Options: Maximum Profits With Minimum Risks

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April  1995
Vol 18 No 8

Just twenty one years ago, I launched out on my personal odyssey to start making serious money by investing in real estate. Although I’d been licensed as a real estate residential salesman and broker and had bought and sold many lots and houses around the country over the years, I’d lost more than I’d made in the process. Why? I should have invested my capital in myself to learn all I could about real estate and finance before investing what little capital I had in property. Consequently, even after two decades of trying, success continued to elude my grasp time after time just when it seemed I had a sure thing.

I didn’t understand some fundamental rules of making money in the real estate business. These resemble those in a poker game.

1.    Winners rely less on luck to get winning cards/properties than on their ability to play and to win with whatever cards are dealt them.

2.    The best player holding the best cards/properties can’t win unless he also has enough money to ante up and raise his bet to protect his position on what he’s holding.

3.    Management skills can provide a real estate player, with only a few chips, the time to outlast competitors who are forced out because when they lose, they lose less.

4.    Players who risk the least with the most leverage on any one venture can play more hands. Ultimately they win more overall, because when they lose, they lose less.

My real financial turnaround came during an exercise at a seminar conducted by Warren Harding. I’d finally begun to start investing in myself by attending creative seminars given by successful people rather than by ‘speakers’ on the seminar circuit. Groups of us were given a hypothetical $50,000. A prize was awarded to the group able to pyramid this capital to the highest ‘paper’ profits. My group won the contest.

Later, Warren pointed out that only two things separated this exercise from similar real world financial success. These boiled down to the following:

(1) Our inability to borrow the necessary capital, or to create joint ventures with those who might provide it. And, even when we have the necessary financial backing,

(2) Unwillingness to place capital at risk because we don’t have enough confidence in our own ability to achieve success.

These are both self-imposed limitations that can be cured with education combined with implementation of what we learn. This concept triggered my own personal break-through.

I had a flash of inspiration. I realized that a single technique would eliminate the need for much capital and risk. Rather risking my meager resources on ownership of high risk, debt-leveraged, negative cash flow properties, I could use Options to acquire control of it without actual ownership. That same day I took a long lunch break and sought out the owner of an office building which had been standing vacant for a year, a victim of the OPEC recession. The next two hours changed my life.

I negotiated a two-year Option to buy the building ‘as is’ at the current value with 10% down, payable in 2 years. In lieu of giving the owner any money for the Option, I agreed to upgrade the building to make it more attractive to the market for both sale and rental purposes. The seller’s loan terms guaranteed several hundred dollars per month net cash flow after all operating expenses and payments once the building was rented up. I closed on the transaction on April 1, 1974. Since then, I’ve never looked back.

LIMIT RISK FROM THE START BY NEGOTIATING FEASIBLE OPTION TERMS.

This small office building story illustrates how critically important Option terms can be to the ultimate profitability of a deal. My Option gave me 24 months to raise the money for the down payment and for rehabilitation of the building. I didn’t wait until the last minute to start setting aside money from my earnings. The certain knowledge that I’d need money to close my Option gave me the incentive to work a lot harder to earn and save more. I also started seeking out tenants who would do their own improvements in return for lower rents. I closed the Option with the building fully rented. My annual net operating cash flow was $7000 more than the loan payments.

The success of this venture was due more to all the previous years I’d spent learning about real estate than to any tricky cookie-cutter technique. Had I not had the experience to negotiate owner-financing as a condition of the Option when the vacant building owner was highly motivated, it’s doubtful that I’d have been able to obtain it once the building had begun producing positive cash flow rents. And if I hadn’t already attained management skills and known how to plan the building layout to attract potential tenants, I wouldn’t have been able to fill the building with tenants who would pay for their improvements so as to give me the cash flow to make my own payments.

Hopefully I’ve made a couple of points thus far. First of all, Just learning Option techniques isn’t enough. You’ve also got to learn the fundamentals of real estate to make them pay off. I’d been in the real estate business for a long time, learning from very expensive, long time experience rather than from seminars that would have been a lot cheaper and which would have saved me many years of effort.

