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It was the early 90’s, and one of my earliest deals with a Realtor®. I was presented with a great deal for a $300,000 lakefront home. I felt I could rent it easily because of its price range and because it was lakefront property. Therefore, I quickly committed to start my option on October 1, whether or not I had secured a tenant/buyer. My rent commitment was $1,400 per month, and of course I planned to charge more in order to make cash flow. October turned into November, November into December, December into January, and January into February. One of the investor groups I used to be involved with used to give away awards called the “Stupidest Moves Award” for the person who makes the most ridiculous, stupid real estate move during the year. Actually, they give away lots of different awards for silly things investors do during the year.  I didn’t even know this award existed until I got it, and the only reason I got it was because I was chatting away about my deals to other investors.  I received a mechanical shark, mounted on a plaque, that was devouring a large monopoly denomination, to depict the eating away of huge profits.

Unfortunately in Michigan lakefront properties are not very desirable in the middle of winter.  I finally rented it in March.  In total I lost more than $7,000 plus utilities for the winter. I was paying more for a house I wasn’t living in than for my own mortgage.

I could have avoided winning this award by either:

1) making my contract contingent on securing a tenant, or

2) waiting until spring to start the lease option.

Lakefronts rent the best in the spring and summer in my area.  People aren’t crazy about moving into a property with a frozen piece of water in their backyard; water which may not thaw for months.  I was too eager and didn’t think it all the way through. Not only did I lose over $7,000 in profit – it was $7,000 worth of cash out of my pocket.  Although I made well over $25,000, it could have been $32,000 with much less stress.  That’s how I earned the “Stupidest Moves Award” in my investment group.  That’s really not the kind of award you want to repeat, but everyone has a story like that in their investment portfolio.  It’s just part of the learning process.

Eagerness to start a deal should never outweigh the time needed for thoughtful preparation in evaluation and construction of an offer.  There are many sellers willing to sell using a lease option, but they must be profitable for you!

Wendy’s Tip
Know your climate.  People don’t like to move in the winter in a colder climate, so if you live in a place with bone-chilling winters, structure your deals, if possible, to start and end in the spring or summer.  Also, try to work around holiday months, especially mid-November and December everywhere in the country.  All of my contracts to buy don’t start until I find someone to rent from me.   I learned this one the hard way.

Creating the Offer

Now that you’ve considered using the lease option technique, you need to step back and take the time to work out the profitability of the deal. Normally you should not throw out numbers to the seller in the excitement of the moment.  Even if they are pressuring you, inform them that you’ll need to go back to your office and crunch the numbers.  In the excitement of the moment you may voice a dollar figure that doesn’t include all the things you need to consider.  In the quiet of your office you will have the time to go through your own profitability worksheet discussed in this chapter and make sure the numbers work for you.  Negotiations and offers are an art form.

Lease option offers, by their nature, rarely require an on-the-spot response. Therefore, you can respond according to the dictates of each specific situation.  There may, however, be situations where you’ll need to respond immediately.  This need may arise most commonly in the case of a subject-to offer on a pre-foreclosure or other competitive bidding situation.

Calculating Your Profit Requirement: Sandwich vs. Cooperative Lease Options

As an investor you must determine your profit requirement for any given deal.  It may vary depending on the type of investment. For instance, I will accept less for a cooperative lease option than a sandwich lease option because I can be in and out of a cooperative very fast; sandwich lease option transactions typically require 18-24 months or more. Is your profit requirement for a deal $10,000, $50,000 or what?  Once you determine your profit requirement, that becomes the bottom line number that must be reached in order to take on a transaction.

For example, if your required profit is $20,000, and an opportunity comes along that will only provide you with $18,000, then you’ll either need to negotiate the terms of the deal with the seller to meet the $20,000 requirement, or pass up the deal. It will not be a win/win situation for the seller and yourself. This is when a Cooperative Lease Option may work. See my website for an article on this technique.

There are times when a seller will do only X, Y, and Z. (X, Y, & Z, being price, payment and length of time). You can input those numbers into your spreadsheet below to determine if it meets your profit requirement.  If it does, you can do the deal.   Sometimes, if it doesn’t you can still negotiate a little further as discussed in the next chapter.  Also, many times the seller is not always set on X, Y AND Z, just X and Y, therefore you can negotiate the Z.  The next chapter will help you think of some creative ways to help bring deals together. However, there are some deals where you will need to just walk away.  Some sellers are just not willing to do what you will need to make it a win/win, and some sellers are not motivated enough or can’t go down on price enough because they owe too much.   Learn to move on quickly and look for another motivated seller.  Wasted time is money to you, and you must move on to another motivated seller if the deal doesn’t work for you.

