Last time we talked about starting small by signing a long term lease on the property you're rent in exchange for an Option to purchase the property. If you've also negotiated an Option to buy with a credit for rents against the purchase price and down payment, you'll be building equity in the property with each payment that you or the person to whom you sub-lease or to whom assign your lease pays.
Your Option should be on a separate, recordable instrument for which you've paid a token sum. This might have been in lieu of your lease deposit. The owner will like it, since this will be outside the purview of any law that regulates deposits on leases. He'll be able to take it tax free and to spend it immediately.
By paying something for the Option, you'll have established a tax basis in the Option contract, which will allow you to take advantage of lower capital gains tax rates if and when you sell it. The key to Option profits lies in fixing the price at the time you negotiate for it. It's always nice to be able to get the full benefit of a fixed price Option, but there's nothing wrong with taking only a portion of any rise in market price, and sharing the balance with the owner. Half a loaf is better than none.
As the market price of the property rises and the loan is paid down, the profit in the Option will be a combination of these factors plus the amount of credit your lease payments would be given. But suppose you don't have the money or the credit rating to be able to get a loan in order to exercise the Option and to buy the property? You can shop for an investor to lend you the money, or for a speculator who will put up the money in return for a share of the profits.
SUB-LEASE THE HOUSE AND SELL THE OPTION!
It's important to bear in mind that you don't have to ever exercise the Option yourself. You can just sell it to someone who might want to buy the house, and get him to pay you the difference between the Option price and the Purchase price. Let's look at the numbers in an example to fix it in your mind.
YOUR LEASE: $500 per month. $100 counts toward price.
TERM: 1 year with an Option to extend 5 more times in
annual 1-year increments at the same price with the right to sub-lease and/or assign it.
After a couple of years, suppose you were to be able to sublease the property for $600. You'd be getting $100 profit each month and also getting $100 credit toward the Option price. If you took full advantage of the total 6 years of basic lease plus extensions, and received this $100 cash profit for 4 of them, this would give you $4800 plus $7200 in credit on the Option.
You might assign the balance of the Lease for the last 4 years to someone for $2500 if you chose to pass on the spread in rents to another tenant who saw the benefit of saving $2300 in rents over 4 years. In the meantime, he'd be paying rents that you'd be getting $100 credit on toward your Option.
OPTION PRICE: $500 down (in lieu of a lease deposit). Option strike price: $45,000 in cash at time of exercise anytime within the next 6 year period based upon $60,000 market value, and today's mortgage balance of $20,000. Whoa! That adds up to $5000 too much. That's right, but that little mix-up in arithmetic might motivate the owner to make the deal when he sees the $5000 extra profit.
Let's make an assumption that the property would appreciate at $1500 per year, or $9000 over the next 6 years. Furthermore, we'll say that the loan balance is reduced by $2000 over the same time. Here's what the deal would look like:
OPTION PRICE: $45,000 + $18,000 loan = $63,000.
LEASE CREDIT: ($7,200)
NET PRICE: $37,800 + $18,000 loan = $55,800
MARKET PRICE: $69,000.
PROFIT: $14,000.
The lease credit plus loan amortization and price increase has earned $14,000 to which any sub-lease might have added another $4,800. Without these, the starter would still be where he is today, but paying higher rents. A buyer could just hand the starter $14,000 and close on the Option without the starter having to come up with any cash at all. And, it's not unthinkable that he'd accept $10,000 for a quick profit if offered by the buyer. Who might that buyer be? Possibly the owner! Here's why:
THE OWNER MIGHT BE YOUR BEST SALE PROSPECT. . .
By having your lease and Option recorded in the public records, you will have clouded the title to the property, thereby limiting the things the owner can do with it. It will be much harder for him to refinance or to sell the house. Suppose he needs to repair the roof, furnace, air conditioner, etc. and has to put a home improvement loan on the house, you'd be asked to subordinate your lease and Option to the new loan.
This would not necessarily be in your best interests because it would put you at risk, and change all the arithmetic on your deal. You'd be perfectly within your rights to insist that the owner pay you a consideration for doing this, or to buy out the lease and/or Option. At this point, you'd have several alternatives to consider. You can barter for TIME, money and/or terms, or all three, on both the Lease and the Option.
For example, you could ask for another 3 years on the lease and on the Option, thereby adding to the cash flow spread on the rents and the profits on the Option. Or you could trade a shorter extension of the lease and Option for some cash from the loan. Or you might agree to a reduction of your rent to $400, giving you a $200 spread in lease cash flow if you were sub-leasing the property. What about getting $200 per month credit against the Option price retroactive to the start of the lease?
If the reason the owner must refinance the property is because of a need for cash, you might agree to convert your lease and Option into an equity position immediately after he places new financing on the property. This way, he can walk away with the cash, and you can make the payments as the new owner of the property simply by exercising your Option ahead of time, taking title subject to the new financing.
YOU AIN'T HEARD NOTHING YET . . .
We've just started on the first link in the food chain. We've barely mentioned investors, and we've still got speculators, finishers and managers to plug into our market scenario. We'll continue this series on for the next few weeks. It's up to you to identify yourself, your kids and your parents as we investigate the market functions each can perform so that everyone benefits.
As we progress, we'll always try to limit risk, secure invested capital and keep a weather eye out for the impact of taxes, governmental regulators, and the potential for predatory litigants who are always poised to pounce on the assets we gradually acquire. By the end of the year, hopefully, you should have a complete program outlined, which can serve as a springboard from which you can launch your own personalized approach to building net worth and income.
