There are three schools of thought when setting a lease option price:

1.    Use current value

2.    Use estimated value at time when contract is to be exercised

3.    Set the price at future market value

To be quick and easy, you can use option 1 by finding today’s value for a similar property, or by using the positive cash flow with some notion of a current cap rate.

However, option 2 is preferable to maximize your profit, while still retaining a bit of future security.For the landlord, option 2 is preferable because it will likely be a higher number than where the property is today.  The future value is determined in the same way as option 1, except you are using a future estimate of rents. Assuming your rents increase by 3% per year, the cash flow at the end of the lease-option would be accordingly higher, as would the expenses (considering inflation).  If done correctly, rent increases would outpace inflation and the property value would increase.  That increase will be reflected in the higher option price at the end of the lease term. It’s not uncommon for a lease term to be anywhere from three to five years, though they can be as short as a few months or as long as ten years or more.  Those points are negotiable.

Option 3 can go either way.  If the market rises the property could be sold at a higher price point, potentially higher than what you would have estimated using option 2.  However, if the market drops, you could lose some of that ground, and maybe even find yourself selling below today’s price point (option 1).

No matter what the purchase price, you also want to make sure you maximize the monthly option payments.  This makes pricing the monthly option payments so very important.

Setting the Monthly Option Payment

Your goal with the option payment is to set it at a level higher than what you currently receive.  This can only be accomplished if the buyer has positive personal cash flow to divert from their personal finances to pay your option payment since the monthly rents from the property wont be enough to full pay the option.

What usually happens is that you set the option payments at the current level of positive net operating income (rents minus expenses and other fees).  Basically, the buyer collects rent, pays expenses, and the difference comes to you.  This allows you to retain the benefit of the property’s cash flow, while pushing the management off to the buyer. It’s like being a landlord with few of the landlord duties.  The buyer makes positive cash flow himself when he is able to raise rents or cut expenses.

You can also set the monthly option payments equal to, or near, what the buyer would likely be paying if they were to obtain a mortgage.  For instance, if the buyer were purchasing your property for $120,000 using a $20,000 down payment he’d be getting $100,000 of bank financing.  Assume a current interest only payment at 8%, or $8,000 per year, or $667 per month.  You might charge the buyer $800 per month as an option payment because your lease allows him to purchase the property without using financing, which ultimately saves him money.  If your property was already bringing in $1,000 per month positive cash flow, the property generates $200 extra (after buyer gives $800 to you each month).  That leaves $200 in the kitty which can go toward the buyer’s future down payment or into the buyer’s pocket.

Summary

By lease optioning your property you avert the slow pace of sales in the current down market, avoid both a lower sales price for your property and the capital gains on that sale.  You get continued monthly cash flow, and a decent down payment to be applied toward other opportunities, which are being purchased to allow for a much higher rate of return than your currently held properties.  It’s truly a win-win transaction, and a creative way for landlords to open their portfolios to take advantage of opportunities that exist in down markets.

For more real estate and personal finance tips, visit the Direct Lending Solutions credit library at www.directlendingsolutions.com.

About the author, Craig Grella

Craig Grella is an expert writing on real estate and personal finance topics. He has worked for large national banks, and for several Fortune 500 companies.  He invests nationwide, and his articles can be found online at www.directlendingsolutions.com.

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The Lease Option Landlord – Part 2

Enter the Lease Option Landlord!

The lease option has been a valued purchase and sales technique for single family residential investors for years, and the process is applicable to small multifamily properties as well.  It perfect for the investor who doesn’t want to sell at rock bottom prices, but who wants to tap into some cash for new purchases.

The method works particularly well in down-markets where buyers are low on lump sum cash down payments, but have good credit and decent monthly cash-flow. A landlord can also perform a lease option using standard template paperwork without the services of an agent or broker and save the hefty commission that comes with those services.

Essentially it works like this:

●     Seller Landlord puts his property on the market under a potential lease option transaction, marketing to buyers (existing or potential landlords) who can put some money down.  He offers it with a small down payment, and a subsequent monthly option payment, part of which accrues toward a purchase price to be exercised at a later date.

●     Seller and buyer agree on terms like future purchase price of the property, length of the lease-option, monthly lease payment, and how much money (if any) will be put toward the future down payment for the buyer.