Profitability for Sandwich Lease Options

The first thing you will need to do is to create a worksheet for profitability for a Sandwich Lease Option.

Appreciation or depreciation is not something you can be exactly sure of, and therefore, will need to be predicted or somewhat guessed.  The newspapers will be a great source for the appreciation rates in your area. Base your estimates on the predictions of your local writers or Realtor® boards.  When calculating the option premium I use 5% because the appraisal market is so tight right now.  When appraisals are loose, or the comparables are wide in their price range, I might use 10%.  This is not appreciation, but an additional bonus we get because we are selling to our buyers on terms.

Cash Flow or Rental Value is something you will also need to evaluate and determine.   You will need to do rental comparables just like you do sales comparables. Here are ways to find the rental comparables:

Read the local paper. Check the all the local rentals.  Those are your comps = comparables.

  1. Check with people in your local landlord group – many rentals are not on the MLS.
  2. Not enough data in #1 and #2? Run a test ad in the newspaper or on Craigslist. Too many calls?  Your price might be too low.  Not enough? Your price might be too high.  It’s a little like fishing.

 

Worksheet for Profitability for a Sandwich Lease Option
Purchase Price$
Expected Sale Price$
Current Value: _____________$
5-10% value of lease option (premium)

Current appreciation:________

$
Cash flow per month ________ x____ mo.$
Your Rent vs. Market Rent$
Other Benefits:$
Total profit of the deal:$

Example #1: Sandwich Lease Option

Let’s look at the facts:

  • Seller will sell you their home for $185,000. It is currently worth $190,000.
  • The appreciation rate is 5 percent per year.
  • It will be an 18-month option, which will result in 7.5 percent appreciation (5 percent x 1.5 = 7.5 percent). That gives us $14,250 ($190,000 x 7.5 percent) of appreciation value during the 18 months.
  • You’ll pay the owner $1,300 in rent. You can rent it out for $1,600, for a cash flow of $300 per month.
  • Note: I usually rent a home for $1,595 vs. $1,600 because $1,595 sounds less than $1,600, but it is easier to show even numbers for the examples.
  • All of the homes in this neighborhood are diverse and unique. Prices range from $170,000 – $285,000. This allows us to build in a higher option premium at
    10 percent or $19,000.
  • The $19,000 option premium and the $14,250 appreciation adds an additional $33,250 to the retail value of the home.

What is your estimated profit in 18 months?  Let’s view how I would figure out the profit of this deal:

Profitability Worksheet
Sandwich Lease Option
 Example 1
Purchase Costs Totals
Purchase Price $   (185,000)
Total Purchase Costs $   (185,000) $   (185,000)
Income Sources 
Current value
($5,000 above purchase price)
 $    190,000
Value of Lease Option (10%) $      19,000
Expected Appreciation
(5% annually, 7.5% over 18 months)
 $      14,250
Expected Sale Price $    223,250 $    223,250
Expected Monthly Cash Flow   ($300 per month for 18 months) $        5,400
Total Other Income $        5,400 $        5,400
Expected Profit $      43,650

The resulting profit from this deal if all payments were made during this option period and it went the full 18 months would be approximately $43,650, less transfer fees, title, insurance and possible option credits from the investor to the tenant buyer. Does this meet your required profit?  If so, then move forward with these terms.  If not, you continue negotiations on the deal or pass it up.

Example #2 – Sandwich Lease Option

Let’s look at the facts:

  • Seller will sell you their home for $145,000 on a 12-month option. It is worth $145,000.
  • The appreciation rate is 3 percent per year which will result in an additional $4,350 ($145,000 X 3 percent) after one year.
  • This home is in an area where all the homes are very similar and range in price from $140,000 – 152,000. This will result in a more modest option premium of only 5 percent compared to the 10% premium in the prior example, or $7,250 ($145,000 X 5 percent).
  • The appreciation and the option premium are $11,600 ($4,350 + 7,250).
  • You’ll pay the owner $1,000 in rent and will in turn rent it out for $1,200.
  • The seller is willing to give you $200 a month credit towards buying this home.
  • NOTE: if you have depreciation then you subtract that number (very possible it can go either way, but this example shows appreciation)

