Controlling Real Estate with Little Money Using Lease Options
While there are many benefits to real estate, two of the more valuable goals are passive income and appreciation. When it comes to real estate appreciation, if timed right, it can be extremely rewarding. We have seen that back in 2003 to 2005. In some markets today, we are arguably seeing similar rapid rise in home values. Back in 2011, I got into real estate truly believing that there will be a rebound. I never expected it to rebound this soon, but if I had known, I would have used lease options to leverage my investments to earn a much greater return.
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Being a new investor at that time, I was not yet comfortable with the idea of lease options. In a short summary, a lease option allows you to put very little money down to purchase a property in a specific future at a specific price. An example of a lease option available in Las Vegas back in 2011 would have been: House A, valued at $100,000 at the time, would be sold at an agreed upon price of $120,000 in three years, with a $5,000 initial down payment that would go toward principal pay down. Technically you would still be renting, as you would have to pay, say for example, $1,400 with $200 of that going to pay down the principal every month ($1,200 would probably be the market rent anyway.)
What I Could Have Done to Optimize My Return
What I could have done back then was to put the $5,000 down to get to lease the house. Right there and then I would put the house on the market for rent for $1,200. Despite the fact that I would have to foot out $200 a month every month, I could control the property with an investment less than 5% of the house’s worth. Furthermore, the extra $200 goes toward paying down the principal. In 3 years, I would only have to pay $107,800 ($12,200 would have been paid towards the principal). Obviously there are some other costs including vacancies and maintenance, so you’d have to have some more reserves to make it work well. Still, if you had $150,000 to invest, you could easily control ten single family homes in Vegas in 2011.
Personally, I did not feel comfortable with a 3 year lease option because I was not confident on how fast the real estate market would rebound. Realistically I was looking at a seven to ten year horizon for real estate return to 2005-2006 levels. As for what would happen in 3 to 5 years? I could not say. One way to combat it, if possible, is to structure a lease option with a longer horizon but with the option to buy earlier. I would have liked to get into a conversation with a seller to create an option like this: $120,000 at 3 year, $130,000 at 5 year, $150,000 at 7 year. Just like stock options, the longer time I have to control it, the more valuable the option is and the more I would be willing to pay. Furthermore, if I lock in the rental price, at year 5 the market rent is likely to be higher than $1,400. At some point I could even be cash flow positive.
In hindsight, if I had leveraged my investment like that back in 2011, it would have been an extremely rewarding investment. With a similar house now costing near $140,000 to $150,000, I would have been in the positive and I still have a little more than a year to go. I could exit in certain ways. One, I could borrow money to purchase the houses at $120,000, thereby getting me a good deal (and today in Las Vegas, it is hard to even find a house to buy). Two, I could sell the house along with the option. I could probably net around $15,000 after selling costs for an investment in about $10,000 (I would have only paid 2 years of principal pay down at this point). A 150% return in 2 years? Not bad at all.
With Great Earnings Come with Great Dangers
On the other hand, if I timed it wrong and the market kept crashing, it would have been very quickly before those options become worthless. If housing prices stayed at $100,000, it made no sense for me to buy a house at $120,000.
In conclusion, this type of investment is extremely speculative and highly leveraged. It is not for someone without an iron stomach. You could lose what you put in or you could earn astronomical returns (imagine at year 7 the house is worth $300,000 while you have an option to buy it at $150,000, with total cash used about $20,000).
Sure I missed a good opportunity, but it is still a good experience to see what could have happened. I will likely utilize this strategy in the future. However, I will not bet the house on it. I cannot accurately guess when the housing market has bottomed. The only yardstick I can use to start considering this type of investment is that if a house costs more to build than to buy it. In that situation the market has to rebound otherwise no one will ever build a house again.