Real Estate – Page 4

The Easiest Money You’ll Ever Make

July 18, 2011

Here’s what you need:

1. 20% of the price of a house, condo or townhome.
2. A few months’ worth of patience.

Welcome to the lucrative world of lease options. They’re a way to increase your wealth with almost zero downside.

Lease-option holder. Still, you probably want one who uses a bottle opener

A lease option involves you buying a second home, renting it out, and giving the tenant the choice (or “option”, if you will) of buying the home once the lease expires. What makes the lease option so wonderful for the average landlord – correspondingly less so for the average tenant – is that you can charge above-market rates throughout the lease. After all, you’re doing the tenant the favor of letting her own the house after a year (or whichever term) expires. It’s like a layaway plan for what the hackneyed expression calls “the biggest investment you’ll ever make.” You let your tenant lock in a price for the house, essentially saying “You can buy the house for $x a year from now, regardless of what the market does. What’s a better deal than that?”

Meh…I don’t know. I’d have to charge an awful lot more than market rents to make it worth my while, if I’m going to have to surrender the asset within a year.

First, kudos for understanding that the house in question is an asset, and can help you grow your wealth regardless of what market conditions are doing.

My pleasure. You do realize that I’m not an actual person, and merely a device of your own creation that you use to clarify your thoughts, right? You’re talking to yourself.

Anyhow, you can typically charge at least 10% above market rent on a lease option. But that’s not really important. What’s important is this:

Most tenants never pick up the option. When the time comes for them to exercise it, it turns out they didn’t spend the previous year saving the requisite cash for a down payment. That’s one reason why they’re renting instead of owning in the first place. Renters, by and large, aren’t as bright as landlords. (Hopefully the smart-but-sensitive renters reading this can comprehend the phrase “by and large”.)

A lease option is similar to stock options, or commodity futures – you’re assuming market risk for the tenant. Real estate prices might rise 50% in the next year, but you’re offering the tenant a chance to lock in a price today. If your $100,000 house ends up being worth $150,000 a year from now, you, the landlord, will have forgone $50,000.

Of course prices could fall, too. Should they, even by just 1%, you’re protected. Obviously your tenant isn’t going to exercise an option to buy a $99,000 house for $100,000. Which means free money for you: you just received a year’s worth of premium rent payments that went well beyond covering your mortgage payments. That’s the ultimate hedge against a declining real estate market.

And if the market rises, rather than declines, you as the landlord still won’t necessarily get screwed. Again, the typical tenant doesn’t plan far ahead enough to take advantage of the lease-option. If the house does indeed rise in value 50%, and theoretically turns into an immediate $50,000 bonus for your tenant, she still needs to exercise the option. That isn’t easy. For an FHA loan, she’d need to put down 3 1/2% to buy the house from you. If she can’t put the necessary down payment on the house together once the lease expires, her opportunity will disappear and she’ll be back where she started, with no equity in a home and a rent payment due at the end of the month. (Actually, the tenant will be several steps behind where she started; now with 12 months of rent payments gone forever.)

Let’s see how this works in practice.

Say you buy a $100,000 house with 20% down. We’re assuming 20%, so you won’t have to pay mortgage insurance. At current 30-year fixed mortgage rates of 4 1/2%, that means you’d be making monthly payments of $405.35. You find a tenant who wants to own a home one day, and offer her a lease-option. Once you do, there are two ways you can do this.

Get the lease-option money up front, or
Spread it over the course of the lease.

Let’s assume a 1-year lease, and that fair-market rent is $450 a month. That’s what you’d charge an ordinary tenant who has no intention of buying the place. That ordinary tenant would pay $900 up front (1st month’s rent + security deposit).

With a lease option, you could ask for an extra $450 payment up front, and let the security deposit apply to the down payment if the tenant exercises the option (which she probably won’t.) Now you get a total of $1350 up front, $450 of which the tenant will never see again, after a year expires and she’s nowhere near amassing the down payment that would guarantee her the house.