●     With the transaction complete, the seller retains title to the property and continues to hold the deed.  If there is a mortgage on the property it remains in the seller’s name and under his credit.  The buyer makes monthly option payments to the seller landlord (that’s you!) until the lease option is exercised and the buyer purchases the property outright (at the pre-negotiated purchase price), and takes title to the property.  At the time of purchase, you will convert the buyer’s down payment, and any sum accumulated for that purpose, and the buyer will bring the difference in cash or bank loans.  Essentially, at the exercise, the buyer is taking you out completely for that pre-negotiated price.

Advantages to the Lease Option Landlord Seller

In addition to getting a down payment to put toward another property purchase, the seller remains on title of the current property, controls the deed, and should the buyer on the lease option default or breach contract, the seller pursues eviction rather than foreclosure.  The seller receives a great sales price at some future date, avoids capital gains tax until then, and receives positive cash flow in the meantime.  If the buyer decides not to exercise the option all the monies paid up to that point remain with the seller-they are not refundable to the buyer.

Advantages to the Lease Option  Buyer

Right to use the property, collect rents and enjoy cash-flow.  Buys a property with relatively low down payment, and defers a larger purchase expense until a later date. If buyer has arranged for a portion of the lease payment to build toward the down payment at lease exercise the buyer has much less cash to bring in later.

Disadvantages for the Seller

If there is currently a lien on the property it will remain in the seller’s name and payments must continue to be made by the seller or his representative.  If buyer defaults seller will have to step back in to manage property.

Disadvantages to the Buyer

Already stated before, in most lease-option transactions it is standard for the seller to keep all payments made on the deal, therefore if the buyer walks away, defaults, or elects not to exercise the option, he loses all those payments and any down payment/ option consideration made at contract signing.

How Much of a Down Payment Should You Collect?

The answer here is easy: as much as you can get!  There is no right or wrong in this case, but the more you get the better.  At the same time, you don’t want to cash-strap the buyer because she should have some money left over to cover any expenses that might creep up unexpected.  Getting a higher down payment in that case may jeopardize the option, and that doesn’t make much sense in the long run.

Start by asking for a down payment equal to the down payment you need on the property which you are looking to purchase. If that’s not feasible, ask for 15% of the purchase price of the property and negotiate down from there. Fifteen percent is less than any bank will require from that buyer as a down payment, and much less than private lenders would ask for.  Also, you aren’t charging financing on the remaining amount, like the bank would, so there’s a benefit for the buyer to get the deal done at that level too.

Check back for Part 2 of this article next week…

For more real estate and personal finance tips, visit the Direct Lending Solutions credit library at www.directlendingsolutions.com.

About the author, Craig Grella

Craig Grella is an expert writing on real estate and personal finance topics. He has worked for large national banks, and for several Fortune 500 companies.  He invests nationwide, and his articles can be found online at www.directlendingsolutions.com.

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The Lease Option Landlord – Part 1

While looking for a place to hang my license I met several “professional” agents and brokers. The difference between professional brokers and all the others is that professional brokers are those who work full-time helping clients buy and sell real estate; that is, they do nothing else on the side.  This is a stark difference from the “side agent” who also has a day-time job, like working as a data entry technician for a local medical lab, and selling real estate only at night and on the weekends.  After interacting with professional brokers I realized how much they knew about the market, and how much they could bring to the table, even for someone like me who was just starting a career in real estate investment.

Now, I rely on professional real estate brokers to help me find and negotiate the purchases of all my units; doing so has saved me thousands of dollars, and more importantly, thousands of hours of precious time.

The following are a few tips to aid you in choosing a broker to help supercharge your landlord business.

Experience Trumps All

Experience is the yardstick we use to measure most professionals.  As a landlord with little time to waste your goal should be to work with the most experienced broker available in your market.  In the long run, an experienced broker will save you time and money; two things which will more than justify the time you spend finding that broker.

Finding an Experienced Broker

You could use online resources like Realtor.com, or visit the offices of local brokers, but that wont guarantee you find someone who has experience with investors and landlords.  The best place to find an experienced broker in your market is to attend local investment club meetings.  There you’re likely to find several brokers who specialize in different areas of the industry with experience in areas like residential property, commercial property, and even mixed-use.  Further, at investment club meetings, you are much more likely to find brokers who are also investors themselves; and this distinction can make all the difference.

