July 1991
Vol 14 No 9
We all know that ownership of assets and/or earnings is a key to wealth. That leverage – the use of O.P.M. (other people's money) can amplify both the positive and negative yield of an investment in terms of income yield and/or gain. That the use of an asset – even when it's owned by another party from whom it has been rented- in the productive pursuit of profit can generate high income to either the lessee or lessor, or both of them. But the concept of waiting to commit ourselves until AFTER a profit has been assured is the most powerful of all. And the two-letter word that sums up this powerful fortune-building concept is IF! Consider how it's used below: IF values go up, I'll Buy. IF prices go down, you'll have to buy. IF cash flow won't support the debt, I'll give it back. IF I sell my house, I'll buy yours. IF I can get 9% financing, I'll refinance the debt. IF you credit part of the rent payment toward the purchase price, I'll buy. IF you'll make capital improvements, I'll lower the rents. IF I can raise the down payment I'll buy. IF you'll give me a big deposit, I'll give you a long term lease. IF I can re-discount your Note, I'll buy it.
IF is a RISK AVOIDANCE word. Think back to some of the bad deals you've entered into. How much would you have saved if you'd had the chance to avoid paying your money once a potential loss became apparent? Suppose you could have canceled the transaction without recourse simply by walking away from a relatively insignificant deposit without any further investment; would you be wiser, but richer today? That's one way to make money – by not losing it. But, the IF concept works best on the up-side.
Everybody would like to be a 'Monday morning quarterback' and replay the game once the outcome is known. The IF concept enables you to put only a token sum into a project until you are certain that it will make a profit. In the meantime, it allows you to multiply your opportunities by conserving your available cash and credit. IF power can be negotiated in infinitely variable ways between parties to a transaction.
'IF' POWER CAN INFLUENCE INVESTMENT OUTCOMES ON BOTH SIDES . . .
When you 'lay away' that Christmas bicycle or put a deposit on a tour – or sign a non-recourse Note – you're more or less saying that IF you decide to continue with your payment, you'll remit the agreed upon remaining balance. It's tacitly agreed that, IF you fail to continue to make payments, no one has any legal redress. All you are risking are payments you've made. Let's bring this a little closer to home.
How many times have you seen tenants walk away from a deposit, or seen a purchase contract fall through – resulting in the Earnest Money Binder Deposit being forfeited? Why? Often, that was because the person walking away from a transaction had a better opportunity elsewhere, or simply changed his mind. The forfeited deposit wasn't big enough to hold him to his agreement. We can see that the lack of additional penalties gave him incentive to default on his contract. The amount of the deposit and liquidated damages thus can be a motivating factor to make or break a deal! From this we can learn some valuable lessons that will apply to a variety of situations:
1. He who has the least to lose or gain controls the IF factor – and the transaction.
2. The IF concept can be designed to hold a transaction together or to break it apart.
3. The IF factor can provide low cost/risk benefits of OWNERSHIP, O.P.M. and USE. By now you've guessed that the 'IF' factor, by another name, is called an OPTION!
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OPTIONS CAN BE LIKE A NITRO-FUELED DRAGSTER.
Over and over I see Option techniques being passed around casually as if they could be used by anyone anywhere. But, for the uninitiated, they can be bane or boon. If I handed you the keys to a sports car you could have an enjoyable ride or a wreck depending on your driving skill and experience. Options can work the same way. To get the most out of them, you have to understand their unique properties. Let's review some of their attributes.
An Option is a legal RIGHT to keep an offer to buy or sell open for a stated length of time. Anytime the right is exercised in accordance with the terms of the offer, that right is converted into a legally binding contract. This may be a separate document, or the terms of the contract may be incorporated into the Option itself. To the extent that the contract that ensues should fail to meet the requirements of contract law, it will not be legally enforceable. That's where Options fail the most.
One of those legal requirements is that 'consideration' should have passed between the parties to an Option. This may be in the form of property, services, any action or forbearance taken, or promise offered by one and accepted by the other in consideration of the Option given by one party to another. The nature of consideration determines the tax result anytime that it is taxed as gain or loss. Inventory is taxed at ordinary income tax rates. Capital is taxed at capital gains rates according to whether it is long or short term. But, there is no taxable event until an Option is either exercised, abandoned, sold or exchanged. Then the applicable portion of the IRC applies. Options have their own portion of the code, TRC Section 1234. If you're planning to use Option techniques, it would. be a good idea to bone up on this section. Consideration, as we've seen, can be a motivator or deterrent to action.
