In a way, an Option is more or less a bet between the Optionor (the person giving the Option) and the Optionee (the person acquiring the Option). In a typical situation, the Buyer pays the Seller for the right to buy a property at a price and under terms for a period which they can agree on.
Absent of personal or financial duress, with a Call Option, the Seller is accepting something of value from the Buyer because he or she feels that the market has peaked and an offer of a higher price during the term of the Option contract is unlikely. Conversely, the Buyer believes that the price will go up over the same period.
If the price does go down, the Buyer has the right to abandon the sums paid for the contract and to withdraw from the transaction. The Seller feels vindicated. The sum received from the Buyer for the Option compensates him to a certain extent for the failure of the property to continue to rise, or for any drop in market value which may have occurred.
Surely, there are as many variations on this theme as there are people in the market. Buyers and Sellers can each have different agendas. Seller/Optionors might need the cash paid for the Option consideration to pay off debts or to take advantage of other situations, or to hedge against market fluctuations. Under current IRC regulations, funds received for an Option are not taxed until the Option either expires or is abandoned. This is one way for a person to raise cash without borrowing or paying taxes on money realized from a sale until years later, regardless of capital gain.
On the other hand, the Optionee/Buyers can control expensive properties with only a fraction of their value while they round up financing, form a syndicate, get zoning and use changed to increase the property's value, hold a property off the market until they sell a competing property, assemble a large tract of land or hedge against inflationary forces which might wipe out a large portfolio of fixed rate mortgages or leases, etc.
One way in which an Option can capture EQUITY through AMORTIZATION lies in its terms. A simple Option might call for a set cash price. The Option contract might state that the consideration would apply to the down payment and purchase price. But it also might not apply to either if the parties specified this in the contract. There's a better way.
An Option might state that the price would be fixed at a certain point in time and that the full price would be paid then. Or it might state that only an amount equivalent to the difference between the Option price and the then existing loan balance need be paid for the property. This would give the seller the benefit of any loan amortization.
An Option might also state that a fixed sum would be paid upon exercise of the Option and title would be taken subject to the liens existing at the time the Option contract was exercised. These terms also would effectively transfer to the Buyer all the loan amortization paid for by the Seller at the term of the Option contract. This would give the Optionee a larger Equity than existed at the inception of the agreement at no cost. You can see that, a negotiation for TIME with this type Option yields as much as a negotiation for PRICE or TERMS once the Option is exercised.
It goes without saying that any fixed price or fixed sum of money to be paid with a fixed rate terms would transfer not only equity to the Buyer, but also any appreciation in the property. And under certain circumstances, it would also transfer tax benefits. How might this be accomplished?
Suppose a Seller needed money because corporate restructuring had caused his layoff. He doesn't want to move and he can't borrow against his large home equity because of his lack of income. The Buyer offers to buy his $250,000 house under an Option contract. Mr. Seller owes $100,000 against the property with payments of $1000 per month including principal, interest, taxes and insurance. He needs $1000 per month income to augment his severance pay and savings until he finds another job. He estimates this will be within the next year.
The Buyer makes the following proposition to the Seller. He'll buy an Option to purchase the property at a price of $75,000 over the mortgage at the end of that time, or whenever the owner moves out and the Buyer will take title subject to the then existing loan balance. The $75,000 will be payable at $1000 per month direct reduction INCLUDING interest at 10% for 75 more months following exercise of the Option.
For this Option, the Buyer will pay $2,000 per month for the next 2 years only. After that, he'll wait until the earlier of the date that the owner moves out or 5 more years, subject to renegotiation at that time in the event the owner desires to continue to occupy the property. Let's see what each has accomplished:
The Seller gets financial relief without the need to sell his property under distressed circumstances at a low price in his slow housing market. He doesn't have to confront all the problems of relocating his family just at the time he's undergoing considerable stress trying to find employment. His family doesn't have to reduce their standard of living. His kids can continue to attend the same schools.
He's getting $2000 per month for which no income taxes will be due, although this will be reflected in his selling price and may be taxed as capital gain or not later on. And, he'll receive another $1000 per month if he decides to relocate to another house or another area. He's got his house sold without having to chance the real estate market's continuing to go down.
The Buyer is buying a $250,000 house for something less than $200,000. He is spreading out his Option payment over 24 months without paying any interest. During the time period between the end of that period and the date of closing -which might be as long as 5 years or even more – he won't be paying any interest while the house continues to appreciate once the market comes back.