Or instead of getting an additional $450 up front, you could just raise the monthly rent. Using our rule of thumb from above, of charging a 10% premium, that means you’d collect monthly rent payments of $495. Now you’re getting an extra $89.65 a month (the difference between the rent you collect and your mortgage payment) simply for getting the tenant to sign one additional piece of paper. Even better, your lease-option tenant is going to be a little more motivated than the average tenant to keep the place looking nice and in good repair. After all, the lease-option tenant hopes to own the place, and relatively shortly.

By the way, that $45 premium applies to the option only. Technically, it’s not even part of the rent even though you’re collecting it every month. If the tenant doesn’t exercise the option, you keep the premium payments.

Imagine test-driving a car for a year, and paying for the privilege.

Again, like in any deal, you’ve got to look at the potential downside: the tenant might be one of the responsible few who actually exercises the option. In this unlikely case, at the end of the lease you’d refund the tenant $990 (or $900, if we’re using our initial scenario of getting the lease-option money up front.) Now the tenant only has to scrounge up $2,510 (or $2,600) to take title of the house under an FHA loan. And she’d still have to make prohibitive mortgage insurance payments. Or she could put 20% down and avoid mortgage insurance, which means she’d need to have saved $19,010 (or $19,100.) As if.

And even if that does happen, you’ve still got a year’s worth of above-market profits to show for it. Plus, you won’t be obligated to your mortgage lender for the next 29 years. Theoretically you could buy another house and do the same thing again. Remember, the tenant is only going to exercise the option if she has a) sufficient fiscal discipline to sock away money for a year, but b) so little fiscal discipline that she’s renting instead of owning in the first place. That’s a tiny, tiny area of overlap.

Wednesday, Part II of how to ~~steal~~ make money with a lease-option.

**This article is featured in the Carnival of Wealth #48**

**This article is featured in the Totally Money Blog Carnival-It’s So Hot Edition**

Filed Under: Education, Entrepreneurship, Estate Planning, Finance, Real Estate Tagged With: lease option

It’s REITcycle Friday!

June 24, 2011

What do Howard Stern and Control Your Cash have in common? Every Friday, we mail it in. Welcome to The Best Of, a/k/a Recycle Friday. In which we take a guest post we wrote a long time ago and see how it stacks up now. With annotations, if necessary. Today’s post about real estate investment trusts – “buildings in baskets”, as they’re called – originally ran on LenPenzo.com. It’s more informative than timely, and it appears that we don’t have to change a thing.

“You can’t make money in real estate these days. It’s impossible.”

Of course you can. The market isn’t “bad” – no market for any worthwhile commodity is either unequivocally good or bad. Real estate, whether raw land or fully improved buildings, obviously has a function and will continue to. Real estate, in and of itself, is not subject to obsolescence. You know, like ambergris or Pets.com stock.

As long as people enjoy living, working and shopping on the earth’s surface, real estate in general will remain a handsome investment for somebody. At least until we figure out levitation, which could be months away.

But public perception clouds everything. One staple of the local news over the last 18 months has been the sympathetic journalist interviewing the poor unfortunate who ended up in foreclosure, because he was mystified that adjustable-rate mortgages and fixed-rate mortgages are different things. So the population at large remains convinced that behind every real estate investment is an unscrupulous lender just waiting to take some nitroglycerin and a match to your life’s savings.

Two things:

a) Read the contract. There’s a reason why although millions of mortgage holders owe more money on their houses than they’re worth, no lender has yet been forced to offer restitution to a gullible homeowner: because mortgage contracts are airtight. Instead, to appease an angry and idiotic public the government has taken to making changes by fiat.

b) If that’s how you feel, why not be on the other side of the transaction?

Yeah, me. A real estate baron. Okay.

That’s exactly what we’re talking about. Via a handy creation called a Real Estate Investment Trust (the acronym is pronounced “reet”, as in the final syllable of “discreet”).