What’s your estimated 12-month profit:

Profitability Worksheet
Sandwich Lease Option
 Example 2
Purchase Costs Totals
Purchase Price $   (145,000)
Total Purchase Costs $   (145,000) $   (145,000)
Income Sources 
Current value
(same as purchase price)
 $ 145,000
Value of Lease Option (5%) $ 7,250
Expected Appreciation
(3% annually)
 $ 4,350
Expected Sale Price $ 156,600 $ 156,600
Expected Monthly Cash Flow ($200 per month for 12 months) $  2,400
Option Credit from Seller
($200 per month for 12 months)
 $  2,400
Total Other Income $  4,800 $ 4,800
Expected Profit $16,400

 

This deal would not be nearly as profitable for an investor.  It would only generate $16,400 before closing costs, not leaving much room for potential problems.  This opportunity does not meet my minimum profit requirement for a sandwich lease option. However, there are ways to renegotiate the deal with the seller. With the appreciation this low it must be more of a buyer’s market.  You should be able to:

  • Negotiate price and terms: Ask for a better price and for additional monthly credit towards the purchase.
  • Ask for the equity buy down of the mortgage during the option period. For example, if the seller owes $100,000 on their home at the start of this option and at the end they only owe $90,000, then you would receive the $10,000 of credit that was paid on the mortgage balance during the option period, because in effect you had been paying that mortgage payment during the option period.

If the seller would not agree to the additional terms, I would gladly let it sit until it makes sense for them to agree to terms that would make this transaction meet your profit requirement or consider a cooperative lease option.  In any case it must meet your bottom line number and result in a win for you and the seller.  Let it sit until their motivation increases.  It can take months, but patience pays off.

Example #3 – Sandwich Lease Option

Let’s look at the facts:

  • Seller has a home worth $235,000 and will sell it to you for $225,000 on an 18-month option.
  • The appreciation rate is 5 percent per year (or 7.5 percent over 18 months) which would generate an additional $17,625. This home is in a very diverse area out in the country.
  • The homes range in square footage and acreage.
  • Prices range from $150,000 – $450,000.
  • These factors let us establish the option premium at 10 percent or $23,500.
  • The rent you pay the owner is $1,200, and the market rent you expect to receive is $1,450.
  • The seller owes $150,000 on their mortgage and agrees to take $75,000, less closing costs, at the time of closing ($225,000 sales price less $150,000 current mortgage balance). This allows you get the mortgage equity during the option period.  The equity from the principal pay down during this option period is estimated at about $200 per month or $3,600.

What is your estimated profit in 18 months?

Profitability Worksheet
Lease Option
 Example 3
Purchase Costs Totals
Purchase Price $(225,000)
Total Purchase Costs $(225,000) $(225,000)
Income Sources 
Current value
($10,000 above purchase price)
 $  235,000
Value of Lease Option (10%) $   23,500
Expected Appreciation
(5% annually, 7.5% over 18 months)
 $   17,625
Expected Sale Price $  276,125 $  276,125
Expected Monthly Cash Flow
($250 per month for 18 months)
 $      4,500
Expected Monthly Equity
($200 per month for 18 months)
 $      3,600
Total Other Income $      8,100 $      8,100
Expected Profit $    59,225

 

Note there are no commissions being paid to Realtors in these examples.  Discussions of working with Realtors will be handled in later chapters, however, if you are paying any type of Realtor commission or option fee up front to your seller, then you will have some out of pocket costs. This will not affect your bottom line profitability, as option fees are applied to the purchase price at closing, but it will affect your upfront cash out of pocket. 

Which of the three scenarios will get you to financial freedom?  The answer is that they all can if you do them correctly.  Example # 2 would probably require changes from the seller to make it work for you.

The primary profit source is the back end – the difference between the purchase price and your selling price that is realized at closing at the end of the lease option period.  When you’re first starting out, you might make deals with smaller backends.  That’s fine.  Those deals help you learn the business.  As you become more skilled in working with options, you will find more ways of improving the numbers to get you higher returns that are still a win/win.  Obviously the higher the backend, the easier it will be to begin working your way towards your financial goals.

Wendy’s Tip
There are always unexpected costs in any deal and, therefore, I like to make sure that I always have extra profit built in to any real estate transaction.

Always plan for something that could go wrong. There will always be someone that won’t pay rent, a furnace that goes out, a roof that leaks, a septic field that fails, etc.  Plan for the worse and you will be safe.