Archives for July 2011

The money’s sitting there. JUST TAKE IT!   

July 22, 2011

Speaking of UC-Santa Barbara, here’s some loser who couldn’t get into a better school. Carol Greider. America’s latest Nobel laureate in physiology/medicine.

A few weeks ago we got chided (chiding is a regular occurrence in our world) by the guy in change of a far more prominent personal finance blog that we occasionally contribute to.

A high school senior had a choice to make – a free ride at a demanding but obscure college, or full price ($40,000) at a heralded school in the Ivy minor League. Let’s call the first school Commuter University, and the latter Pretension College. She posted her dilemma on the site and asked commenters to weigh in.

Can you guess what people recommended? Here, we’ll do it in multiple-choice form:

__ Do whatever you think is best.
__ Either one is a good choice, there are pros and cons to both.
__ This is the time to live, not to think about financial considerations.
__ Have you thought about student loans?
 __ Are you insane? Go to the school that’s offering the full scholarship.

The answers were evenly split among the first 4, with one vote for #5. You can probably guess whom.

#1 and #2 don’t even count as advice, but that doesn’t stop people from sharing their non-opinions. #3 and #4 are essentially the same (rotten) advice, which is to incur debt now and worry about the ramifications later.

The worst part is that she was going to study a hard science, too. Look, if you major in chemistry, it doesn’t really matter whether you do it at Duke or at the University of North Texas. It’s not going to impact your ability to get a job in your chosen field. Only those who employ non-scientists (sociologists, social workers, basically anything that starts with “soc-”, with the possible exception of soccer coaches) care that you went to a “prominent” school. A Harvard English degree might be more profitable than one from Cal-Santa Barbara, only because of that ridiculous concept called cachet. It’s not as if the professors at the former can inspire you to parse the meaning of Pilgrim’s Progress any better than those at the latter.

This girl was obviously bright enough to get the attention of multiple schools, but her financial acumen was the equivalent of a kindergartner’s. And along with the failure to make the obvious decision were a litany of excuses, most of them citing “life experiences” and other non-monetary considerations. Not that non-monetary considerations aren’t important in this life, but paying for college isn’t one of them. Knowing that you’re going to be incurring 4 years’ worth of student loans is like knowing that you’re going to have a gigantic credit card balance in 2015. Or knowing that you’re going to lose every game of chance you play. Or knowing that your house is going to lose $40,000 in value. The last three examples are somewhat subject to explanation, but the first one was a fixed cost that this woman gleefully embraced. The two birds in the bush are the primary motivating factors for many a young person who can’t see the giant California condor resting in her palm.

We finished our diatribe by asking an equivalent question with a slight twist, which no one (including the story’s protagonist) bothered to answer:

This time, it’s Pretension College that offers you the full scholarship. Meanwhile, Commuter University starts off your freshman orientation week by handing you a $40,000 check. Now which school do you prefer?

**This article is featured in the Carnival of Personal Finance #320-Plutus Awards Edition**

Filed Under: Bad Examples, Consumer Debt, Education Tagged With: Carol Grieder, college, Nobel Prize, Santa Barbara, yakezie

Stealing Money With Lease Options

July 20, 2011

If you missed Part 1, check it out now (funk soul brother)

This is what happens on the 365th day of most lease-option agreements. Either that, or someone reups.

Don’t confuse a lease option with its sturdier sibling, a lease purchase, in which you’re obligated to sell the house and the tenant is obligated to buy (unless you mutually agree not to.) Because clearly you should avoid this, we’re not going to explain why you shouldn’t. You shouldn’t smoke cigarettes either, but if you don’t know why we’re not going to waste time telling you.

Again, it’s called a lease option. You want the tenant to be in a position where she can choose to buy the house. If she’s required to buy the house, that means you’re required to sell it. You want to hold on to your asset if at all possible.

We’ve left one crucial piece of information out so far. How many tenants exercise their lease options and live happily ever after?

Some estimates range as low as 5%, which common sense should dictate is a reasonable figure. Again, to exercise the option the tenant has to be able to diligently save for 12 months (or however long the lease is.) Leopards don’t change their spots. Why wasn’t the tenant able to have saved that money in the first place? The vast majority of lease-option tenants simply don’t have the self-control to build up a down payment. What they do have are dreams built on gossamers.

