the buyer are so obvious. Why would any seller agree to let a buyer have one?
There can be considerable subtlety when it comes to the motives of a seller. First, a rental’s appeal can be enhanced by adding a right to buy. Additional, higher rents and Option consideration paid by a tenant can save a landlord from financial ruin. Tenants can be motivated to perform repairs and/or make capital improvements as a condition of the Lease/Option. Management effort can be significantly reduced. An adroit seller can negotiate the terms of a Lease/Option to either motivate a tenant to buy the property earlier or later to fit into the seller’s tax strategy.
Terms can be set so there’s little chance that a tenant will exercise the Option at all. Sometimes a tenant will accept a property which is only marginally livable and do all the necessary fix-up to bring it up to code in expectation that he will be able to buy the property with sweat equity. In so doing, he saves the owner the expense of vacancy, repair, financing and sales commissions.
Most people are happy to let someone else do the dirty work. An owner of property with management intensive low income units can panic at the loss of a manager. He’s only too happy to offer the property with a Lease/option. The same holds true for the owner who is confronting major repairs beyond his financial capacity. He’s eager to let someone else shell out the cash he needs in return for an Option.
Let’s not overlook ways Options can generate sales. Many sellers just don’t want to spend the money for rehabilitation and modernization, landscaping and appliances that’s required to sell a property. Sometimes disenchanted sellers with expired listings don’t want to re-list with real estate agents. The Lease/Option is an easy way out for them. Lease/Options can be used to generate rents while having a paying caretaker work for free. When money is tight, the Lease/Option is an excellent way to allow a buyer to occupy an expensive residence or one with extensive fragile landscaping and high maintenance requirements pending availability of financing.
Lastly, a Lease/Option can be structured as a tax and timing device which effectively can match losses to gains by trading low lease payments with a high price to produce capital gains rather than rental income, or high rents with a low price to produce net passive income sheltered by losses from other negative cash flow properties. Lease/Options can delay sales until a later tax year or until a person is over 55. Or they can delay an Exchange until suitable replacements have been located rather than taking a chance on iffy IRS delayed Exchange regulations or fly-by-night ‘facilitators’.
By enumerating the various benefits for both buyer and seller, I think we’ve pretty much described the potential players in terms of the problems and opportunities they confront. Where do we find sellers? Everywhere! In the ‘for rent’ columns. ‘For Sale ads and signs. ‘Loans Wanted’ and ‘Personals’ columns. FSBO's. Expired listings. Investment clubs. Exchange marketing meetings. ‘Fall Through’ records at loan companies and Realty Boards. Owners of resort and vacation properties as well as low income multifamily units in high crime areas. Any property that’s been vacant a long time. Charitable organizations that have been gifted real estate without management. Owners who are ill, disable or needing to wind up an estate. Executors. Trustees.
Out-of-area investors who employ rental management firms are a good source because their leasing agents can be a mother lode of opportunity for the buyer seeking Lease/Options and trying to fill them with tenants. Leasing companies accumulate rental histories of many properties in area. They know the names and addresses of out of state owners. They know occupancy and vacancy rates, repair and capital improvement histories, equipment replacement dates, and most importantly, they are the first to know when an owner is ready to get out of the landlord business and is ripe for a Lease/Option offer. Establishing a working arrangement with them is a good idea.
From the start, it’s important to convince the leasing agent that you will be listing all properties you purchase or lease with his company. Let’s face it. He needs job security too. Ask him to send each owner a form letter any time that the rental agent must contact him or her for additional funds to offset a vacancy or a repair expense. This form letter will state that you, an investor are interested in leasing the property on a NET basis, slightly below prevailing market rates. Your letter might also offer to take care of ALL maintenance and vacancy expense in return for a credit of a portion of the rental to be applied toward the purchase price in the event you decide to buy at a later time during the lease period. So much for sellers.
Who are buyers looking for Lease/Options? Everybody with a TV hooked up to late night cable GET-RICH-QUICK-GURUS who’ve been brainwashed to buy with ‘nothing down’. Every would-be pyramider is looking for houses he can buy with a Lease/Option. People who would like to ‘try out’ the neighborhood, school system and job market are naturals. Those people who aren’t ready to make a commitment on a personal loan, but who want to freeze the price, will like a fixed price and/or fixed rent Lease/Option.
