The More You Know, The More You Make . . .


October 2007 Vol 31 No.1

           A falling tide lowers all boats regardless of their size or the skill of their crew.  When real estate sales slowed, and the market top was reached, desperate speculators, builders, lenders, and assorted middlemen were caught with too much money tied up in unsold residential real estate.  Then the market began to correct with a vengeance.  Until the pending Sub-Prime meltdown runs its course, it’s probably going to get worse before it gets better; but not for everyone.

           In the spirit of kicking people who are down, I can’t resist saying “I told you so.”  For two years prior to the market stall of late 2006 I advised everyone to get out of the pool with his or her profit.  Now, those who heeded this advice and got out at the top are poised to re-enter the market.  They’ll be able to buy at the bottom and start the process of pyramiding their equities once more.  Does that mean that those who ignored the signs of an over-bought market and continued to buy and hold at the top are now out of the game?  Not if they learn how to use one of the most useful tools in the real estate pantheon: Options.

           There’s nothing magic about an Option to buy.  Bear in mind that I’m not talking about a Lease/Option at this point.  I’m talking about using an Option to speculate on a price rise rather than using highly debt-leveraged real estate that comes with high payments and high risk.  Just as nobody knew exactly when the market top was going to arrive, so nobody really knows when house values and sales will start climbing back.  What we do know is that prices can start to climb without warning and those who aren’t on that boat when it sails will see owners’ equities rising without being able to participate.  This begs the question:  How does one speculate on the market if nobody knows when or if the market is going to come roaring back?  By betting the least amount possible with the longest odds.

           When you think about it a little, in the vast majority of cases an Option is really just a bet that the market will either rise or fall.  Despite what many claim, nobody really knows what’s going to happen in the future. Think of all those people who had it made in the stock market until 9/11/01.  The next day they lost fortunes even though the companies whose stocks they held were not affected by what happened.  In 2000 and 2002 for equally unaccountable reasons, stock market investors got another dose of the same medicine from which some of the highest flyers such as Microsoft never recovered to their pre-2000 price levels.

           The top passed without warning just as suddenly in the housing market when somebody noticed that there was no reason for housing to be as expensive as it was.  As if of a single mind, the public simply refused to buy at the prevailing prices and the house of cards started to crumble.  First to feel the heat were luxury condo developers whose buyers refused to close on their purchase agreements.  Next in line were luxury homes in new subdivisions.  Then came houses that had been financed to marginal credit risks with Sub-Prime loans that included adjustable payments. 

           Oddly enough, at the very top of the market where few speculators dared to tread, there wasn’t much of a real estate crash.  The same was true of bread and butter houses in areas where there had been very little speculation on prices or funny financing.  So, one might say that the only losers in the current market slow-down are those who gambled on price rises to bale them out, or one more fool who would pay them back the money they had bet.  They probably didn’t perceive that they were gambling, but without any control over pricing, or any exit strategy, the public might just as well have gone to Las Vegas to bet their money.

           Those who knew enough to use Options to speculate on property rather than buying properties financed by personally guaranteed loans lost very little.  They are now are in position to Option houses at desperation levels that represent real value that they can hold or resell at a profit when prices bounce back.


           The housing slump has been a completely different story for those who bought property to hold for long-term income and appreciation.  Long-term investors don’t mind a little price appreciation, but they make most of their money from two sources; net income and having tenants pay off their houses.  Thus, they have to buy their houses with feasible terms at reasonable prices in order to be able to generate income from rents sufficient to pay their operating costs as well as a reasonable return on investment.  Keep reading.  You’ll soon see how to do this. 

           In the more speculative markets, many would-be investors had their eyes firmly fixed on the rising prices of houses rather than on the economic aspects of their purchases.  Secretly, they weren’t really long-term investors.  They intended to hold their houses until they could sell them at a profit; so they rationalized that a little negative cash flow would be justified with an increase in prices. Whether they knew it or not, to the extent that they bought negative cash flow rentals, they were gambling on selling out at a high enough price to recover all their losses in addition to making a big profit. 

           Those who bought only positive cash flow rental houses without any thought of reselling are no worse off today than they were when their equities were skyrocketing. Better yet, they’ll already be invested in real estate if and when the market takes off again.  In the meantime, they’ll quietly pay down debt and enjoy the financial security that positive cash flow brings.