Would you buy a lottery ticket with a 95% chance of winning? For a smart landlord, that’s what a lease-option is. The downside here is minuscule. Not negligible, but tiny. Remember, the worst-case scenario is that you got a year’s worth of free money. For that worst case to happen, the appraised value of your house has to have risen enough that it’s worth the tenant’s while to make an offer. Plus the tenant has to be good for the money. Future housing prices and your tenant’s ability to save are two variables out of your control, but the odds are still hugely in your favor.

One advantage to lease-options is that they work in both expensive and cheap housing markets. In the former case, tenants are looking to lock in a price for fear that eventually they won’t be able to ever buy anything. In the latter case, when the likelihood of the tenant exercising the option is greater (yet still small), you the landlord protect yourself against any potential losses. While still charging premium rents.

(Obligatory paragraph about the morality of this, and seriously, we’re not going to address this again. The tenants know what they’re getting into. They have to sign the lease-option agreement, which means they’re obligated to read it or get someone to explain it to them.)

Really, the only downside is the 5% chance that you could “lose” (i.e. have to sell) your house. Even if that’s a conservative estimate, it’s still overwhelmingly likely that once your lease-option term expires, you’ll still have a house and your tenant will have nothing. That house remains an asset, and not just in that it’s got a dollar value attached to it. At Control Your Cash, we define an asset as something that’ll help you grow wealth (You really need to read the book.)

The house doesn’t just have an intrinsic worth, it enables you to increase your own worth by letting you rent it out – over and over again.

One more thing. Make sure your lease-option agreement prohibits the tenant from coming to the end of the term, not having the money to purchase the house in hand, and thus simply assigning the option to someone else whom she can then buy the house from at her convenience. This is called a “non-assignability” clause. You don’t want the tenant’s rich uncle covering for her and taking your asset.

Rent-to-own is how certain enterprising furniture and appliance sellers got obscenely rich. If there are enough people out there who can’t even muster up the requisite money to buy a sofa without making a year’s worth of payments, imagine how many more can’t do the same thing for a house.

**This article is featured in the Carnival of Personal Finance #319-Summer Heat Wave Edition**

Filed Under: Consumer Debt, Healthy Living, Making Smart Choices, Real Estate Tagged With: lease option, lease-option agreement

The Easiest Money You’ll Ever Make

July 18, 2011

Here’s what you need:

1. 20% of the price of a house, condo or townhome.
2. A few months’ worth of patience.

Welcome to the lucrative world of lease options. They’re a way to increase your wealth with almost zero downside.

Lease-option holder. Still, you probably want one who uses a bottle opener

A lease option involves you buying a second home, renting it out, and giving the tenant the choice (or “option”, if you will) of buying the home once the lease expires. What makes the lease option so wonderful for the average landlord – correspondingly less so for the average tenant – is that you can charge above-market rates throughout the lease. After all, you’re doing the tenant the favor of letting her own the house after a year (or whichever term) expires. It’s like a layaway plan for what the hackneyed expression calls “the biggest investment you’ll ever make.” You let your tenant lock in a price for the house, essentially saying “You can buy the house for $x a year from now, regardless of what the market does. What’s a better deal than that?”

Meh…I don’t know. I’d have to charge an awful lot more than market rents to make it worth my while, if I’m going to have to surrender the asset within a year.

First, kudos for understanding that the house in question is an asset, and can help you grow your wealth regardless of what market conditions are doing.

My pleasure. You do realize that I’m not an actual person, and merely a device of your own creation that you use to clarify your thoughts, right? You’re talking to yourself.

Anyhow, you can typically charge at least 10% above market rent on a lease option. But that’s not really important. What’s important is this:

Most tenants never pick up the option. When the time comes for them to exercise it, it turns out they didn’t spend the previous year saving the requisite cash for a down payment. That’s one reason why they’re renting instead of owning in the first place. Renters, by and large, aren’t as bright as landlords. (Hopefully the smart-but-sensitive renters reading this can comprehend the phrase “by and large”.)