Once his payments start, interest is included in the $75,000 for the equity over the existing loan. Based upon a market interest rate of 8%, the present value of the money he's paying out would only amount to about $180,000 for a $250,000 house without regard to the interval between the time when the $2000 per month payment stopped and the $1000 per month payment started. This would depend upon whether the Seller moves or not.
And during this entire time, the underlying loan payments made by the Seller will be amortizing the debt on the property. His Option terms will capture this as written.
In the meantime, he's got no management or maintenance chores and he's got plenty of time to look around to decide whether to sell his Option after a year at lower capital gains rates or to hang on to it while the house appreciation and amortization continues to increase his Option equity.
This example points up one more point. Expensive houses rarely command sufficient rent to make their ownership worthwhile to an investor. In the Washington D.C. area they make more sense because government payrolls constantly push up housing demand and appreciation. This was also true in California for several decades. But without appreciation, it's difficult to justify the risk in buying this type of house. The foregoing example illustrates ways in which uneconomical rentals can make fine investments through the use of Option strategies.
Options also enable one to invest in areas at some distance from their normal sphere of investment or operations without concerning themselves with management problems or exposing themselves to local politics which might be arrayed against an outsider.
Options enable the buyer to leverage s portfolio of properties to an extent that would be impracticable using any other form of debt-based leverage. Finally, because of their nebulous nature, Options enable their holder to maintain an extremely low profile. They can't be seized nor are they subject to attachment of liens and judgments.
It's a mistake to automatically think of Options as being linked to Leases or vice versa even though, used in tandem, Lease/Options can give Buyers and Sellers the best of both worlds. Leases can control income and possession or use of a property. Options can control gain and Amortization. In combination they are construed as installment purchase contracts in many jurisdictions and in Internal Revenue Service rulings.
Thus, properties under long term lease Options confer EQUITABLE TITLE on Lessee/Optionees as well as the right to depreciate the property to shelter income. Like Jack Spratt and his wife, they lick the platter clean.
Both Lease and Option strategies separately can effectively use the equity of the Seller without paying market rates for it. In so many words, they enable the Lessee/Optionee to benefit from the Lessor/Optionor's equity and property ownership at very low cost, with high leverage, safely and simply. Their unique properties allow them to do this in combination with current laws. Here's a simple summary of how they control benefits:
|
SMITH: BUYS A RENTAL |
|
LEASE/OPTIONS A RENTAL |
|
$100,000 |
PRICE |
$100,000 |
|
5,000 |
CASH DOWN PAYMENT |
5,000 |
|
750 |
MARKET RENTS |
750 |
|
756.28 @ 10% |
PAYMENTS/LEASE |
600 |
|
125/MO EST |
TAXES & INSURANCE |
125/MO EST |
|
(232.55)* |
MONTHLY CASH FLOW |
(84.05)* |
|
2,909.09 |
DEPRECIATION |
2,909.09 |
|
8,672.89 |
INTEREST |
-0- |
|
934.79 |
15% BRACKET TAX SAVINGS |
691.36 |
|
500 |
EST. MAINTENANCE EXPENSE |
500 |
|
750 |
VACANCY/CREDIT LOSS |
600 |
|
900 |
MANAGEMENT COSTS |
900 |
|
402.51 |
ANNUAL LOAN REDUCTION |
600 |
|
95% |
LEVERAGE |
98% |
|
102,791** |
FIRST YEAR'S RISK** |
5,311.24 |
|
5,000 |
5% APPRECIATION |
5,000 |
|
5.3% |
1 YEAR TOTAL YIELD |
105% |
* Net cash flow numbers are arrived at by multiplying monthly rents by 12 to get annual income, then deducting payments, maintenance, management, vacancy and credit losses, taxes and insurance (when not part of the payment) and adding back in the net tax savings based upon a 15% tax bracket. This is then reconverted to monthly figures by dividing by 12. The example presumes that the Option and renewals are structured so as to capture all the amortization and tax benefits at the cost of bearing all risks of management, maintenance, vacancy and credit losses.
** Under cost recovery accounting theory, all positive cash flow reduces the investment while negative cash flow increases the invested amounts and risk of loss. The first year's total investment figures against which yield is measured is derived by adding all first year's net negative cash flow to the purchase price. Presuming that the above mortgage loan carves full personal liability risk, it plus first year negative cash flow is the cost basis for arriving at investment yield. Note that the Lease/Option doesn't carry this liability, yet the yield is 20 times as high on the same investment.
Learn more about OPTIONS from Jack Miller's Wealth Without Risks E-book e-book