           It’s all well and good to talk about what a person should have done; what should a person be doing now?  The market is just as iffy now as it was at the top.  From time to time a note of encouragement is injected into real estate news stories, but there’s really no good news out there.  The Sub-Prime plague is spreading through the finance industry.  The dollar continues to drop like a rock against foreign currencies presaging a rise in interest rates at some point in the future.  Unsold inventory continues to pile up despite the desperate attempts of builders and lenders to sell their inventory through massive discounting and auctions where the starting price is as low as 50% of the original appraised values

           This is depressing sales of existing houses in the areas where it is taking place, and frightening the entire lending industry; or at least those who haven’t been driven out of the market.  Sellers see little relief on the horizon.  They should be ripe for Options and Lease/Options that would give them some payment relief thereby enabling them to hang on a little longer.  For the entrepreneur who wants to harvest the opportunity presented by the current situation, getting an owner to agree to an Option contract or a Lease/Option is going to be the key to making a lot of money at some point in the future. 

           This is rarely going to be accomplished by throwing out a lot of offers to Brokers who have very little incentive to present them.  Those who would avail themselves of the opportunities that Options and Lease/Options present are going to have to deal directly with people to whom they can explain the benefits and answer questions.  Clearly, prior to doing this, the entrepreneur had better learn something about how Options work before trying them out on a homeowner.

           A Lease/Option won’t be very attractive to Homeowners who want to remain in their houses because it would require them to leave.  On the other hand, it would be an ideal solution for builders, lenders with foreclosed inventory, investors, and people who moved out and bought another home only to see the sale of their former home fall through.  Distressed owners should be delighted to have someone come along and take care of their property while helping out with the negative cash flow.  The more owners’ responsibilities and negative cash flow you can relieve them of, the more credit you should be able to extract against the down payment and purchase price.  I’ve seen as much as 150% of all rent payments credited toward the purchase price of a distressed owner.  Bear in mind, that this is only possible when there’s a lot of equity at stake and a motivated owner who doesn’t want to lose it.


           Just about every benefit of actual ownership of a house can be captured with a Lease/Option; but there’s a catch.  You have to try to set your rents at a level that motivates the owner while still generating cash flow for yourself.  If you’re leasing a house under terms that require you to make high rent payments in return for a credit toward the purchase price, there is going to be negative cash flow.  You’ll either need deep pockets, or an investor with deep pockets who will provide the funds you need in return for a piece of the action.  You also have to know how to manage and maintain rental properties so they continue to appreciate

           Meeting these requirements can be hard, but can be well worth it.  You’ll have a very small investment in comparison to the costs of owning the property.  If the rent you collect is larger than the rent you pay there will in effect be a negative investment.  If you can get a large credit for rents paid toward the eventual purchase price and down payment, you’ll be amortizing the price in leaps and bounds.  It’s as if you had wrapped the existing loan with a loan that called for zero interest.  If prices snap back, your Option will enable you to capture any increase in market value.  Depending upon the actual terms of your Lease/Option, you may not be responsible for any maintenance or repair; or you might agree to take these on for a credit against the purchase price that exceeds 100% of payments made.  

           Now comes a very neat aspect of Lease/Options.  Under their Doctrine of Substance over Form, the IRS looks beyond the paperwork in a transaction to see what is really taking place.  When a person has a “preponderance of the badges of ownership”, he is deemed to be the owner for tax purposes.  As the owner, he is entitled to not only write down the property, but can also exchange his interests tax free or to pay only capital gains on a profitable sale of his interests.

           What are these “badges of ownership”?  They are the duties, privileges, and obligations an owner would have.  If your Lease/Option required you to pay the taxes, insurance, and loan payments, and keep the premises repaired, rented, and managed; you’d be in exactly the same position you would be if you’d bought the property; and taxed accordingly.  What’s really mind boggling is that if you Lease/Optioned a house and moved into it as your primary residence, you’d qualify for a tax exemption of up to $500,000 for a couple who owned and resided in it for the requisite 730 days out of the five years immediately preceding its sale.

           The joker in the deck is that, even with the low interest rates that prevail today, an expensive house can be leased for rents that are far below the amount of loan payments.  This opens the door wide for entrepreneurs or investors willing to sell their present home and take the money tax-free.  They can then Lease/Option a more expensive home for at least two years and repeat the process.  Give that some thought; you’d be paid to live a couple of steps above your income level and pay off debt, or mortgages, with the tax-free money from home sales.              