Many people rush out to obtain Options without negotiating feasible down payment and financing terms from the start. That’s like playing poker with ‘table stakes’. If you don’t have the necessary cash when it comes time to exercise the Option, you can’t play your hand no matter how good it is. It’s more important to always structure terms that you can meet, and hopefully, that can be met by others in the market. Here’s why:

An Option gives the holder the right to buy or sell a property. The more feasible the terms of the Option, the more it will appeal to the market. You’ll soon discover that you can make as much money selling a well constructed Option as you can in exercising it to buy a property. Once I realized this fact, even though I was a Broker, I stopped taking listings on property at all. Instead, I began to negotiate relatively short term Options of from 6 months to 1 year on houses.

My objective was to pay roughly 80% of true retail value. Next, I’d list the property, as owner/Optionee, for sale in the Multiple Listing Service, offering higher commissions than Brokers could earn selling their own listings. To motivate agents to generate quick sales to pin down especially lucrative Option profits, I offered bonuses. These included cash, trips, a year’s lease payments on a Mercedes Benz, etc. for anyone bringing in an all cash buyer. All of this generated a constant flow of sales income with little effort on my part, and it gave me a chance to focus on obtaining more Options. Using Options paid a lot more than listings.

Here’s an illustration: A $100,000 house with a $40,000 existing mortgage might be optioned for six months. The price would be $40,000 over the mortgage balance, with a $10,000 down payment (toward which all Option Payments would be counted). The owner would carry-back a second mortgage in the amount of $30,000 at 8% with payments which would amortize the loan over 30 years, but with a balloon note due in 10 years. The Note might contain a provision for an additional 5% discount in the event the loan was paid off within the first 3 years. Consideration for the Option would be $1000 when the contract was signed, and $1000 payable to the seller each month until the Option was exercised.

This house would be bargain priced in the MLS listing book at $95,000 net of all closing costs except 8% sales commissions – 5% under the true market value. A buyer could either refinance the loan, or assume it. If he refinanced it, you would get the benefit of the 5% discount you’d built into the 2nd mortgage as well as the return of all funds previously paid for the Option plus any amortization on the existing first mortgage, plus $15,000 profit less 8% commission, and less any funds used to spruce the property up. Or you might sell it on a wraparound mortgage and build in additional profits with a spread in the interest rates. Your gross profit margin based upon an $80,000 purchase Option price and $95,000 sale price would be $15,000 less $7,600 for commissions or about $7400. Bear in mind that the salesperson did all the work. All you did was to obtain the Option. Your exposure to risk would be limited to the $1000 per month for the Option. Or, you can do what I did whenever I could afford it. I just waited until I’d paid in enough for the down payment and kept the house as a rental to build my estate.
OPTIONS MAKE MORE EXPENSIVE PROPERTIES FEASIBLE

All around the country, there are larger luxury homes for sale that aren’t feasible as rentals, but which could generate huge profits using Option techniques. Because of the down-sizing of corporate America and Government institutions, many formerly high-paid executives are in a cash squeeze with high house payments which no longer fit into their shrinking budgets. The market for these houses is extremely thin in many areas and sales are slow. Cash invested now can buy a disproportionate share of the eventual sale proceeds. Here’s a way that these Options can be structured:

Let’s say that a $350,000 house with a $200,000 loan requires monthly payments of $2000. The recently laid off occupant living on severance pay can afford n o more than $1500 per month payments, and is falling behind. There’s too much equity to walk away from. Suppose you contracted to buy a purchase Option for $50,000 payable in one hundred installments of $500 per month to be used to augment the owner’s mortgage payments. Your negotiated bargain price would be $75,000 over the mortgage balance at the end of that time or when the house finally sells.

Both parties could benefit from this arrangement. The owner would cut his out of pocket monthly payments down to a manageable $1500. You would effectively have a zero-interest loan payable on the $50,000 installment contract for the Option. If the house sold right away, you’d receive everything over the $75,000 payable to the owner for your own use. Meanwhile you’d continue to make your $500 per month payments on your contract. Remember, it doesn’t come due merely because the owner sold the house. If the property failed to sell right away, you’d get the benefit of all future appreciation and the loan reduction without any vacancy, repair, or management expenses until the house sold. In the meantime, the seller would be receiving his profit in subsidized lifestyle benefits.

