How Buying a Seller Financed House Is Like Buying a Stock Option
Buying a seller financed house is very much like buying a stock option because of the nature of leverage. If done correctly, a leveraged buy can achieve tremendous profits. On the other hand, you can lose all your initial investment if done in a wrong way. Before digging further into the nature of a seller financed deal, let’s look at what a stock option is like. Since we are talking about buying houses, let’s deal with buying call options alone and ignore puts for now.
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Buying a stock option, in this case a call option, is buying the right, not the obligation, to purchase the underlying security (a fancy word for stock in this instance) at a predetermined price within a certain period. An American option is the right to buy it anytime within the certain period, whereas an European option settles on a specific date. This right to buy comes at a cost obviously. The counterparty is the one who is willing, for a fee, to offer you that right.
So for example, Widget Corp. right now is trading at $30. As of the market right now, I can buy an option to purchase Widget Corp at $30 a year later for $3. How do you calculate the call price? You can get all fancy and stuff, but at the end of the day, there are a couple of main components: volatility and time value of money. When you purchase this option, you’ve “borrowed” the $30 for a year because you hold the right to own it but didn’t actually invest in the stock. Also, the stock can go up and down, you hold the upside for anything that goes above $33 ($30 price and $3 premium you’ve paid).
If the stock trades for $35 a year later, your option is now worth $5. This is because you hold to right to buy the stock at $30. You paid $3 for it, If you sell it by exercising the right to buy the stock at $30 and quickly resell it for $35, you stand to profit $2. A handsome 66.67% return.
On the other hand, if the stock is trading at $28 later, your option is worthless because you will be buying the stock at $30 if you exercise it. In other words, you lose the $3 you pay.
A dangerous bet perhaps?
Seller Financed Home
Let’s use a real life example of a house I’ve purchased last year.
On a certain house, I put $5,000 on a house that will cost me $106,500. I bought it on a 15-year amortization at 7.5%. Not exactly the best of terms, but I knew I could make it work. Like an option, I bought a house at a predetermined price and I had the option to pay it off (or exercise it, in stock terms) at anytime (although I do have a prepayment penalty if I pay off too early, somewhat similar to that of an European option in the sense there’s a stricter timeline).
With a new carpet put in and certain repairs and all that shenanigans, let’s just say my initial investment came out to be $7,500.
With my PITI, HOA, maintenance, and vacancies cost built in, I'm looking at a payment of $1,350 a month. I only rented the place for $1,045 a month. So I'm short about $305 a month. Interestingly, you have to remember, the loan is amortized. At the very first month my principal paydown is $307, and it will only go up from there. Ah ha, not too shabby!
With the crazy state of the Vegas market right now, I’d conservatively say this house is worth about $135,000 at the moment. Let’s see what type of equity I’ve earned (I won’t be selling it right now because there are selling costs, taxes, and prepayment penalties I’m not interested in paying):
One year of $305 monthly shortfall: $3,660 (let’s keep it simple, I won’t use time value of money and NPV in this calculation)
Initial investment: $7,500
Total “investment”: $11,160
Difference between $106,500 and $135,000: $28,500
Total return: 255.38%
What if I invested in this all cash (essentially, I’d take away principal and interest payment which is about $941)?
So I add subtract $941 from my monthly cost, so my cost is $409 and I take in $1045. I get $636. I paid $106,500 for the house.
My yearly return would have been:
Positive cash flow: $7,632 (at $636 monthly)
Difference between $106,500 and $135,000: $28,500
Total investment: $106,500
Total return: $36132, or 33.93%
*Total return in both instances are really unrealized values, which means I don’t really earn this until I sell. Selling costs can be expensive, so I’d rather wait out a bit longer.
Which is better? I think I like the first one better. Similar to a stock option, I just leveraged my bet. The seller of the option, in this case the house seller, lost the benefit of gaining home appreciation. Unfortunately, on the first option, I do have a negative monthly cash flow as opposed to the second option. Here, I have to consider how long I have to hold the investment. I could be looking at a yearly investment of $3,660, which over the course of 15 years, comes out to $109,800. That is assuming that in 15 years rental prices stay the same, which is extremely unlikely.
On The Other Hand…
Suppose the housing market crashes. What happens? What if the house drops to $80,000 in value?
In the first option, my house is indeed underwater. Like a stock option that worths more than the market price, I won’t be able to move it without losing money on purpose.
Is that necessarily truly terrible?
Not exactly. Despite the fact that I owe more than the house is worth, I know that in several years, my principal repayment will whittle the debt to less than $80,000. More importantly, even if I were to let go of the house after one year, what is the most I could lose?
$11,160. Substantial sum indeed, but it is certainly less than the fall of the home from $106,500 to $80,000. To a cash buyer, his or her equity has just dropped $26,500! Granted, the cash buyer did earn $7,632, so in reality, the buyer lost $18,868.
Yet interesting, as I hold the option I just hedged my losses. My losses were nearly 50% less than the cash buyer. Suppose the housing market fell even further to Detroit level of $6,500! What is my loss? $11,160. What is the cash buyer’s loss? A whole lot more.
While I have the option to decide whether to ride out the market (remember, I do have to fill in $305 a month at this point), the cash buyer is forced to keep the investment and hope that the rental income will bring the buyer back whole (it’s going to take more than 10 years if the housing value dropped to $6,500). While a 7% return is not bad, you have to wait a long time to earn your capital back.
This is what a stock option can do it. Going back to the first example, your maximum loss in a stock option is $3. Whereas if you actually bought the stock at $30 and prices fell down to $20, you will lose $10 holding the stock. So who’s being more exposed here?
Get My Drift Yet?
I know buying a seller financed home with negative cash flow can be a speculative play (I know, we all want to get a positive cash flow seller financed home, but if you can’t, do you still want to play this game or not?). There are certain dangers out there and you can get yourself into some troubles if you go overboard, as I have discussed in the Biggerpockets podcast, but there are many ways to hedge yourself against losses:
1. Lower your initial capital investment – the less you invest in the property, the less you lose. Sometimes it is better to get a lower down payment and pay higher monthly cash flow because in a seller financed home, you only lose as much as you put in.
2. Set longer payment terms – drag out the mortgage as long as you can. Here I was forced to do 15-year amortization. I’ve done 40-years. The longer the more flexibility. Just like a stock option. The longer the predetermined settling period, the more likely you have an opportunity to win more.
3. Have some cash reserves – well, this should be done anytime you leverage. Push yourself to the limit you will burn and lose it all.
So personally, despite investing in an uncertain time in Las Vegas, I still prefer using seller financing as a way to hedge my risks – I will try to put as little money down as I can for each deal if possible, even if I have the cash. Because if the market does fall from this artificial bubble, my losses will be limited to what I put in while I could use my cash to score much better deals. If it keeps going up, I get higher returns because of my leverage.
I generally try to keep my cash flow as breakeven as possible. Yet keep in mind that, while I could increase my down payment to lower my principal payment, I’d rather keep less cash invested in from the start.
Real estate debt isn’t that bad, if used wisely.