Brokers with investing experience know all the documents you’ll need before you make an offer, how to successfully negotiate that offer, and give you tips on managing that property once you own it.  The broker who helped me purchase my first property even gave me advice on the eviction process when my first tenants decided to stop paying rent; a tip which saved me hundreds of dollars in legal fees.

Interviewing Potential Brokers

When interviewing brokers make sure to ask the following questions, in order of importance:

●        How many properties, similar to the one under your consideration, has the agent/broker successfully identified and negotiated for his clients?

●        What is the agent/broker’s philosophy on determining value? Do they rely on comparative market analysis, appraisals, broker price opinions?

●        Does the agent have any commercial sales designations like CCIM, or any continuing  education certificates showing a further interest in investment real estate?

●        Will the broker help you find tenants or manage the property?

●        Does the agent/broker represent only sellers, buyers, or both?

●        Does the broker spend most of his time in the office, out in the field, or working from home?

●        Is the broker reachable on weekends during evening hours?

If you are considering this broker to help you list property for sale, there are a few additional questions you should consider:

●        What is the broker’s average list price to sales price ratio?

●        What is the broker’s preferred marketing strategy?

●        Can the broker provide at least three references with which you can speak?

Finally, you’ll ask about their fees for helping you purchase or sell property. While it is customary for the seller to pay sales commissions, it is not uncommon for those costs to be split between buyer and seller on larger residential and commercial properties.  Commissions are a negotiable item on most real estate contracts and you should understand the fees before making offers.

Buying: A Closer Look

Most real estate commissions allow brokers to prove certain educational achievements, like college degrees, in exchange for concessions on certain licensing requirements.  While education does play an important part in a broker’s career, it should not take the place of actual sales experience. Due to issues of confidentiality, your broker may not be able to share every detail of previous transactions, but he should be able to supply references.  Get three and call each one.  Make sure the references are not from recent transactions. References to transactions that took place very recently will likely be in the “honeymoon” period and might not be completely objective.  References from transactions a few months past have the benefit of time to reflect on things the broker did that they could have done better.

Many commercial purchases require an offer be made before viewing the property. Make sure your broker is familiar with that process, and has drawn the contract to leave sufficient room for you to walk away if you see something you don’t like at the property.

Selling: A Closer Look

The sales price ratio is very important.  A tight ratio, that is an average sales price very close to the list price, tells you the broker prices property efficiently and has a thorough understanding of her market.  A loose ratio, one with more variation between average sales price and list price, tells you the broker might not have her finger on the pulse of the market, or might just like to get units up on the MLS and let the chips fall where they may. Brokers with a tight ratio tend to put more time into determining fair market value while those with loose ratios tend to rely on their negotiation skills.

A tendency tight or loose is neither right nor wrong, but using brokers with a loose ratio can take extra discipline on your part. Many investors rely on their broker to accurately price their property for sale, and will make assumptions about potential profit on that price recommendation. A broker which prices your property high just to assuage the investor’s irrational thoughts of value is actually doing a disservice, because when the broker needs to drop the price to actual market price, or lower, the investor will have to recalculate their costs and profit; which, in turn, may affect the investor’s decision to keep the property on the market longer or remove it until he can get a better price.

Documentation

Buying and selling rental property is more than just numbers; it requires attention to detail and a thorough understanding of contracts and real estate paperwork..  When problems arise in real estate the place you go to settle claims is the contract.  The broker you choose should have be able to demonstrate her knowledge of all the forms you will likely encounter during the transaction.

Real estate commissions make many standard forms available as templates through the local MLS, and technology makes it even easier to access and submit these forms with just the push of a button; but it is important your agent know how to deviate from, or modify, those forms if necessary.  Sometimes stock paperwork is just not appropriate.

Summary

A real estate transaction can be wrapped up in a few hours, or it can take years. Choose your broker wisely, not because he is your friend or you were referred to him from a friend, but because he has relevant experience, has demonstrated knowledge of transactions similar to your transaction, and most importantly, because you feel comfortable working with that person.