In 1982 General Motors wanted to raise money, but keep it's taxes low so as to obtain the maximum cash to use in its operations. It sold an Option on its New York headquarters building for $500,000,000 TAX FREE! It continued to lease the building and the lease terms were used to adjust the economic factors to make this a good deal for everyone. As you can see, Option techniques aren't limited to small investors. And it should be fairly obvious that the $500 million Option consideration strongly motivated the Optionor to exercise the Option rather than to abandon it.
On the other hand, when Donald Trump agreed to purchase the Pennsylvania Rail Road's property in New York, his contract required only a portion of any profits to be paid if/when the property was developed. This was subject to getting a lot of approvals and financing, feasibility, etc. He had control over a large and expensive parcel of real estate with no down side risk. Eventually, he walked away from a part of it and made several million dollars on the rest – still with none of his cash. By arranging his terms carefully, he eliminated the majority of the risks and costs of holding while he tried to make a profit out of his control over the property.
On a smaller scale, an Option gives the low-budget entrepreneur tremendous leverage at low cost. I essentially retired out of active brokerage by taking 6 month Options of houses, then SELLING THE OPTION to an ultimate buyer of the property. The key was to negotiate an Option to purchase at a NET price for the owner's equity based on about 80% of fair market value. For instance, if a $100,000 house had a $60,000 loan, my Option would call for me to pay $20,000 NET to the owner of the house within the next 6 months. I'd assume all costs of sale, financing, advertising and minor cosmetic fix up. I customarily paid $100 for the Option consideration. If I didn't sell the property, I just let the Option lapse. All it cost me was the $100.
Owners who sold me an Option were motivated either by aversion to the conventional brokerage market, the need to settle the net sale proceeds so they could commit themselves to another purchase, a distress situation which wouldn't wait for normal marketing time in the conventional market place (in which case I'd pay them sufficient cash to solve their problem in return for a deeper discount on their price). Out of town owners on their second or third go-around with local brokers were especially receptive to selling me an Option. But there were other advantages too.
The normal commission split between listing and selling brokers is 50/50 in most markets. This is sub-divided once again when a salesman from one office sells a listing of another salesman in another office. Thus the commission is divided into 4 parts. By acquiring an Option, I was able to sell the OPTION rather than the house per se. This took the sale out of the realm of the Multiple Listing Service and all those commission splits. I could realize about 4 times the amount from a sale that the MLS market usually provided. But there's more! Remember, I tried to buy at 80% of true market value and sell at 100%. Assuming that I only realized 10% after expenses, that was still 6 times the net amount I'd have normally realized. Or to put it another way, I MADE 6 TIMES AS MUCH MONEY USING OPTIONS INSTEAD OF LISTINGS WITH EQUAL WORK!
There's another little piece of magic in using Options speculatively. While I'm a licensed Broker in Florida, I'm not licensed in other states. That puts me on a level playing field with non-licensed speculators in the other 49 states. Conversely, OPTION TECHNIQUES PUTS THEM ON A LEVEL PLAYING FIELD WITH ME EVEN WHERE I'M LICENSED! Instead of taking listings which require a license, they can buy Options and resell them – which doesn't require a license in most states. It can even get better.
OPTIONS GIVE YOU GAINS, LEASES GIVE YOU CONTROL, USE AND CASH FLOW . . .
Many states require that a property manager be licensed. But what about the person who MASTER LEASES a property at wholesale rates, then sub-leases it for a higher rental? The same mark up that applies to selling property also applies to leases. A lease is like a Promissory Note. To the extent that you pay a deposit – and specify in your Master Lease that it is forfeitable as FULL LIQUIDATED DAMAGES in the event of a default on the Lease, you've essentially got an Option to Lease (which is the obverse of a Lease with an Option to buy).