It operates on the same principle as a mutual fund – a fund manager creates an investment out of disparate pieces of other, more basic investments. In the case of a mutual fund, that means companies’ stocks, accumulated in differing proportions and sold to you and me in easily digestible chunks costing as little as $250. In the case of a REIT, a fund manager puts together real estate investments and lets you buy in.

This is not some new development. REITs have been around for 50 years. If you have a 401(k), there’s about a 4-to-1 chance that you’re investing in one right now and don’t even realize it. (Wait, you mean you’re one of the people who actually researches to determine what’s in his 401[k]? Congratulations. Gold star for you.)

So with a REIT, I’m buying little pieces of all my neighbors’ houses?

Doubtful. Not quite. Particular REITs specialize in different market segments. For instance, some focus on industrial sites only – factories, warehouses and their ilk. Others invest solely in what are euphemistically called “entry-level” homes – mobile homes and starter apartment complexes. Some REITs even concentrate in market segments as arcane as storage facilities or medical buildings. (I’d link to examples of each one, but that means I’d run the risk of one of you investing his entire net worth in a particular REIT, losing every penny, then suing Len and me for making the hyperlink so tempting and easy to click on. It’s much easier to paint that scenario than to write an appropriately worded disclaimer.)

REITs even trade publicly, just like the mutual fund that comprises your 401(k) probably does. But unlike stocks and mutual funds, of which there are myriads upon myriads, REITs are less plentiful. Only about 200 REITs trade on the NYSE and NASDAQ boards, making REITs fairly easy to keep track of. There they are, on the ticker, right next to the ordinary stock quotes and index figures. There are a few private REITs as well, but they’re only for the extremely wealthy and the connected. Let’s just say that the people who buy into them aren’t reading about them here.

You know what a dividend is, right? An annual (or quarterly, or in rare cases monthly) cash payment that a company makes to its stockholders, just for owning the stock. Managers do this to make the stock more attractive compared to other stocks you might be thinking about buying: you can think of the dividend as just a consistent discount on the price of the stock.

Well, not only do many REITs offer dividends, the ones that do offer dividend yields about quadruple those of stocks that do. When you buy a REIT, ideally you’re more interested in receiving regular income payments than in watching your stock appreciate so much that you can cash out and spend the rest of your life floating in a pool and scarfing down bonbons. REITs bottomed out last March: the index that measures their overall value (the Dow Jones Equity All REIT Index) fell 75% from its high of 2 years earlier. But since reaching its nadir, it’s more than doubled. Again, this isn’t about finding something undervalued and loading up on it – it’s about generating regular revenue while everyone around you complains about how the market is cruel and mean and why can’t my house be worth more just because I want it to?

**This article is featured in the Totally Money Blog Carnival #25-Start of Summer Edition**

Filed Under: Finance, Investments, Making Smart Choices, Real Estate Tagged With: new investments, real estate, real estate investment trust, REIT

15 Years to Freedom

June 17, 2011

Thanks to Arohan at Personal Dividends for indirectly helping us out yet again. He’s the guy who graciously lets us guest host the Carnival of Wealth every month, and also let us write this post for his last year. It appears here in slightly updated form on Recycle Friday. Again, updates in CYC Burnt Umber. This week’s topic? Halving your mortgage. Totally legally:

It’s the modern exemplar of fiscal responsibility – the mortgage you pay off in half the time of a standard one. Granted, people who carry 15-year mortgages are generally the same ones who alphabetize their refrigerators and iron their gym clothes. But people like that are worth emulating in a society where the populace now regards mortgages and credit card debt as no more obligatory than rural speed limits.

Obviously, paying a mortgage off in half the standard time means you’re making payments twice as big, or close to it.