For more information on buying and selling investment property, or obtaining mortgages for that property visit the credit library at Direct Lending Solutions (www.directlendingsolutions.com).

About the author, Craig Grella

Craig Grella is an expert writing on real estate and personal finance topics. He has worked for large national banks, and for several Fortune 500 companies.  He invests nationwide, and his articles can be found online at www.directlendingsolutions.com.

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How to Choose a Real Estate Broker

Allow me make a confession to you – I am a conservative Real Estate Investor.

I don’t make apology for it, it is what it is. That doesn’t mean I do not take risk. On the contrary, if you asked my wife, I believe she’d tell you she has to reel me in from time to time. Though I do not mind risk, my conservative nature forces me to mitigate risk as much as possible. I do that by trying to be prepared.

Let’s face it – regardless of where you fall on the political spectrum, the economy smells worse than a gut truck. America is hemorrhaging jobs, incomes are down, foreclosures are up and real estate has tanked.

Governments around the world are paralyzed with the fear that their banking systems may fail. They have instituted “Stress Tests” for the banks. Basically what they do is put them through a simulated financial upheaval to see if they would survive. Most banks pass the Stress Test, many do not.  I thought, “why not adapt this idea some?”

Why not perform a “Rental Stress Test?” Take your rental business and assume the worst – and see if you’ll survive.

I’ve mentioned elsewhere of how I use Excel before I make an offer I run numbers through my super-duper, top-secret spreadsheet. This spreadsheet has my assumptions (which are conservative BTW) and I just plug in the variables (price, interest rate, etc.). If the numbers work – I make an offer. If they don’t (or are marginal) I pas. Plain and simple.

Now, I can be a little paranoid. Well… maybe a LOT paranoid – but I like to be prepared. So in taking a look at the economy I try to imagine what could happen:

• Even more foreclosures
• Even fewer jobs
• Even lower incomes

All of that, potentially, points to – LOWER RENTS just to stay competitive in the market.

So here is what I did for my Personal Stress Test…

On my spreadsheet I used all my current data (mortgage, insurance, taxes, maintenance, vacancies, etc.) and I slashed my rent income to 80% of the market rate (or current rent whichever is lower).

If the property still cash-flowed it passed. If it did not – it failed. Now this does not mean that I plan on dumping the property, but it does mean that I have to stay on top of this property and keep it as lean as possible.

I have found that this “Rental Stress Test” has bled over into my purchasing criteria. You can’t be too prepared in the event of a bad economy. I’m not trying to bee doom and gloom, but I sure want to know what it is going to take to tank my real estate business.

I am very interested in your thoughts…

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Rental Stress Test

This subject could easily fill a book, so here are my reasons in bullet-point form:

• Too many complaints from neighbors. Tenants usually only sign a year lease so if they annoy their neighbors, they can simply move. The neighbors then transfer their frustration and annoyance to the landlord.
• Condo Associations. If you like to invest by committee, condos are for you. Don’t want to afford that fat assessment to resurface the parking lot right now? Too bad. Pay up.
• Condo Commandos. These people are usually retired and have nothing to do all day. Nothing, except get all up in your business that is. They feel that you as a landlord are devaluing their property by renting your unit and they won’t let you forget it.
• No cost controls. Between assessments, community equipment (laundry, elevators, etc) repairs and joint utilities (water, electric, garbage) your monthly condo dues could fluctuate wildly and there’s nothing you can do about it short of buying the majority of the units in your condo complex so your vote has enough weight to tell them you don’t want to pay.
• The condo association can take possession of your unit by law. Besides the county tax collector and Internal Revenue Service who threaten to take your property (unit) if you don’t pay them, surprise(!!!), the condo association can and will do this also if you don’t pay them.

And that’s not to mention the situation where some incompetent condo president decided to allow a few owners to claim on the association’s insurance policy unnecessarily. Now no insurance company will insure the association and they had no choice other than to buy a policy from Lloyd’s of London.

For anyone who doesn’t know, Lloyd’s of London will practically insure anything but you’ll pay dearly for it. Want to insure your cat against being struck by lightning? Call Lloyd’s. You’re Mariah scary Carey and you want to insure your legs (of all things) against damage? Call Lloyd’s.