A lease option is similar to stock options, or commodity futures – you’re assuming market risk for the tenant. Real estate prices might rise 50% in the next year, but you’re offering the tenant a chance to lock in a price today. If your $100,000 house ends up being worth $150,000 a year from now, you, the landlord, will have forgone $50,000.

Of course prices could fall, too. Should they, even by just 1%, you’re protected. Obviously your tenant isn’t going to exercise an option to buy a $99,000 house for $100,000. Which means free money for you: you just received a year’s worth of premium rent payments that went well beyond covering your mortgage payments. That’s the ultimate hedge against a declining real estate market.

And if the market rises, rather than declines, you as the landlord still won’t necessarily get screwed. Again, the typical tenant doesn’t plan far ahead enough to take advantage of the lease-option. If the house does indeed rise in value 50%, and theoretically turns into an immediate $50,000 bonus for your tenant, she still needs to exercise the option. That isn’t easy. For an FHA loan, she’d need to put down 3 1/2% to buy the house from you. If she can’t put the necessary down payment on the house together once the lease expires, her opportunity will disappear and she’ll be back where she started, with no equity in a home and a rent payment due at the end of the month. (Actually, the tenant will be several steps behind where she started; now with 12 months of rent payments gone forever.)

Let’s see how this works in practice.

Say you buy a $100,000 house with 20% down. We’re assuming 20%, so you won’t have to pay mortgage insurance. At current 30-year fixed mortgage rates of 4 1/2%, that means you’d be making monthly payments of $405.35. You find a tenant who wants to own a home one day, and offer her a lease-option. Once you do, there are two ways you can do this.

Get the lease-option money up front, or
Spread it over the course of the lease.

Let’s assume a 1-year lease, and that fair-market rent is $450 a month. That’s what you’d charge an ordinary tenant who has no intention of buying the place. That ordinary tenant would pay $900 up front (1st month’s rent + security deposit).

With a lease option, you could ask for an extra $450 payment up front, and let the security deposit apply to the down payment if the tenant exercises the option (which she probably won’t.) Now you get a total of $1350 up front, $450 of which the tenant will never see again, after a year expires and she’s nowhere near amassing the down payment that would guarantee her the house.

Or instead of getting an additional $450 up front, you could just raise the monthly rent. Using our rule of thumb from above, of charging a 10% premium, that means you’d collect monthly rent payments of $495. Now you’re getting an extra $89.65 a month (the difference between the rent you collect and your mortgage payment) simply for getting the tenant to sign one additional piece of paper. Even better, your lease-option tenant is going to be a little more motivated than the average tenant to keep the place looking nice and in good repair. After all, the lease-option tenant hopes to own the place, and relatively shortly.

By the way, that $45 premium applies to the option only. Technically, it’s not even part of the rent even though you’re collecting it every month. If the tenant doesn’t exercise the option, you keep the premium payments.

Imagine test-driving a car for a year, and paying for the privilege.

Again, like in any deal, you’ve got to look at the potential downside: the tenant might be one of the responsible few who actually exercises the option. In this unlikely case, at the end of the lease you’d refund the tenant $990 (or $900, if we’re using our initial scenario of getting the lease-option money up front.) Now the tenant only has to scrounge up $2,510 (or $2,600) to take title of the house under an FHA loan. And she’d still have to make prohibitive mortgage insurance payments. Or she could put 20% down and avoid mortgage insurance, which means she’d need to have saved $19,010 (or $19,100.) As if.

And even if that does happen, you’ve still got a year’s worth of above-market profits to show for it. Plus, you won’t be obligated to your mortgage lender for the next 29 years. Theoretically you could buy another house and do the same thing again. Remember, the tenant is only going to exercise the option if she has a) sufficient fiscal discipline to sock away money for a year, but b) so little fiscal discipline that she’s renting instead of owning in the first place. That’s a tiny, tiny area of overlap.

Wednesday, Part II of how to ~~steal~~ make money with a lease-option.

**This article is featured in the Carnival of Wealth #48**

**This article is featured in the Totally Money Blog Carnival-It’s So Hot Edition**

Filed Under: Education, Entrepreneurship, Estate Planning, Finance, Real Estate Tagged With: lease option