But you aren’t. Here are a couple of graphs that show how long it takes to start making a dent in the principal when you finance your house over 30 years, vis-a-vis 15 years. We used standard market rates, which we’ll quantify in a second. The purple line is your cumulative interest payment, which you obviously want to keep as low as possible. The purple line moves in concert with the yellow line, which is your principal balance: you want the yellow line to take as short a path as possible from the northwest corner of the graph to the southeast corner.

30-Year Mortgage

A Comparable 15-Year Mortgage

That second graph is revolutionary, and indicates how there’s not only never been a better time to buy a house (or houses) than now, but that there’s never been a better time to get yourself into a 15-year mortgage.

Around 1981, 30-year mortgages were going for 18%. Just for sheer horror value, here’s a comparable chart from then. We enclosed it in a thick red border to denote danger:

It’s true: There are homeowners whose 30-year mortgages are coming due this year, who as recently as 2008 still had less than half equity in the house. These people might be your parents. Don’t show them this article.

But getting back to the relevant charts, the first two: we’re not criticizing people with 30-year mortgages. Given such variables as human life expectancy, house obsolescence, and wages and salaries, 30 years has always been the historical happy medium for a mortgage term – not so long that you’re on the hook into your senescence, and not so short that you’re forgoing dental floss to make payments.

However, we’re in The Great 21st Century Stagnation and everything’s at least a little askew.

Here are the actual current mortgage numbers. The average 30-year mortgage right now goes for a minuscule 4.33%, which still dwarfs the average 3.85% that 15-year mortgagors are paying. The difference between the rates has never been this big. Ever.

Last summer, the median home in the United States sold for $176,400 according to the first chart on this page.

Aside: some esoterica from that chart.
the string of “N/A” in the Detroit row is amusing. What a craptastic town. Nothing there is applicable.
the numbers for Ocala and Ft. Myers seem low until you remember that the vast majority of those homes are snowbird apartments.
building restrictions in the Bay Area have had the desired effect, if the effect desired was pricing everyone out of the market.

If you bought the median house with an average-priced 15-year mortgage, how big would your monthly payments be? Here come the math:

Mortgage Payment Calculation

You really need to stop complaining. “Waah, I suck at math. I’m no good with numbers (giggle).” It embarrasses us both.

Would you say “Waah, I suck at English. I’m no good with words” in public? Of course not, you’d sound like a tard. How is this any different?

Take your interest rate, divide it into the number of payments you make annually, add 1, take to the power of (negative) the number of payments you’ll make over the life of the loan, subtract from 1, multiply by the number of payments in a year, divide into the interest rate, multiply by the amount of the loan. Wasn’t that easy? You should have learned how to do this in the 6th grade. Clip and save the formula, it comes in handy all the time.

Anyhow, your monthly payment is the product here, which is $1291.58.

10 years ago, the average 30-year mortgage went for 7.96%. Let’s plug that interest rate into the above expression and see how much house we could have bought with such a mortgage back then, given the same monthly payments.

You ready?

A house costing $176,693.34.

Yes, today you can pay a house off in half the time it would have taken to pay off the exact same house (plus a medical supply table) in 2000.

In other words, God wants you to not only buy a house today, but be free of your debt obligation no farther in the future than O.J. Simpson’s not guilty verdict is in the past.

Everything beyond this is speculation, but the Fed chairman has indicated that he wants to keep inflation low and money tight. Maybe taking him at his word is foolish, but it seems as though mortgage rates can’t fall much lower. If you’re looking at a 15-year mortgage, and the economy stabilizes between now and 2025 (which of course it will), your 178th, 179th and 180th payments could be awfully palatable and the checks downright fun to cut.

(Thanks to TheMortgageReport.com, which we didn’t crib from to write this post. But it’s one of the very few well-written and informative blogs on any subtopic of personal finance. And Dan Green, the guy who runs it, makes awesome charts.)

**This article is featured in the Yakezie Carnival-Tour de France Financial Factoids Edition**

Filed Under: Making Smart Choices, Personal Finance, Real Estate, Rental Property Tagged With: 15-year mortgage, 30-year mortgage, home equity, median price