I’m sure there are other reasons but those are the major sticking points for me. Investor beware.

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Why Condominiums Are A Bad Rental Investment

The real estate market has had its ups and downs, with the end result being plummeting rents and massive foreclosure rates.  For the savvy investor, this also means sweet deals on respectable properties.  This, of course, leads us to the question of the hour: should you pay off the mortgage(s) on your rental properties, or do you leverage the equity you’ve built in them to purchase new ones?

Understandably, it’s a tough call.

Paying Off Your Mortgage – Pros

It doesn’t take an accountant to figure out that a property without a mortgage is inherently more profitable.  More of the money that your

tenants pay you go into your pocket, making a mortgage-free property an ideal situation for many.  Not only that, but paying off your mortgage is also much easier to do when the property is rented out- if the tenant is paying the mortgage, you really have nothing to lose aside from a little sweat equity every now and again.

This may all seem quite basic to anyone with a bit of financial know-how, but have you really considered all of the finer details?

• Little/no mortgage payments - Using the income derived from your tenants to pay down the principle owing will lower mortgage payments.

• Lower overall overhead -  Reducing mortgage payments and/or interest payments reduces your financial overhead, making it easier for you to obtain profitability.

• More equity available if necessary - Obtaining loans at an excellent interest rate on the value of a paid-off property is surprisingly easy (it’s amazing the value that financial institutions put into debt-free assets).

Paying Off Your Mortgage – Cons

Many people reach this far and say “really, there are cons to paying off my mortgage?”  Well, in fact, there are.  Quite a few of of them actually.

If you’re the financially creative type, paying off your mortgage does indeed reduce your overhead.  It also increases your profitability for each property, and increases the amount of cash flow that you may wind up having to pay taxes on.  There are many tax loopholes that exist for properties that are still mortgaged, and those options start drying up once there is no lien against the property.

As well, using your working capital and income to pay down your mortgage on your rental properties also means that you have less liquid assets available to you for immediate financial purchase or investments.  For some, this will not be a big problem, but for others it can outright stall their investment plan.  Talking to a certified accountant that specializes in real estate accounting is always a good option in determining which road you should take.

Some advantages to keeping your properties mortgage are:

• Constant new cash flow - In rare instances where the market plummets this can be a problem (owning a home worth less than the mortgage is never a good thing), but for the most part a sound property investment will grow in value.  Leveraging the equity in your rental properties via HELOC’s or traditional mortgages can provide a steady, relatively low-risk influx of cash.  Someone else’s cash, as well.

• Tax breaks and profit reduction - For most people it doesn’t make sense to reduce profit, but for those seeking low-risk tax shelters, an investment property is a great way to tie up cash in an appreciating asset.  Homes that are mortgage offer more in the way of tax credits as well, so talk to your account to see what applies to you.

If you are willing to accept some risk in your investment strategy, leveraging the equity of your current rental properties to purchase some new ones can be a great way to increase your investment portfolio.  There are many landlords who have dozens of rental properties, each remortgaged when their mortgage comes up for renewal.  As always, ensure that you think your financial strategy through before making any decisions.

Good luck out there.

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Pay Off the Mortgage or Leverage Your Equity? It’s a Tough Decision.

These days, as any real estate agent will tell you, it could take the better part of a year for the process to come to a close. In the past I have made posts detailing some of the completely unprofessional behavior exhibited by the banks during the “short sale” process.

For the uninitiated, a “short sale” is when the bank agrees to discount the loan amount due on a property usually due to some financial hardship on the part of the borrower. Whereas, a foreclosure is when the bank takes possession of a property and evicts the previous owner with the intention of selling it at market price to re-coup its losses.

I have also heard stories of people basically squatting in homes where they live there but are only paying utilities and not rent or a mortgage payment. In this case, if the property is actually foreclosed on, they will be given 30-days notice to vacate the property. Not a bad deal for a short time anyway.

Recently, I heard an interesting news report about why the banks are doing everything in their power to delay a short sale or foreclosure. Surprise! It’s for their own benefit, of course.

Basically, when a bank forecloses on a property, they typically take some kind of financial loss which affects the bank’s balance sheet. This is not usually a problem for the bank if it’s a few hundred properties.  However, when the number of foreclosures is in the millions (like is happening today) it causes a big problem for the banks in that those losses are large enough to affect the bank’s stock price which in turn affects their market capitalization.

