How I Learned to Profit from Options the Hard Way!
Friday, August 28, 2009 | Ethan RobertsRating:
Tycoon readers, When my editor told me that this week we were going to have a special "Options Week" theme, and asked me to write something about that topic, a funny and strange feeling came over me.
In an instant, I was overcome with panic. Huge beads of cold sweat appeared on my forehead, and I began to quiver and shake!
Ethan hears the word 'options'...
What could be the root cause of this angst and consternation? Was it ... something traumatic or devastating from my past?
Suddenly, a wave of vertigo took hold of me, and I felt as though I were falling through space. ...
Something about 'options' was making me dizzy...
But options?
If you've ever traded them -- or never traded them -- you might have experienced a similar feeling before you got brave enough to make your first trade.
Good Lord -- all those complex, scary terms like "butterfly spreads," writing covered calls, selling puts. ... Whoa, that's just not my thing.
So then I composed myself and picked up the phone. I thought to myself, maybe I had better consult with an expert on the subject.
'Hello... Chris Rowe, what in the heck is this butterfly thing?'
Now fortunately for Tycoon readers, all week long you've been treated to some excellent articles by the rest of the Tycoon editors, who are experts on how to utilize options to profit in any number of ways.
They take the scary, complex stuff, and make it a whole lot easier to understand and put into practice.
Options are a Part of Everyday Life
But I really had to stop and think about how I could relate the subject of options to what I do, which of course is real estate investing.
So, the first thing I did was go to Wikipedia to look up the technical definition of options.
"In finance, an option is a contract between a buyer and a seller that gives the buyer the right -- but not the obligation -- to buy or to sell a particular asset (the underlying asset) at a later day at an agreed price.
In return for granting the option, the seller collects a payment (the premium) from the buyer. ...
If the buyer chooses to exercise this right, the seller is obliged to sell or buy the asset at the agreed price. The buyer may choose not to exercise the right and let it expire."
And then it hit me like a ton of bricks! "Of course -- I have done that!"
Help! Help! Hey, I'm under here somewhere!
You Might Have Used Options Before and Didn't Know it, Either!
In real estate, there is a common type of contract called the Lease with Option to Purchase.
Basically it is a unilateral (i.e., one-way) contract between the buyer/tenant and seller/landlord, that allows the buyer to lease a property for a certain length of time and then buy it if they so choose.
If they decide not to buy it, they simply walk away with no further obligation to do anything. The reason why it is considered to be unilateral is because the tenant/buyer has the right to decide whether to go forward or terminate the deal.
Usually, the price is fixed at the time that the lease-option is signed. Most often, the buyer puts up a fee at the time of contract to lock in the current price on the house.
If they decide not to buy the house, they may have to forfeit their fee, but locking in the price in advance protects them from buying the house at a higher price later on if there is price appreciation.
However, if -- by the time they are ready to buy -- an appraisal shows that the value of the home has declined to below the option price, they can walk away, or perhaps even re-negotiate at the lower price.
So, it's a great deal for the buyer!
However, a lease with option does have several advantages for the seller/landlord as well.
- For one thing, they can set the price at a level higher than their own purchase price, and thus guarantee themselves a profit, even after closing expenses.
- In addition, they receive the option fee from the buyer. If the buyer doesn't close (which happens quite frequently), the seller keeps the option fee.
- Third, they have rent coming in from day No. 1 of the lease, until the day of closing, with no downtime.
- Fourth, they save on paying real estate brokerage fees when they enter into a lease with option, because they are selling it themselves to their tenant.
Ah, the ultimate Quid Pro Quo!
My Memorable Introduction to Options
So then how could a deal like this have been so problematic for me, that it I break out in a cold sweat and suffer from vertigo, just at the mere mention of the word, "Options"?
To discover the answer, once again, I go back in my time machine, to the date, January 2005...
Ethan drags out the dusty old time machine again...
In January, 2005, I bought a bank foreclosure -- a three-bedroom, two-bath, 1,425-square foot ranch in Jacksonville, Fla. I paid $113,000 for it, and put another $3,000 into fixing it up.
This is what it looked like on the listing sheet before I purchased it:
And this is what it looked like after I rehabbed it....
After the rehab was finished, I found a tenant fairly quickly. To my surprise and delight, the tenant immediately expressed an interest in writing a lease with option to buy. She said she needed a year or so to improve her credit before she would qualify.
At the time, the value of the home was about $132,000-$135,000, and the mortgage loan officer who was working with her told me that she would only qualify to $140,000.
So, after some consideration, we agreed to set the price at $139,000, which allowed what I thought would be another normal 4%-5% of appreciation in the year to come.
WRONG!
I must admit that I made the mistake of not taking an option fee from her. I guess I was trying to be the nice guy, but it seems that nice guys usually get burned in real estate deals.
