Leases and Options resemble interest-only Notes and mortgages with balloon payments when you come to think of it. A properly drafted Lease incorporates a promise to pay with security for the promise in the form of some sort of collateral in the same way that a Note and mortgage do. The Option requires a lump sum payoff – or another promise of payment – just like a balloon note. Oddly enough, when people see a Lease and an Option, they don’t perceive the possibilities for wrapping either – or both – of them. Read on.
We all know how to wrap a lease. All you have to do is to negotiate a long term lease (or a short term lease with several Options to renew) at wholesale NET prices, then sub-lease the property at retail to get a cash flow spread. In the advanced stages, leases can include special provisions for repairs and capital improvements which can be apportioned between owner, lessee and sub-lessee. And to the extent that these can generate spreads between the cost to the lessee and the amount charged, they too can generate cash flow.
Options can be structured to work the same way. And they can be used to enhance a property’s appeal or to detract from it, depending upon what the various parties want to accomplish. Here’s an example:
Once upon a time I owned an expensive and fragile water front house about 150 miles away from my area. I couldn’t get management nor could I sell it; so I made an Exchange offer to a person who owned some lake front building lots in another State. He originally wanted $300,000 for his lots but after considerable negotiation, accepted my $200,000 house and took back an Option on the lots plus a three year Option on one half of the timber rights which motivated him to sell off any timber that he could during the next three years and allowed him to repurchase the lots for $200,000 plus 10% interest for the next 10 years. This balanced our opposing views of the equity neatly.
If the lots were really worth his asking price, he’d be able to sell them, use the money to buy them back from me and still make his profit. At the same time, he’d still have my house, and I’d get cash from the lots. If any of the timber were cut, we’d both reap an extra dividend from the sales. This Option cut both ways as far as marketing the lots was concerned.
First of all, I’d effectively hired a motivated salesman who could make almost $2000 per lot for every lot that he sold and bought back from me for his set price. And it also helped me price the lots for re-sale because his Option supported any price that I might ask that was less than his price. I could maintain that a buyer had already contracted to buy the lots at a higher price than I was asking. In fact, he managed to sell 4 of the lots under his Option.
After a time, I traded the lots, subject to the Option, for an industrial property. The incentive for the transaction was my willingness to lend the other party cash on a first mortgage loan against the lots. Once again, this enhanced their salability, since financing was now in place. And this financing was flexible enough that it could accommodate any subsequent transaction that might require substitution of collateral or lot releases. But everything was still subject to the original ‘buy-back’ Option.
Then the buyer found he couldn’t sell the property because of the depressed economic conditions and re-negotiated the loan. He deeded the property back to me, subject to an Option to sell it at a price which included my loan as well as a factor for inflation and interest. This was still below the amount of the first Option. Now, let’s see what we’ve accomplished:
If no one sells the property, I’ll have bought it for the amount of my loan plus interest – or at a price of about 30% of the original Option price. In addition, I’ll still have the industrial property I traded for. If the party who re-negotiated his loan exercises his Option, I’ll be paid in full plus interest plus appreciation. And if the original Optionee exercises his Option, everyone gets paid top dollar for their equity.
As you can see, the use of Options made this property easier to sell the first time around, made it more marketable, and potentially more profitable, to all of us.
There’s one more little wrinkle to this story. The property was held by a corporate pension plan, so all the profit would be realized tax free. All too often, small corporations fail to fund their Pension Plans and get into trouble with ERISA (Employee Retirement Income Security Act) auditors. If they’d buy Options to hedge inflation risks to their portfolios, they could then use the Option consideration to invest in long term zero coupon bonds safely to hedge any down turn.
The Options would avoid leverage problems that create tax on unrelated business income that pension plans, IRS, and Charitable Trusts must avoid; and they’d eliminate any management problems that real estate might generate. All that’s necessary to convert real estate holding into Options is to sell a property at a low price as in the previous example, and retain an Option to buy (or sell) it at or near the price paid for it. Voila, no more real estate worries for the pension plan or the Trustee.