As we stated in rule number 2 on page 1, consideration can be used to motivate either party in a transaction. As the Lessee, you'd want to keep your Option/Deposit low to limit your risk. As the Lessor, you'd want to keep it high to motivate tenant performance. The Option consideration and/or deposit is being used to transfer risk from one party to the other. But it can be used for other things too. For instance, suppose you wanted a higher deposit. I could agree, but only if you'd also gave me a MULTI-YEAR OPTION TO LEASE at a fixed rate. Thus, as market rents rose, I'd get the benefit of them while you remained at a fixed rate. And I could bail out at any time.
A fixed rate lease in a rising market effectively transfers equity from the owner to the tenant. This isn't noticeable in short term rentals, but in long term leases, it becomes a crucial factor in evaluating a property. At one time Safeway – the super market chain – had 50 year leases which yielded 6% fixed to the owners of the stores. When interest rates went to 14%, these leases became extremely valuable. Their value was calculated the same as a wrap around mortgage with an 8% spread and some 25 – 35 years remaining. By negotiating multi-year leases, you're putting yourself into the same position. You might have a 3 year base period with ten renewal Options of 3 years each. These could be transferred or assigned for a consideration, exchanged tax free, or you could hang on to them and enjoy the cash flow.
While leasing may seem a far cry from your normal activities, it remains one of they only viable techniques for people in industrial or expensive areas where buying isn't feasible. And remember, you can still lease and/or Option individual houses everywhere for reasonably short terms. One fellow I know got started by leasing his own apartment long term in return for an Option on all 40 units in the complex.
OPTIONS TO LEASE AND LEASES WITH OPTIONS HELP TO CONTROL TENANTS
Anytime a landlord has vacancies, he's losing money he'll never recover. One way to alleviate this condition is to offer an Option to prospective tenants as an inducement to sign longer-than-normal leases at higher-than-market rents. There are only two things wrong with this approach. If the owner really doesn't want to sell, there's a danger that the Tenant will exercise his Option and buy. And, in a soft market, the Tenant may not want to commit himself to a multi-year period at high rents for fear that he won't be able to come up with the cash in the event he decides to buy his residence under the terms of the Option. Here's where the strategy comes in.
Suppose you'd rented to a Tenant and offered an Option to Buy. Now it seems he's about to exercise the Option. Why not buy it from him? Let's say the Option price is at appraised value when exercised. No great deal for the Tenant, but he's still intent on buying. You might offer him 90 days free rent in exchange for cancellation of the Option. Or cash. Or a good used car. Or discounted paper. I offer to refund the tenant of the Option consideration plus any pro-rata credit toward the purchase price in the event they elect to give up their Option. I'm also willing to give them an Option to renew their lease at the same rents for several years even after they've surrendered their Option. Let's face it, better the Tenant you know than a stranger.
To get around the higher-than-market rent problems, I make them this deal: They borrow $3000 and give it to me for an Option to buy at market price when exercised. The tax-free Option consideration counts toward their down payment. I lease them the premises for 3 years at $100 BELOW MARKET RENTS. They use the 'saved rents' to pay back their loan. If they choose not to exercise their Option, they've amortized the Option consideration over the 3 year period and recaptured it in the form of reduced rents. Meanwhile, I've gotten the use of the $3000. It acts like a big security deposit, since any default on the terms of the lease also voids the Option.
If I don't want them to exercise the Option, I buy it back as stated above. If I do want them to exercise – and cash me out – I offer them special 'decorating allowances', new appliances and carpeting, etc. to get them to buy at a time when I need the money. In the meantime, they do all the maintenance and keep the property ship shape as a condition of their Lease and Option. In order to deal with capital improvements made by Tenants (which I continuously encourage) my Option price may be pegged to the Consumer Price Index. This way, the value of their personal contribution to the property isn't reflected in the price they have to pay. Otherwise, they'd be doing the improvements at their own expense, then turning around and buying them from me at the appraised price.
Anytime you can get a Tenant to take an active interest in improving property at his own expense, you can give him an Option to either extend his lease with no increases for a period of years, or agree to buy them from him at fair market value at the time he departs the premises. This gives him both the incentive to make desired improvements while he gets the use of them at no cost during the lease term. Converting car ports and garages into family rooms has almost become a ritual for me with those Tenants who have the necessary skills and resources. All they need is the incentive.