           That’s a nice story, but who would make this kind of a deal with you?  After all, if a person were wealthy enough to own a vacant expensive house with a high equity, why wouldn’t he either sell it or just leave it vacant?  Trade places with such a person.  If your $500,000 little-used spare house could be rented out to a responsible person, your insurance costs would go down.  Moreover, you could depreciate it and write off all expenses of operating it as a rental.  You could also stop worrying about vandalism that a vacant expensive home attracts.  No more frozen pipes or neglected landscaping.  Best of all, as a business asset, it would qualify for a tax-free exchange when you sold it; so you could avoid gains taxes, recapture of depreciation, and the Alternative Minimum Tax in one fell swoop.  It doesn’t take much imagination to see a wealthy highly taxed person going for this.

           To obtain these benefits, one such owner in Southern California even went a step further and offered to return all money paid by the Lease/Option holder in the event he didn’t exercise the Option for any reason.  Why?  Because he wanted a responsible live-in caretaker in the event that the house appreciated further.


          The ideal candidate for an Option is a person who doesn’t want to move out of his home, but can’t afford it.  This also applies to investors who have fallen in love with negative cash flow houses that they want to hang onto until the market comes back.  In contrast to Lease/Options, even though they provide fewer benefits, pure Options enable investors and speculators alike to control the profit on a property without the risk of loss of large sums of invested capital and effort that ownership of a highly leveraged could demand. 

           Because there’s no need for management or maintenance, Options also make it feasible to invest out of your own area when you can find opportunities that offer higher returns.  You don’t have to know anything about management or maintenance. All you have to do is to give the Option-seller money, or if you don’t have much money, a continuing source of income, to supplement his payments.  Sure, that’s negative cash flow, but your negative cash flow will be rewarded with a very high yield on the investment.  Here’s an example:

           Suppose you found an owner in desperate straits who was paying $2700 per month on two mortgages on a $500,000 house.  One is for $300,000 and the other is an equity line of credit for $60,000.  He is chronically running about $300 short each month and has been using his line of credit to make up the shortfall.  He is making only minimum payments on his credit cards and is accruing almost 30% interest on the unpaid balance.  He is sinking fast and doesn’t know what to do; but you do.

            You offer to make up his $300 payment shortfall until he sells the house – or for five years max – in return for a 5-year Option to buy.  Your Option contains a formula that divides all his equity 50/50 anytime in the next five years that he sells his house.  In the worst case, you’ll pay out $18,000 over five years to get half of his current equity, or $70,000.  If he sells the house sooner, you’ll get the same profit, but you’ll pay out less.  If the house appreciates at 5% per year, you’ll be adding a little over $1000 per month in equity at a cost of $300.  The figures will surely vary, but do you think there are any Roth IRAs or Pension Plans out there that in areas with less future potential that might like to fund these payments in return for half of the profit?  Mine would! 

            You’d think that sophisticated owners and hard-bitten builders would be wise to your scheme and turn you down.  To see why they might agree, walk a mile in their shoes.  They’ve got a major investment with no way out other than to go deeper and deeper into debt with no real hope that things will improve any time soon.  At some point, they’ll reach their debt limit and lose their houses and their equity; and more than anybody else, they know it

           In my area, a home builder has been advertising ZERO DOWN PAYMENT, ZERO INTEREST, ZERO PAYMENTS FOR 3 YEARS on houses priced at boom levels.  What’s he up to?  Although his ads don’t reflect this, he’s advertising to sell a house with a Lease/Option.  With 40 or 50 vacant houses sitting idly waiting for buyers who won’t even look at his models, he’s eating taxes, maintenance, security, insurance, and heating and cooling bills.  He can use the contracts for those who can qualify for a loan to buy it at his price to get a little slack from his own lender.  If that person buys the house at the end of three years, he’s saved a lot of his invested capital whereas if the lender takes the houses back, he’s lost everything.  If the buyer reneges on the contract and walks away, at least the builder has saved all the costs of operation that the buyer paid, including landscaping.

           Who would enter into this deal?  Anybody who wanted to live in a new house with new appliances, carpets, luxury amenities, etc.; all for the cost of taxes, insurance, and maintenance.  This deal is a blessing for the person who can then sell his lower priced home, and use the sale proceeds to help pay for his lifestyle.       


Learn more with Jack Miller's “OPTIONS FUNDAMENTALS – THE MISSING PAGES”, Home Study Course

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