If you are looking to build lots of equity into your real estate deals before closing, here is one trick you should know about.
There are a couple of ways to build a high equity deal, one being to get a better price. However in real life, getting someone to give away tens of thousands of dollars in real estate equity is a hard sell. I feel that it's much easier using the option.
Let me tell you a story to explain how they work.
John is a dairy farmer. He owns 500 acres of land just outside of town. The land has been in the family for 4 generations and his great granddad started the dairy farm.
Over the years the new home subdivisions have been creeping slowly towards his dairy farm.
One day he gets a call from a large home building company and they ask if they can meet with him. The next day a few men in a new SUV show up, look at the land and tell him that they would love to buy his property for a new subdivision and golf course. They say they’ll pay top dollar. He’ll be rich, he can quit the dairy life, and they say they’ll even name the subdivision after his family. They say that they’ll give him as much time as he needs to shut down the dairy. And they say they’ll pay him what he would have made from the dairy until they close.
Sounds like a great deal doesn’t it?
The Downside for the Seller:
There are a couple of issues that could come up for John.
An option is an agreement to buy the property for a certain price, some time in the future. Usually a clause is included allowing the buyer to extend the time frame. Big housing corporations do this all the time to tie up huge tracts of land when the market starts appreciating quickly. This locks down the property so that no one else can buy it and lock in the price.
They will go to a farmer and make an offer to buy their property for what the farmer sees as a great deal in the present. The trick is, they tell the farmer that he can still use his land. They are going to pay him a yearly amount (the option consideration), he can stay on the land, and they will buy it soon.
Usually the sellers don’t really consider the big picture of what they're getting in to. They see a multi-million dollar payday when the closing comes, and a check for a yearly amount that could be over $100,000.
What they don’t see is the potential downside. The market is hot and going up, and the seller will miss any future appreciation gains from holding the property.
One Sided Agreement
Another big issue is the very real prospect that the sale may never happen. The option is only binding on the seller, which is why it’s called an “option.” The buyer is buying the “option” to purchase.
Let’s look back at John’s situation for a moment. Let’s say that he took the deal and started to shut down his dairy operation. He’s all excited, telling his friends he's hit it rich. It takes a while to get everything shut down, get all the cows sold and start the cleanup. A couple of years pass, and John has the dairy shut down, started taking some vacations on his option income, and started looking at houses to buy when the deal closes.
This is when things start to turn for the worse. New home sales slow and inventory starts to pile up. John doesn’t really take note of it, he’s just waiting on next month so that he’ll get his option renewal check. One afternoon the phone rings, and on the other end is the home builder’s attorney, who explains to John that the builder decided to cancel plans for the subdivision and golf course.
Sadly enough, John has no recourse. And he’s in a bad situation. The cows are gone, and the dairy is shut down. The price of raw land has been dropping, and no one is interested in buying a 500-acre farm. He spent the money that he got from the sale of the cows, so he can’t start the farm back up. He’s left with two choices. Either sell the 500 acres at a bargain-basement price or divide it up and try to sell off smaller parcels individually.
If John had held out for a real offer instead of taking the option, he would have been much better off.
For the builder it was a great deal. He locked in a good price on the land and protected himself from the downturn.
How is all of this going to help you?
You are most likely not buying 500-acre farms to build subdivisions, but you can use some of the same tactics in your real estate business.
In most cases it wouldn’t make sense for you to just buy an option on a house. It would be a drain on your cash flow and the seller may damage the house. How can you get an option and get the seller to leave?
The Lease Option
The best way to accomplish this is with a lease option.
A lease option works because you are going to lease the property with a master lease that allows you to sublet the property. You lease it, get an option for a good sales price, then lease it to someone else.
This could work extremely well for resort area properties that could be rented out as Air BNB or vacation rental. If your lease was for an annual rate and then did vacation rentals, the extra profit would be in your pocket. Also, the likelihood of the property appreciating is greater. This could make you tens of thousands on a future sale.
