Hunting Happiness

We have our first investment property now officially done. A family moved in on a three year lease-option program. We took a lot of cues from Scott Frank and Andy Heller’s “Buy Low, Rent Smart, Sell High”.

The family is pretty much the ideal tenant both from the book and in common sense. They have two young children and have roots in the community. They got into some financial trouble a few years back but have been fine since. They also are in a situation where their income is artificially low while one of the parents finds a job in his or her long-term career path. Due to those two factors, combined with the increased tightening of credit, they are not able to obtain a loan on our home, even though even on one income the payment is within normal limits. I expect a year down the road their credit will have improved and they will be back to dual income status and will be able to qualify. I place the odds at 75% that they exercise the option.

Monthly cashflow on the property is approximately $250/mo positive. If they exercise the option, we expect to net a total of around $25K, including cash opportunity cost.

The high-level concept behind the method is to invest in single family homes that can be had *modestly* below market value and lease-option them to a family who due to transient financial circumstances is currently unable to buy directly. The option price is set at the higher end of current fair market value (FMV) and held there for the duration of the term. The term is usually between 24 and 36 months. Typically they will pay an up-front option fee of 1% of the option price. This 1% is refunded if they buy; otherwise it belongs to the owner. Another standard part of the program is applied rent, although in this case the tenant requested other improvements in lieu of this. A landlord would offer back a percentage of rent paid (often 10%) in the event the tenants exercise their purchase option. All of this is designed to incent the tenants to treat the property like their own, since they may very well end up owning it.

Here is an example using our actual Property #1. I have adjusted the numbers off a little to keep things anonymous.

Option Price $150,000. Monthly lease payment is $1000. Tenant therefore supplied $3,500 up front, composed of $1,500 option fee, $1,000 security deposit, and $1,000 first month’s rent. They can purchase the home at any time for $150,000 and will receive the option fee back in the event they do. If they do not exercise, they get the security deposit back but we keep the option fee.

This is a good deal for the tenant because it holds the price fixed. If they rented for three years then entered the purchase market, the same house would be worth about $15K more. So for 1% up front, they can save up to 10% later. They are also guaranteed that we wont’ sell the house during the 36 month term. We will also allow a little more latitude to the tenants because of the option money.

It is a good deal for us because it allows us to lock in the option price at the higher end of the FMV. It also allows us to avoid paying 6-7% of the purchase price to a realtor. If the tenants do not end up buying the home, we have the option to sell it at approx. $165K, or to find another lease-option tenant, but with the option price and rent adjusted upward to FMV.

I believe this is a legitimate way to build long-term wealth with a manageable amount of risk. We are actively searching for more properties with a goal to acquire two in 2008 for a total of three. There is no better time to be giving this concept a shot because it involves buying now (with soft market and low prices, including high foreclosure rates) and delaying selling for several years when the market will presumably have recovered. The tightening credit standards are also setting the rent-buy dividing bar down toward rent further benefitting the model.

I will write another post with some things that surprised us and things to watch out for.