Woody's daughter wanted to go into business, so he bought a large house and converted it into funky retail space. The problem was that neither the public – nor after a short time his daughter – was much interested in funky retail merchandise. So the store stayed empty and abandoned for 4 years.
Jeff has a different idea. Funky office space might succeed where funky retail fails. Jeff convinces Woody that there's little risk in taking a chance on his own vision of the future when the building has sat idle for four years, Woody agrees and they structure the following transaction:
Jeff will lease the building for 2 years at $300 per month, but he won't pay anything to Woody. He'll use the money to convert the retail space to office space, install necessary lighting, landscaping, paving, carpeting, paneling, etc. At the end of that time, Jeff has an Option to buy the building for $60,000 with all of the $7200 in improvements credited against the down payment of $15,000. Woody carries back a $45,000, 8% mortgage with payments of $330.19 per month principal and interest.
In order to secure Woody, they agree that he has the right to monitor the improvements to assure that Jeff is actually making the changes agreed upon. These are made a part of the Lease terms, spelled out on a month-to-month work progress chart. After 2 years, Jeff will get credit for his $7200 costs as a down payment. He'll complete his purchase at the original price they agreed on. Jeff keeps all income from any sub-leased space he manages to rent over the interim 24 month period.
Everything goes as planned. At the end of 2 years, Jeff's net rental income is now $900 per month from small offices he rents. With payments of about $500 per month once taxes and insurance are added to his payment to Woody, Jeff is making $4800 per year in net rental cash flows on his investment of $15,000. That boils down to a 32% yield on the same equity that Woody is only earning 8% on. That's four times as much return as Woody is getting.