Control Without Investment
Another great thing about lease options is that it allows you to have control of the property without a large investment. If the option is in place, they cannot sell the property. You can draft an option that requires your approval before they can alter the financing.
This can create some interesting scenarios for making money without ever closing on the property.
Let’s say that you found an inexperienced landlord named Ben. Ben had purchased a 3-bedroom house in a good middle-class rental area a couple of years ago. It was a good area, but Ben was doing a poor job as a landlord. He wasn’t very thorough in checking out his tenant applications and had already had to do two evictions and had lost several months of rent. As a result of this, he had been pulling money out of his own pocket to cover the mortgage payments.
You meet with Ben and offer to help him out by lease-optioning the house for five years. You set a target sale price that would give Ben a small profit over his purchase price. Ben agrees, and you lease for enough to cover his expenses, and you give a $1,000 security deposit and $1,000 option consideration.
You immediately go to work and find a quality, qualified tenant and lease to them at a small monthly profit. If you did your job well when qualifying the tenant, and are a good landlord, you will not have a lot of turnover (I go more in detail on choosing tenants in my landlord training course. Email me for more info).
A couple of years pass by and the market is heating up. Home inventory is low and selling for a premium. Ben had given you an option to buy the property for $120,000, a $10,000 profit for him. One day you get a call from Ben, who tells you that someone had approached him with an offer of $180,000 for the property (no pie in the sky, this is based off 2014 to 2017 appreciation numbers in FL).
Ben is very irritated that he allowed himself to get into this mess and feels that you took advantage of him (almost always happens).
You calm him down and explain his options:
- You can close on the property, then sell it for $180,000 or more on the MLS.
- You could assign your option to someone else for a very large fee, and they would close on it.
- You could find a buyer and do a simultaneous closing and pick up $60,000 for yourself.
But you let him know that you are a fair person, and you understand his situation and want to do the right thing. You offer to sell him back the option for $20,000 at the closing of his $180,000 sale.
Ben doesn’t like it, but it’s the best option that he has.
This is just one possible scenario of what can happen with a lease option.
The market could go down instead. If it did you could step out of the purchase deal at any time. The lease may be a little stickier, but I put a 30-day lease cancellation clause in my lease that gives me an out.
When doing this type deal there are some thing to be aware of.
A savvy real estate investor would want a large option consideration and a large deposit, but the average Ben will be more flexible. When you are new in this game, it’s always best to do business with other people who are new. An old real estate investor with years in the game didn’t get there by being naive. You may think that you have the upper hand on them, but that’s what they want you to think. Usually it’s because you missed something, and they will spring it on you later if needed.
Option consideration amount:
One thing to note about any option consideration paid. If you eventually buy the property, it is credited towards the purchase price. If you don’t buy, you lose the money.
This is a good reason to keep the option consideration as small as possible. If someone wants more money in the deal, give them a larger security deposit, not more option money.
Be careful of the double option:
I have known investors in the past that have done a “sandwich” lease option. This is where the investor lease options the property from a seller, then immediately lease options the property to a buyer. The investor attempts to charge the buyer a higher monthly rate and more option money than he paid the seller.
This sounds like a great deal for the investor, but I’ve seen it go wrong before. Usually it all goes well until the end, when the investor tries to get the timing of the closings right. If the closing is set for a certain day and the buyers mortgage is postponed, the investor has an issue. If he cannot get an extension, he could possibly lose the deal, and his option consideration.
If for any reason the seller doesn’t close, then the investor is very likely to be sued by the buyer for damages, and possibly be accused of fraudulent business practices by the state attorney.
I think that it’s better to be safe and stick with a single-sided option. That will keep you busy enough.
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Disclaimer: I am not an attorney or CPA. The content herein is merely opinion, and should in no way be considered legal or financial advice. Please seek professional legal and financial advice for your specific situation.