How can we avoid taking risks that the owner will fail to pay his underlying loan obligations? Let’s start with the obvious. Option those houses that are free and clear! It amazes me that would be entrepreneurs flock to the newer properties upon the advice of a variety of gurus who don’t understand risk. Aren’t new houses usually leveraged to the hilt either by the builder or the first owner?
Don’t they have loans which reflect all the evils of current high interest rates and variable rate mortgages? Aren’t the owners locked in to high payments far above the range of comparable rents? Aren’t they already beset by hoards of graduates of recent investment courses who think new houses mean low maintenance and assumable equities? There are few exceptions to the rule that misery loves company.
The preoccupation of neophyte investors with new properties offers unparalleled opportunities for those investors who can home in on the older free and clear or low, assumable, safe loans which can provide built in cash flows. Because of the necessity to buy with nothing down, few of the new arrivals to the real estate scene envision being able to control those large equities without much cash because the focus on OWNERSHIP versus CONTROL OF CASH FLOW AND GAIN. You do not need to OWN a property to make a profit!
Let’s continue looking at a $160,000 house. If it were free and clear of all debt, what are the cash flow needs of the owners relative to the house? Zero! What they WANT may be quite a different matter, but what they NEED is zero.
Armed with that fact, and in possession of the insight that most of the free and clear houses are owned by middle class people who simply paid them off, you won’t be dealing with affluent people accustomed to having thousands of dollars lying around.
Indeed, they’ d be the first to rush to the bank and to deposit it in an account paying about 5X interest or so. They need to KNOW that their assets are secure much more than they need the highest yield. If you don’t believe this, try to sell someone with a free and clear house on putting a mortgage against his home and buying gold shares from South Africa. Try it on your parents or grand parents and see how far you get. They want SAFETY versus YIELD. Actually, they want something in between which is reasonable:
Enter the lease/Option. If our $160,000 house owner wanted to move on to greener pastures and you were a solvent, respectable neat person who offered to pay him $9000 per year rent in advance for 5 years for an Option to buy his house, with the rent to count against the purchase price, he might want to do some negotiating, but in his mind your quiet little voice would be saying NO RISK. He couldn’t lose his assets! Like the sage once said, IT’S THE PRINCIPAL OF THE THING THAT COUNTS MOST.
Most of us don’t want a return ON our assets as badly as we want the return OF our assets. Because the title remains in the hands of the owner until he’s been paid off, he has little risk. If the leasee fails to pay rent, he has only to evict. That’s a simple prospect. And if the rent is paid annually in advance on a net lease, hasn’t the owner converted his equity into a cash flow without any effort at all and limited risk?
In a test tube environment, one might look at this as a technique workable only in a tight market where the owner has little chance to get a conventional sale, but this isn’t necessarily true. Most people want newer houses and they by pass houses between 20 and 30 years of age even in hot markets. An owner with a large equity might still have a difficult time getting his cash out of his house and when a person offers to lease it to provide cash flow income, it can still be attractive.
Another category of owner that is being ignored in the market is the person with a home between 10 and 20 years old who has a mortgage which carries an interest rate between 5% and 8%. Many of these are assumable, and the problem lies in the huge equity the owner has. He usually needs some cash in order to move on to greener pastures or another house. And because he still needs to make payments on the underlying loan on a monthly basis, he must have sufficient income on any transaction to pay that. But this is the key to making a deal with this type of owner.
I can think of one house in my area which fills the bill. It was built in 1958 and originally financed with an assumable FHA loan at 5 1/2%. It now has a loan balance of $9000 or so with PITI payments of $166 per month. It has a value of about $200,000 but its original cost was $14,500; financed with an FHA loan with less than $1000 down including closing costs.
From the owner’s point of view THIS IS THE TRUE VALUE. All the rest is due to inflation. Of course, he’s ready, willing and able to get all he can get, but his COST is what he’s got in the back of his mind. If we agreed to pay him $725 per month rent which is tantamount to receiving $800 per month gross rents before paying management fees and to secure our lease for 7 years; in his mind he’d be receiving $559 per month in pure profit without any effort at all. We’d be certain to point out that this boils down to a return of 46% per year on the original purchase price of the house, and a return of 671% on his down payment.
