The Power of Options

General Real Estate Investing
1

We just had one of our investments grow up and cash out.
It worked so well for us that I thought I would share it with you.

A little over ten years ago, someone responded to a mailing we did to find leads on houses to buy. They were homeowners who were having a bad time, but they did not really want to move out of their home if possible. They didn’t want to sell, but they needed money badly to solve some pressing problems. No one would lend them more money, and the credit cards were maxed out. They were calling us to borrow money.

They were behind in the payments several months and facing foreclosure. The air conditioning had just gone out, and the roof was leaking. To ad insult to injury, the transmission went out on the husband’s car, and his job was in jeopardy if he didn’t get it repaired soon. They had a lot of deferred maintenance because they just couldn’t catch up with their bills, but their debt was catching up to them. They needed a solution fast.

It’s not really our business to lend money, but it is our business to buy things. We bought an option on their house for $10,000 cash that was in a self-directed IRA. The money was first applied to the back payments and the repairs to bring the house back to good condition, and to the car transmission, and then to the rest of their other bills. It solved their most pressing problems, and they were happy. They wrote us a letter saying that we had pulled them out of the quicksand.

The option let us purchase the house at any time in the next twenty years for the value we agreed to back then of $89,500. This was above their mortgage balance, but it was below the fair market value of the house at the time. Now time has gone by, and the house just sold for $203,723.

The homeowners collected about $42, 000 at the closing for their equity. We collected $109,300 after the smoke cleared due to the appreciation over the ten years. We had no management, no vacancies, no negative cash flow, and no further payments after our initial option consideration. Best of all, the gain was in the IRA. The sellers stopped the foreclosure that was threatening them, saved the husband’s job, and fixed the house on the option money. They didn’t have to move, and they didn’t have to make payments to pay back the option money. They only had to give up the upside potential of the house.

If N=10 years; PV=$10,000; FV=$109,300; and PMT = $0; I get a yield of about 27% average annual compounded return on the money we invested. This is not too bad compared to CD or money market rates over the last ten years.

You might want to try something like this if you have an IRA that’s not working hard enough.

2

Valgolas,

GREAT WIN-WIN STORY!!! What a wonderful business this would be if they all worked out like that! Congratulations!

Mike

3

Congrats on making a WIN for everyone involved! Congrats to your evergrowing IRA too!

4

Thanks, guys. I like a story with a happy ending.

There is just one thing. It wasn’t my IRA. It was in my 20 year old son’s IRA. He worked for a friendly company for a while in the summer when he was nine and ten years old in order to have earned income for the sole purpose of funding an IRA. Too bad they didn’t have Roth IRA’s back then - it would be even better.

Since he was such a shrewd negotiator at ten years old, he managed to beat us out of this option deal for his IRA. We win some, and we loose some. You just do the best you can.

Now, if he can do this same deal over again, multiplied times ten, with the money from this first deal, he will be a millionaire in his IRA by the time he is thirty years old. Not too shabby!

If you have kids, you might want to think about getting them involved in this kind of investing.
They will thank you for it later!

5

Valgolas! – You answered my question I was going to post – mostly.

I was listening to a Barney Zick seminar (on cd) – he mentioned a great cookie cutter plan – I hought it sounded great… but then later, I started to get confused.

He said to help people with their payments (taxes, utilities, whatever) in exchange for an option to buy – even an option to buy at current mrkt prices – with the understanding that they are giving up all FUTURE increases in the house’s value.

Then record a memo of option.

That way, the owners get to STAY in the house, and you get to eventually profit from the difference between the option price and the sale price (assuming the overall price has increased over time).

What confused me later (and still does a little now) is… WHEN does that sale take place??

Question #1: How do you know it WILL (ever) take place within the option time span?

The idea is to let them STAY in the house – but you don’t profit until they are OUT of the house.

Question #2: Also, how do the owners know you will not exercise the option until THEY want to vacate (sell)?

How did they know you wouldn’t give them the 10k option consideration – then excercise the option two weeks later?

Question #3: How do you word THAT aspect in the option – or do you?

Would love to solve this mystery!

Thanks!