Options work best with those who want to raise cash or create income while they continue to use or hold the optioned property. Another example of this might be a commercial property or a tract of land that was a few years away from being developable. Contrast two methods of buying a $100,000 tract of land. Conventionally, one might expect to pay $10,000 down, and 10% per year over 10 years on the $90,000 balance. With full amortization, payments over the period would be $1322.64 per month ($15,871.71 per year). Over the 10 year period the total funds paid out would amount to $168,717.12.

Alternatively, suppose the owner was offered $10,000 for a one year purchase Option. It would include a right to extend the Option an additional year each time an additional payment of $15,000 was paid. All payments would count toward the purchase price. If the Option was extended 6 times, the full purchase price would be paid within 7 years. The total amount paid would have been $68,717.12 less than with a conventional loan. Moreover, annual payments would have required $871.71 less too.

There’s no magic potion you can use to induce someone to sell an Option. A key is to empathize with other’s financial and tax problems, then to proffer the Option as a problem solving tool. If a person needs to raise money to pay taxes, selling property will only make the problem worse, while selling an Option itself can create fax-free cash. If a person has credit problems, lending him more money won’t get him out of debt, but buying an Option from him will provide needed funds with which to pay his bills and/or clear up his financial statement.

LEASE/OPTIONS OFTEN WORK WHERE OPTIONS ALONE WON’T

A Lease/Option won’t necessarily solve all the problems of financially distressed owners when it forces them to relocate. On the other hand, with a burned out, motivated owner who can’t find a way to get out of a property, use of a Lease/Option can be ideal. Here’s how I bought my first apartment house.

The 64 year old owner was burned out. I paid him $1000 as a Lease deposit, and master leased the 11 units at a rental based upon 90% of the rents that had been reported on his last three income tax returns. There were lots of needed repairs that were going to reduce the net income even further once they were completed. So we agreed that my ultimate Option price and terms were to be based upon a formula. My first year’s net operating income (after deducting the cost of repairs needed to bring the property into conformance with building, health and safety codes) would be multiplied by 10 to arrive at the purchase price.

He agreed to carry the financing. The loan was to be paid back over the next 180 months at zero interest. The present value of all my payments ultimately came out to less than $40,000. I never had any negative cash flow with this fully leveraged property because of the Lease/Option terms. Why did the owner make this kind of deal? He wanted out more than he wanted profit. – was the only person who would take over management of the property that was standing between himself and his own personal freedom.

Lease/Option techniques work well for those who must relocate to new jobs, divorced couples, burned out managers, and for REO properties. The real key to success is to structure break even cash flow terms based upon the former owner’s performance. This way, you get paid for the management improvements that you can implement. Another tip is to start with a single year’s Lease/Option with multiple year renewal Options. This enables you to reap the rewards of your own efforts as the value of the property is increased because of cash flow yields. On the other hand, if you aren’t able to turn the property around, you can jump ship after a year and try again elsewhere.

Options can be used to time transactions. Certain investment properties can be exchanged tax-free for others so long as the properties have been held in a qualifying use for a year prior to, and following the exchange (2 years between related parties). A tax-free trade might be made, then to raise immediate cash, an Option rather than the property itself could be sold without waiting for a year. The sale of the traded property itself would be closed after the required year’s holding period to preserve the tax deferral.

Anyone can sell their primary residence for cash and defer taxes so long as a replacement residence is purchased within 2 years. Suppose a laid-off person needed to sell his house to raise cash, but wouldn’t be able to qualify to finance a replacement without a job. An Option might be sold on the residence. The two year period wouldn’t start until the house itself is sold later on.

Over-55 year olds can sell their primary residences and exempt $125,000 of the gain from taxation. An under-55 year old couple could sell an Option on a house, take out tax-free cash, and close the house sale after his 55th birthday, thereby avoiding losing the $125,000 exemption because of being a few years too young.

Profits on capital investment, business or residential property held a year or more is taxed at lower rates. Selling an Option to defer the sale of qualifying property until it has been held a year can lower sellers’ t axes.

 

Copyright Sunjon Trust  All Rights Reserved
Quotation not permitted. Material may not be reproduced in whole or in part in any form whatsoever.
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