The five most important words in any real estate transactions are WHAT'S IN IT FOR ME?
What are some of the advantages to using Options? Of course specific benefits will vary according to the individual needs of the parties, but we can make some general statements with regard to Options that might apply to everyone at one time or another. Let's start with LEVERAGE.
Leverage usually relates to the employment of assets belonging to someone else to amplify investment results. OPM! Without leverage it's doubtful that any of the major fortunes of the world would ever have been started. Certainly in our world of today, there would be little chance for. someone to pyramid equities without the use of leverage. But leverage has a serious drawback. It cuts both ways.
To illustrate this, suppose you borrowed $300,000 with which to buy a house. If you were an investor, today the lender might expect you to put at least $15,000 of your own money up as a down payment. Without regard to any interest or cash flow (it would almost surely be negative with that much leverage), you'd have arranged to control $315,000 in assets with only a $15,000 investment. Now your fate is in the hands of the Gods and the United States Congress, the court system, the Federal Reserve, the Economy, Rent Control and Tenant's Rights advocates, your fellow entrepreneurs and major demographic trends. The interaction between all these market forces will either drive the value of your property up or downward. Let's look at the results of both swings.
Suppose you enjoyed a 10% per year increase in prices for 7.2 years and then were able to sell out for all cash, take your profit and run? In that time a compound rate of return of 10% per year would double the price of the property to $630,000. Since you would have paid $315,000 for the house, you'd have received a 100% return on your investment over the 7.2 years, correct? NO!
You'd have received a 2100% return over the period. Keep in mind that you only invested $15,000 of your own money. Assuming that cash flow was neutral, the rest of the investment was from BORROWED funds. Is this a typical real estate return? Yes, when prices are going up. As a practical matter, many of the smaller houses bought in the United States over the past 40 years were financed with LESS THAN DOWN PAYMENT. Added to this, in the past few years prices rose by as much as 30% in really “hot” areas. Where leverage was used extensively, real estate fortunes were made; and lost when the market imploded.
In California, Florida, and Nevada from 2002 until 2005, speculators rushed into the markets to join in the orgy of highly leveraged estate pyramiding. Loans were piled upon loans as leverage became the secret to growing millions of dollars of accumulated real estate equity. There was no tomorrow. Everyone would become millionaires.
It didn't matter that speculators were paying too much for properties with too much leverage to make any sense so long as the rate of appreciation remained higher than the costs of financing. But it didn't! Like an over-inflated balloon, suddenly all the air went out of the market and real estate sales slowed to a stop. Reverse Amortization Loans, indexed loans, and balloon Notes came due and millions of properties were foreclosed. Public confidence in automatic profits ebbed. Speculators – especially builders of new homes — tried to get out of the market by slashing their prices. This put a damper on the existing home market. For many leveraged investors, interest was costing more than price increases were offsetting. The leverage sword began to cut the other way.
When prices were going up in the preceding illustration, an increase of only a little under 4.9% in the purchase price doubled the return to the investor. But note, when prices started going down a similar percentage DROP in price WIPED OUT THE SPECULATOR'S EQUITY. Any further drop would leave him owing more for the property than is worth. When this happened in 2006 and 2007, thousands of would be entrepreneurs defaulted on loans and were foreclosed, or filed for protection under the Bankruptcy laws, losing the product of years of prior investing and speculation.
Options would have prevented this loss had they been used to obtain leverage instead of multi-level debt financing. Take the same $315,000 house is the earlier illustration. Suppose instead of arranging for financing the speculator had offered the owner $15,000 for an Option for 7 years. At the end of that time the balance of $305,000 would be paid.
For the moment, disregard whether or not this would have been attractive to the owner and concentrate on the mathematics of the situation. The investment results would have been precisely the same whether prices went up or went down just as if the property had been leveraged through conventional financing options. But there would have been a completely different result with regard to the total investment portfolio had there been many such leveraged properties in a single portfolio.
For example, suppose the same person had purchased 20 such properties that subsequently fell in value by 20%. Assuming that there had been full personal liability for the loans, that decline in value would have left the speculator with a NEGATIVE EQUITY of $1,260,000 or so for which he would have paid $300,000 at time of purchase. If he found it impossible to continue to hold the properties because of the continuing drain of negative cash flows and the non-availability of additional financing, he'd not only lose them, but would be fully liable for the $1,260,000 of loans in excess of what they might have brought at foreclosure sales. In California, because of a special State law, he’d have been able to walk away unscathed, but in all other States, he'd have to repay this prior to being able to start to rebuild his portfolio. Or he'd have to file for Bankruptcy protection as so many people have done over the past few years.
Under the same set of circumstances, the holder of an Option on those properties might well have had the ability to hang on until prices improved. Because he wouldn't have used costly financing, there would have been little duress or incentive to let the property go until the Option expired; which might have been after market values had bounced back. If the decision were made to abandon the Option, he'd have had no personal liability on the contract to complete it and at least the $1,260,000 of negative equity would never have been a liability that he would have been obligated to repay out of savings and future earnings. There certainly would have been no reason to file for Bankruptcy.
Anytime that there is an opportunity for profit, there's a corresponding risk. The strategy that successful investors employ seeks to reduce that risk at every turn while maximizing return. No investment tools do this as well as Options. Very few do it as poorly as expensive, multi-layered institutional financing plans which call for indexed interest, short term repayment periods and restricted transfers of the property from one party to another.