– TW

6

i assume the owners still carried the mortgage that whole time. I understand you were under contract, and perhaps you could have even filed an affidavit at the courthouse (in essense a contract lien). However, the bank holding the mortgage remains in first position. If the owners had gotten into financial trouble again and the bank repossed the house, you have no recourse. Did you structure your contract around this potential snafu and if so, how?

7

Hello, TimW!

Barney was a good guy. I was saddened to learn of his recent passing. He will be missed.

I suppose there are several ways to structure a transaction like this one. In this particular case, most of the terms of the agreement were written into the option itself. The term of the option was to be for twenty years. That is, we could exercise the option to buy the property (for $89,500) at any time within the next twenty years, subject to a few restrictions we agreed to in advance.

One of those restrictions was an agreement not to exercise this option for at least seven years. They wanted their children to finish school in the same school district before they would want to consider moving. So you can contract for almost any terms you agree to in the option agreement.
Structure it to match the needs of everyone involved.

After the seven years had passed, the sellers wanted to wait a little longer before they moved and asked us not to exercise the option until they worked through some other problems and found a retirement home. This was ok with us. The property was still appreciating, and we were not in any hurry to cash out. I suppose this could have been an opportunity to negotiate some kind of benefit to ourselves for delaying the exercise of the option, but we did not. The people in the house were doing everything else right, and had even made improvements to the house, so we didn’t push for a better deal.

Alternatively, they had the right in our agreement to buy out our position. They could refinance the property to pay us off if they wanted to make us go away and keep the house instead of selling it. Retaining this right was important to them, but it made little difference to us as long as we got paid somehow.

IRA money is long-term, especially in this case. We were betting that the house would be sold or refinanced somewhere in the twenty year span. If not, we would do something different with it before it expired.

8

Hello, 7sunnydaze!

We have structured these kind of deals in several ways. Most of them have never been a problem, but once in a while someone does not keep their word as they agreed to do. Big surprise, right?

I do not think that just recording a “memo of option,” like the TimW mentioned is strong enough. With all due respect to Barney Zick, I think you need something better.

If you have an option to purchase an interest in real estate, you are in a stronger position if you secure your option by recording a Deed of Trust. (Substitute “Mortgage” for “Deed of Trust” if you are in a mortgage state.) This is much like a Performance Mortgage. It is common to use a Deed of Trust to secure a Note. It is a little less common to use one to secure an Option, but it works in much the same way.

Instead of just a cloud on the title and a contract right as in the memo of option, you now become a lienholder on the property. Clearly, this is better for several reasons.

If you use a Deed of Trust with good language like a Fannie Mae Deed of Trust, you will be well protected. Make sure that you have language that protects you in the event that the homeowners do not make their payments on the underlying first mortgage. Generally, you should have the right to make these payments to protect your position and deduct them from the eventual proceeds to the seller. Be sure you have an assignments or rents clause, and a call provision in the event of a default. This is pretty standard stuff in junior liens, but you might want to discuss this with a competent legal professional in your state to comply with your state laws.

If you use the Deed of Trust approach, try to structure it as a wraparound to include the first mortgage, and use an escrow company to clear the payments. That way, the mortgage payment comes to your loan servicing company, and they send it to the first mortgage holder. This gives you better control over the underlying liens. You will know much earlier if there is a late payment problem.

This structure has worked well for us. The only thing that I have found that works better is the Land Trust. Simply convey the property into a land trust with a trustee you like. Your company is one beneficiary under the land trust, and the former homeowners are the other beneficiaries. The terms of the trust agreement dictate how the property will be sold and the proceeds divided among the beneficiaries. Of course, it also covers the occupancy of the premises, as well as the responsibility for the mortgage payments, and any other issues related to the agreement between you and the sellers. The land trust approach moves you beyond being a lienholder to actually controlling the title to the property.

9

Valgolas, it makes very hard to concentrate on the discussion at hand with your caption distracting even the most pious of readers. Are is it just me that’s having that problem?

10

It’s not just you, it makes it hard to read when something is moving on the monitor that much.

11

Sorry, guys. It doesn’t show up on the computer that I am usually on.
All that I see is a small square with a red “X” in it. I thought it was gone.