Controlling Real Estate with Little Money Using Lease Options

4

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.

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.)

The 20 Best Books for Aspiring Real Estate Investors!

Here at BiggerPockets, we believe that self-education is one of the most critical parts of long-term success, in business and in life, of course. This list, compiled by the real estate experts at BiggerPockets, contains 20 of the best books to help you jumpstart your real estate career.

Click Here For Your Free eBook!

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.

Oh yeah I forget, you can leverage this without going to the bank asking for a loan. Not all of us can get a bank loan, but that does not mean it should stop you from investing in real estate.

Photo:FromSandToGlass

About Author

Leon Yang

Leon Yang is an active real estate investor in Las Vegas. He is a buy and hold guy who also likes to flip from time to time. His main passion is to traveling to the less traveled places and inspiring others to become financially independent through real estate.

4 Comments

  1. Great write-up! Sounds to me like you really have to know your market and where it may be heading. I’m not sure I am comfortable with only having buy vs build prices as a yard stick. There was a lot of new home inventory in 2008 nationally speaking from what I gather now far less, and very slowly growing.

    Many builders have dropped their profit margins to compete with the foreclosure boom. That in the past five years did not drive the cost of existing homes up 20-40%, not sure about Vegas one of the hardest hit I read, it just drove builders margins down. In my area there is little building going on and a lot of foreclosures on the market still, no appreciation sellers are still taking a loss. So this plan would not have worked around here. Maybe having 3-5-7 yr. leases might help depending on when it rebounds. Having money tied up going nowhere not good, maybe taking a loss. Some areas are so densely populated there is no room for new construction.

    I’d probably track some more metrics like job and population growth migration, median home values, median age; city data .com has it or county websites. I am gathering it now to see if it is a good time to build. These LO’s sound like a good tool for builders with so many buyers that have been foreclosed can’t qualify for loans. Except I would not sell the future at a high appreciation rates given the current market trends.

    • Leon Yang

      Thanks Terry! Surely it is important to look at the market as a whole before making any investment decision. Again, it is a highly speculative play in my mind at that time and I knew Vegas was going to rebound. It is not for the faint of heart of course but in my analysis I was pretty confident it was going to go up. It did go up a lot today already and it was a lot faster than I expected. Nevertheless, I was confident to say 5-7 years would have given me a lot of flexibility to see the appreciation through.

  2. Glen Sonnenberg on

    One thing I’d like to read more about is the tax implications of using a lease-option from a seller’s perspective. I have a house in Vegas which I’m renting out and considered offering that to my tenants. However, in reading it appears like this might be an issue for tax purposes. It seemed like if I was to apply a portion of the rent towards the principle or the option purchase price that it might be considered an Installment sale. Do you have any real-world examples of how you handle multi-year option agreements like that in terms of taxes? Any advantages/disadvantages in the way you structure these agreements?

    Glen

    • Leon Yang

      Hey Glen, I’m probably not too sure with regards to the tax consequences to the lease options. I’m glad that you brought it up. I would want to look into it but again I’m not an accountant so I can’t really say. If you are considering selling, I’d love an opportunity to buy!

Leave A Reply

Pair a profile with your post!

Create a Free Account

Or,


Log In Here

css.php