He’d be correct in that analysis. That would be a great return for him at no cost to us. We’d be getting the use of his equity without any interest cost at all over the first year. If we managed the property ourselves, we’d save the rental commission and our overall cost would be NEGATIVE; decreasing each time we raised the rent in the ensuing years. At the end of the 7 years, if we raised the $800 rent that we charged the occupant by 5% per year, and experienced a month of lost rents each year, we’d have made a spread between what we were paying out and taking in, and this would be increasing each year. Moreover, we could negotiate a credit toward the purchase price out of the rents too with a little more effort.
It shouldn’t be too hard to get an owner to give you a 30% credit toward the down payment and purchase price of a house which generates him that much cash flow each month; absolutely guaranteed without effort over a long period. Remember, he’s seeing cash flow that compares favorably with any pension payment he might anticipate. And he’s still got perfect security.
But what about you?
Anytime there’s an underlying loan or loans the Optionee is running a risk of losing everything because of default on the part of the seller. You’ve got the right to protect yourself against this, so you need to structure into your agreement that the owner will indemnify you against any such default whether it’s due to rain, hail storm, sleet or snow. How might he do this? He could place a note into escrow secured by another property. He could insure or bond against the eventuality, or he could allow you to make the payments out of the rent. This would be great, but it might jeopardize HIS security.
You might both agree to have a single bank collect your rent payments and to apply them against his payment and other expenses. Or you might place into the terms of your lease or Option that an adjustment in cash flow, time of exercise of the Option, price or terms would automatically take place anytime the owner failed to meet his obligations.
For example, suppose your lease stated that you would be responsible for making all payments and remitting the balance of the lease payment directly to the owner together with a monthly statement of disbursements, BUT that if the owner insisted an making the payments himself, after you sent him the rent , he’d agree to the following provisions to secure YOUR position:
1. Anytime he failed to make the payment on the underlying loan on time, he’d agree to extend your Option one month. His payment record would be the determining factor.
2. Anytime the loan payment were to remain unpaid for 30 days (a technical default on many notes) , you’d have the right to pay the mortgage yourself and to reduce the purchase price by an amount equal to 200% of that.
3. In the event the property should fall into foreclosure for any reason, you’d be given a Warranty Deed by the Owner and allowed to cure the default even if it meant refinancing the property. If such event, the owner’s equity would be represented by your personal unsecured Note payable in a single payment without interest at the end of the lease/Option period. And you’d be allowed to keep all the proceeds of the refinance.
4. The owner would be allowed to keep all proceeds of any insurance claim in the event your interests were not protected and the Option price would be reduced on a ratio of 125% of the amount received, or at his option, he could give all the proceeds to you for the purpose of restoring the premises to their original condition.
You can see that there are myriad ways in which the Optionee can not only protect himself, but also generate cash flow, profit, and a strong negotiating position in the future on the same property. But there are other hazards one must consider aside from payment of taxes, insurance, and loan payments. One must consider the owner’s having some sort of financing either as a primary loan or as an underlying loan contained in a wrap around loan which could also place the Optionee in jeopardy.
What should one do about this?
You could put language into your Option and Lease that made it the responsibility of the owner to pay all underlying loan payments as they fell due, whether they be balloon payments, demand notes, accelerated payments which fell due because of any default which may have occurred for any reason. Thus if a due-on-sale clause were to be called, it would be the seller’s responsibility rather than yours to refinance the property and to repay the loan.
Think about that for a moment. If he had to refinance the property, wouldn’t he need your permission. If the provisions of # 3 were to be implemented, you’d own the property outright albeit you’d need to get a new loan for the balance of the current loan. Of course, armed with a Warranty Deed as a foreclosure sale, you’d be entitled to any surplus cash bid in – and sometimes foreclosure sales attract very high prices.
Your owner would still be protected with his Note as provided for in paragraph #3. You’d get the cash.
There are many different ways to make structure a lease and/or an option.
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