Suddenly they’re not so rich and can’t operate like they used to. So, their answer is to delay, delay, delay so as to spread the losses over time which in turn reduces the hit to their stock price.

Take a look at this interesting interview of former bank regulator William Black, author of The Best Way to Rob a Bank Is to Own One.

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Why Banks Aren’t Foreclosing on Schedule

So the other day as I was preparing the spreadsheet I use to track income and expenses for my rental properties in 2009. After finishing that task, I had a chance to look back at the spreadsheet for 2008 and noticed a few things.

• The constant expenses incurred by the properties (property tax & insurance) are lower than they were last year. This is a good thing since rents are ridiculously low due to the downward pressure exerted by a glut of housing units available for rent.
• I had large gaps in rental income last year due to needed repairs and thanks to irresponsible tenants. Read a good example of that here.
• Due to the number of new renters coming into the rental market, some with not-so-good credit, it’s now possible to ask for first month’s rent, last month’s rent AND a security deposit. Here in Melbourne, Florida for the longest time, tenants only were asked for first month’s rent and a security deposit. I’m not sure why this is but it seems the be the done thing here.

Seeing that there’s nothing that, I personally, can do about the ailing economy, here’s what I can and will control during the upcoming year:

• Every time an insurance policy comes up for renewal, I will do some checking for alternative pricing. No more “automatic renewals” for insurance policies. Sorry insurance agents, you guys have had it WAY too easy for too long.
• Regular property inspections: At least once a quarter, I will inspect each property to make sure that tenants are upholding their end of the agreement. (i.e.- they break it, they fix it) Too many times, I’ve had tenants bail on a lease and leave me with the repairs.
• All tenants will continue to pay late fees. No exceptions. The other day, I had a tenant call me to say that they “mis-budgeted” due to Christmas (whatever) and could they pay late. “Sure,” I said “as long as you include the late fees.” I could tell that the tenant was hoping I would say “Sure and don’t worry about the late fees.”

So there you have it, dear readers, the Landlord-Success.com New Year Resolutions^TM for 2009!

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The Economy’s Effect On Rental Property

Apparently the reason he started buying all these properties was that back in 1973 our “good friends” at OPEC decided to basically stop supplying oil to the United States and other countries who supported Israel during the Yom Kippur War

Apparently, the ensuing oil crisis caused the United States and other western countries to seek other oil supplies as a way to blunt the effects of another potential shock to oil prices.  This included drilling domestically which made Oklahoma City a good place to be at the time.

A huge influx of people descended on Oklahoma City looking for well paying yet unskilled jobs in the oil industry. From what this guy said, there was such a shortage of housing that people were living in tents just to be close-by to these jobs.

As a result, the landlord business was the business to be in at that time. After 1980, oil prices declined for 6 years due to a glut of oil on the world market. Over-production and weakening demand were the main reasons for this situation.

According to this guy, around this time people began leaving in droves from the oil industry, including Oklahoma City, thereby devastating the housing market there. From this guy’s account, you couldn’t give a house away to save your life. Sound familiar?

His advice and my takeaway was that:

• Most times, it doesn’t matter how smart you are and how hard you work, a lot of people’s success comes from luck and being in the right place at the right time.
• Real estate is not the most liquid of assets in hard times.
• Big booms (real estate, oil, gold, technology) don’t usually last
• Keep your chin up. Things will tun around.

Personally, I like what Warren Buffett says, “Be nervous when others are greedy and greedy when others are nervous.”

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Sage Advice From An Ex-Landlord

Also interesting is the occupancy of the large national banks in these buildings. My hotel room faced a building having at least 40 floors with the name Wachovia emblazoned across the top. If banks are failing left and right, how can they afford to occupy enough of a 40-story building to have their name on it?

I know that Orlando is a major city in Florida and the big banks feel the need to have a presence and all major city centers but business is business. According to the Orlando Business Journal , “Wachovia posts $8.9 billion loss, will cut 10,7500 jobs.” I guess it’s better for the company’s bottom-line to cut jobs than relinquish real estate in a major city center.

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Tough Times All Over