How Buying a Seller Financed House Is Like Buying a Stock Option

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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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Stock Option

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.

Related: BP Podcast 013 – Buying Real Estate with Seller Financing and Speculating with Leon Yang

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.

Photo: Perpetualtourist2000

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.

15 Comments

  1. Hi Leon,

    Love your article!

    Free and clear houses have some of the best opportunities for both buy and hold and buy and sell on terms for the new and experienced RE Investors.

    How do you did this?

    Example:

    $100K house

    Buy the house
    Create 2 private notes
    85% 1st
    15% second

    You have flexibility in how you draw the notes to the private seller.

    And if you do it correctly you can sell the front end of the first, the 1st 60 payments after 6 months seasoning, this is called a “partial” in the note brokering business.

    Secondly, you could offer $110,000 ($10K more) for the free and clear house if you could get interest free seller financing.

    Say $100K house
    Say 180 payments – 15 years
    Payment is 611.11

    Market rent is $800

    So many options with free and clear houses! And no due on sale clause.

    And Bill Gulley, correct me if I am wrong, the SAFE Act is about how many houses you can sell on Seller Financing, but not how many houses you can buy on Seller Financing.

  2. Andrew Herrig on

    In the scenario where the house value falls to $80k, how do you only lose $11,160 if you get rid of it after one year? The only way I see to do that would be to default on the loan, which obviously has long term negative consequences.

    • I must agree with Andrew. Buying a property that has negative cash flow is very risky and speculative. It could pay off huge, but could also backfire huge. Based on the podcast, it seems that you have applied this strategy on a large scale. I woundn’t have the stomach for this unless I had already built up a significant portfolio that provides even, steady cashflow, year after year.

      • Leon Yang

        As I mentioned in the podcast, margin of safety and cash reserves are both very important to leveraged investing. I wouldn’t do it either if I suffer substantial negative cash flow. I have been building it without a substantial negative cash flow that I can’t handle.

    • Leon Yang

      Defaulting on the loan can have long term consequences but the point is that you are still limiting your losses based on what you invest in. I would only default IF homes fell tremendously AND I cannot service the debt. In the example above I can service the debt for the entire 15 years so I’m not too worried – I wouldn’t give up my equity if the home value only fell 20%, but if it fell 70%, then what? And one more thing I guess i should add is that you are looking into this investment with the ability to buy the house with cash if needed. With 11k down you have another 95k to invest in other things etc etc. Leveraging to the hilt with little equity behind has not been something I advocate

  3. Incredible post Leon, your ideas have been banging around my head all day since I read it. This post typifies what I like best about Bigger Pockets — there are always a multitude of ways to look at things, it’s up to the individual to determine the approach that suits their short and long-term goals the best.

    Another wonderful perspective from the great people at BP. Thanks for sharing your experience.

  4. Mike Smith on

    I don’t think you fully grasp the implications of leverage… The degree to which you leverage an investment determines the level of magnification of return (both positive and negative). For example, lets say you buy a house for $100k with cash. If the value of the house goes up to $110k or down to $90k, you have a return of +10% or -10%, respectively. But suppose instead of paying cash you put $10k down and finance the remaining $90k… If the value of the house goes up to $110k you’ve made a +100% rate of return (ignoring income and expenses associated with owning the property), because you invested $10k and the value went up by $10k. Now assume the value goes down to $90k… You have a -100% return because you invested $10k and lost $10k of value. If the house goes down to only $80k you have a -200% return and now are in a negative equity position. Leverage is great on the upside but very bad on the downside, because all it does is magnify returns. The cash buyer whose house goes down to $80k had a -20% return but the leveraged buyer had a -200% return. The only way to a avoid this is to always use non-recourse private loans where the seller can only take the property back upon default and not sue for the deficit balance if the house is underwater. And personally, I feel like strategically defaulting on notes is both bad ethics and bad business. It will destroy your reputation and credibility, and eventually no one will want to lend to you. The big difference between purchasing stock options and the method you wrote about is that options do not require debt, which is an obligation pay a balance. Don’t get me wrong, leverage is a big part of my business model. But when i sign my name on a note and agree to repay a debt i take that very seriously. And also, I don’t think investing in properties with negative cash low is very sustainable… But good luck

    • Leon Yang

      I do hand the property back to the seller in case I default, in which case my losses are protected. Similar to everyone who’s underwater, they wouldn’t be selling their homes right now IF they can service the debt would they? If they had put 30k down on a home and borrowed 270k, and now it is worth 100k, yes the loss in HUGE compared to the 30k, that is ONLY if they sell it on the market and then attempt to repay the debt. If they walk away and short sale, then they lose what they put it, which is far less than what they would have to pay in the former option.
      I say it is still similar to stock option because I can hand the house back to the seller. And I’d say the seller would rather me default because now they got an extra down payment, loads of interest payments, and have a house with a tenant who’s paying competitive rent. Trust me, they won’t be losing sleep on this.
      I am obviously not in this business to default on anything. I understand where my debt to equity ratio stand and where my cash flow is at. With that being said, I am at a much better position to capture appreciation in the market because I used leverage. And I’m NOT advocating BPers to go out and leverage all their holdings. I’ve mentioned again and again there has to be cash reserves and margin of safety that can last you for a long time. That is how you should approach leverage, not just get scared simply because ONE property has negative cash flow.
      Like I said before, obviously you can put MORE down to make it cash flow breakeven/positive, but you could have saved this cash for something else (vacancies, repairs, etc etc) in exchange for a small amount of negative cash flow over time. I take the flexibility and cash reserve any day.

  5. Playing the appreciation game has made many investors really rich and have devestated others. It is a risky game to play but the returns can be amazing.
    You need to understand the risks though and negative cash flow if a big risk. You may be able to cover it now easily but years down the road things can change and that few hundred dollars might be a big burden.
    As Mike Smith points out leverage cuts both ways so it needs to be used intelligently to set the deck for getting the benefits.

    • Leon Yang

      Yes Shaun leverage can be dangerous if done incorrectly. It is something I always try to point out. The point is if a few hundred dollars down the road might be a big burden for you then you shouldn’t be taking on that kind of leverage in the first place. I think I may have come across the wrong way as I am currently cash flow positive as a whole. I am not bleeding a bunch of money a month praying for appreciation. That is not the game I would like to play.

  6. Leon, interesting article. I like the stock option analogy. I would love to hear the impacts to your business with the Dodd-Frank legislation. It doesn’t sound like you are trying to owner occupy any of these (which would bring D-F into play). However, D-F does impact how many you can unload to owner occupants with seller financing annually. This may be down the road for you as it seems you are on an acquiring frenzy (not selling now or in the near future). What are your thoughts?

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