Part of the tenant's requirement for getting a loan was to make 12 consecutive rent payments on time by check, and she did that faithfully.
Meanwhile, this was the bubble year of 2005 and homes were appreciating that year faster than ever before. By the time the following spring of 2006 came, the house we had contracted to sell at $139,900 was worth more than $160,000!
Remember, Buyers Have Rights and Sellers Have Obligations. Big Ones!
However, the transaction was anything but simple, due to some ongoing buyer credit issues.
The mortgage company decided that the only way they could get the deal done, was to treat it like a "refinance." Due to a quirk in the mortgage rules -- and because she had lived in the home for more than 12 months -- despite her not actually owning the home, they were able to do this.
So, the loan company sent out an appraiser, who came back with a value of $162,000. They qualified her on a 90% Loan-to-Value ratio, which came out to $145,800.
In other words, I got the $139,000, and the mortgage company took the rest on points, fees, etc.
Amazing how their fees totaled up to the exact 90% value figure!
Seller's Remorse
We finally closed the deal, and I made a profit of perhaps $22,000 or so after expenses (my real estate commission at purchase offset the cost of repairs and improvements).
Not too bad, for holding a property for about 14 months. I shouldn't complain, really.
But it kept eating at me for many months thereafter that I had sold a home worth $162,000 for $139,000, and that I had neglected to take an option fee as well!
So, Tycoon readers, if you want to profit from a real estate option, begin by learning from the mistakes that I made on this deal, as well as the basic rules that I described above. Make sure you do the following:
At the time, the value of the home was about $132,000-$135,000, and the mortgage loan officer who was working with her told me that she would only qualify to $140,000.
So, after some consideration, we agreed to set the price at $139,000, which allowed what I thought would be another normal 4%-5% of appreciation in the year to come.
WRONG!
I must admit that I made the mistake of not taking an option fee from her. I guess I was trying to be the nice guy, but it seems that nice guys usually get burned in real estate deals.
Part of the tenant's requirement for getting a loan was to make 12 consecutive rent payments on time by check, and she did that faithfully.
Meanwhile, this was the bubble year of 2005 and homes were appreciating that year faster than ever before. By the time the following spring of 2006 came, the house we had contracted to sell at $139,900 was worth more than $160,000!
Remember, Buyers Have Rights and Sellers Have Obligations. Big Ones!
However, the transaction was anything but simple, due to some ongoing buyer credit issues.
The mortgage company decided that the only way they could get the deal done, was to treat it like a "refinance." Due to a quirk in the mortgage rules -- and because she had lived in the home for more than 12 months -- despite her not actually owning the home, they were able to do this.
So, the loan company sent out an appraiser, who came back with a value of $162,000. They qualified her on a 90% Loan-to-Value ratio, which came out to $145,800.
In other words, I got the $139,000, and the mortgage company took the rest on points, fees, etc.
Amazing how their fees totaled up to the exact 90% value figure!
Seller's Remorse
We finally closed the deal, and I made a profit of perhaps $22,000 or so after expenses (my real estate commission at purchase offset the cost of repairs and improvements).
Not too bad, for holding a property for about 14 months. I shouldn't complain, really.
But it kept eating at me for many months thereafter that I had sold a home worth $162,000 for $139,000, and that I had neglected to take an option fee as well!
So, Tycoon readers, if you want to profit from a real estate option, begin by learning from the mistakes that I made on this deal, as well as the basic rules that I described above. Make sure you do the following:
1) Find out in advance what credit obstacles the tenant may have.
2) Set an option fee with the buyer/tenant, typically anywhere from $1,000-$3,000, to provide you with some insurance, in case you end up having to sell the home for less than what you thought -- or, as in my case, less than what it's worth.
3) Look for a buyer/tenant who can qualify for an amount that is substantially above the current value of the home, in case of dramatic appreciation. You can always come down on price if necessary because the home does not appraise for what you are asking.
2) Set an option fee with the buyer/tenant, typically anywhere from $1,000-$3,000, to provide you with some insurance, in case you end up having to sell the home for less than what you thought -- or, as in my case, less than what it's worth.
3) Look for a buyer/tenant who can qualify for an amount that is substantially above the current value of the home, in case of dramatic appreciation. You can always come down on price if necessary because the home does not appraise for what you are asking.
Yes, investing is a constant learning process, no matter how long one has been doing it.
And that is why all of us at The Tycoon Report are here to share with you all that we have learned (and sometimes the hard way) over the years.
So Tycoon readers, what about you? What was your best options investment ever? Your worst one? The one that still causes you too to feel vertigo? Let me hear!
See you next week!
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Ethan Roberts
Contributing Editor
The Tycoon Report