Managers are logical Option seekers. They see investors making millions off their management efforts and eventually they decide to get into the game themselves. Young people without any assets are previous credit history have very few ways to get into a home unless they use a Lease/Option. And those who’ve managed to ruin their credit ratings must also use this approach. High flyers who want to live in an expensive house without having to make big payments are willing candidates. Low flyers who want to build equity out of their rent payments while they wait for interest rates to drop. People in a cash flow squeeze who want to prevent the landlord’s selling their home out from under them. YOU! ME! EVERYONE I know would like to buy using a Lease/Option approach.
Alright already. So we’re all convinced that there are possibilities on each side of the market. What should we do about it? If you’re a seller, you might do what one real estate company did to boost both sales and rentals. They advertised to prospective renters, and wrote letters to existing tenants saying that there would be a 10% credit from the first day’s rental payment on the purchase of ANY HOUSE LISTED IN THE MULTIPLE LISTING SERVICE whether they owned it or not. Let’s look at the arithmetic:
Suppose there was a 6% commission payable on the sale of any house listed by the broker involved, or 3% for any house he sold, but listed by another broker in MLS. And let’s say we’re talking about a $100,000 house. A sale would generate $3000 to $6000. Now, suppose that same house rented for $750 per month – $75 of which was to be credited toward a purchase. It would require 6 years of rental accumulations in order for the tenant to acquire even 5% of the purchase price. And the broker will earn most of that back in commissions on the sale if he doesn’t sell his own property.
The terms of the rebate credit agreement were that all credits were extinguished anytime that a tenant left the premises for any reason, whether voluntarily or because of a default on the lease leading to eviction. Each month a statement was sent to the tenants showing their accumulated credit. This motivated them to continue to remain year after year despite rent increases. And it enabled the company to attract stable, high quality tenants from other landlords who could meet above market rental rates.
HOW DO YOU GET THE SELLER TO GIVE YOU A LEASE OPTION?
Suppose you are the tenant who wants to motivate the owner to give you a Lease/Option; what inducements can you offer? Put yourself into his shoes. Every landlord wants tenants who pay on time as agreed, do all the repairs, never call to complain about anything, and never move out even when the rent is raised. So you should offer to do things which respond to these innate landlord fantasies. Some of these might include the following:
1. Prepay rents 3, 6, 9, 12, 60 months in advance in return for an Option with part of the rents to apply toward the purchase price. Long term tenants are like money in the bank to a landlord. And advance payment assures no credit or collection problems in this recession environment. Almost irresistible. You’ll be the only game in town.
2. Prepayment could do the job, or it might be combined with an agreement to perform any cleanup or fix-up the property might need to put it into condition to rent. And all future repairs up to a set dollar value could also be your responsibility with a corresponding offset in the rents, deposits or Option price. Of course, your Option might be leveraged to include additional properties which are causing problems for the owner in return for your solving all maintenance and/or management problems.
3. You might offer income-short owners a substantial upfront cash payment in return for an Option. That might cure a serious need for cash. Or you could agree to pay higher-than-market rents which would solve cash flow problems in exchange for extra high credits toward the Option strike price. (i.e. for every dollar of rent, $2 would apply toward the purchase price and down payment.)
4. You can always throw in other property that the owner WON’T afford to buy as Option consideration such as special tools and equipment, a vehicle, toys such as boats and RVs, Time Shares, vacant lots, etc. This not only buys you an Option, but it also disposes of the property at what’s effectively a retail price.
OPTIONS AND LEASE TECHNIQUES ARE ONLY LIMITED BY YOUR IMAGINATION . . .
Over the past several decades I’ve used Options and Leases to buy and sell properties, balance equities in Section 1031 Exchanges, to free properties of debt without using cash by substituting an Option for the loan. I’ve used them to create financial structures which generated tax write-offs for both buyer and seller. They’ve been a part of my asset protection program and estate planning. I’ve used them to motivate tenants and to compensate repairmen. They can help you get around the Due-On-Sale clause and to get assets out of bankruptcy. Once you get into the myriad applications of Options you’ll wonder why you use anything else. And remember, they’re invisible, cheap, simple intangible rights which can become part of every transaction you engineer.
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