Flipping Vs Buying and Holding - Basic Exit Strategies (Part 2 of 2)
In the previous Flipping vs.
Buy and Hold article we discussed the pros and cons of flipping and other short-term or near short-term strategies for buying real estate.
We covered the advantages of flipping and the tax ramifications of selling properties in less than 366 days.
Now let's discuss all of the long-term strategies.
Recall they include:
Recall the buying values were as follows: Purchase Price: $100,000 Market Rent: $1200 Purchase Price to Value: 70% Actual Value: $143,000 Equity Value: $43,000 Local Appreciation Rate: 3% Estimated 1 Year Future Value: $147,300 Long-Term Strategies The classic concept of investing is to buy and hold the property for a long time.
Length of holding may change upon individual taste.
The ideal way is to buy and hold forever.
Thus, you buy the property then simply rent it to various tenants over the years.
In some cases you may have tenants for a few years or even over a decade or longer.
Let's discuss the three above long-term strategies.
Renting out a home In this traditional scenario you buy a home and either rehab it or have the tenant rehab it for you for sweat equity.
When you did your first analysis of the property for a rental there is a rule of thumb that many investors use to determine if a property will fit their buying criteria.
This is known as "The 1% Rule".
In the 1% Rule you are measuring if a property will cash flow assuming you are getting a loan.
Even though you are paying cash this is still a good rule to use.
The 1% Rule simply states that the monthly market rent must be equal to or greater than 1% of the purchase price.
In this case 1% of $100,000 is simply $1000 (you are moving the decimal to the left by two - or simply crossing off the right two zeros).
Well, anyone can see that $1200 rent is greater than the minimum $1000 rent which a $100,000 home will require.
Thus, this is a good rental purchase.
One item you must consider is there will always be periodic maintenance on the rental unit over the years so you do have to account or hold reserves aside for those repairs.
On a side note, I always recommend purchasing a Home Warranty for your rental properties.
This covers may things an insurance policy doesn't cover and you can search on the Web for local companies and how they operate.
Also, when purchase rentals there is always another item known as the vacancy factor.
This is how often your home may remain vacant between tenancies.
You can check local census information on the web also.
The aforementioned 1% Rule can help account for some of this if only vacant for a month or less.
In this scenario which has no loan, the rental profit will be equal to $1200 per month times twelve months.
The profit is $14,400 per year in steady income.
In future months, inflation can result into higher rents and higher profits.
The only downside is the occasional maintenance and the usual repainting and recarpeting every few years between tenants.
$14,000 a home per year is not a bad form of retirement.
Renting out a home where tenant does the rehab Often landlords are more distant to their properties and don't want to put up with the repairing of the homes between tenants.
This can sometimes be an advantage to you.
If you are getting a new tenant into the home you can use something known as "Sweat Equity".
This is exactly what it sounds.
The tenant is using their own skills and know how to make repairs to a property with either reduced rents or in lieu of a security deposit.
If you do go this route you must hold them accountable for the repairs.
If they don't do repairs on time or on schedule or they even fall behind then the rent for that month should be at its normal level.
This requires a little bit more time since you or your representative must visit the home periodically to ensure the work is getting done.
Other than that, you not only get to make the monthly rental but your monies from your purchase price (let's say $7,000) is now being performed by the renter and usually for a stronger discount since labor is usually dropped.
As an example, let's assume your home needs basic painting, carpeting and a few holes in the wall and some fixtures.
Instead of a $1200 security deposit you take only $900.
The rents are reduced to $1000 for the next 16 months.
The prospective tenant is a painter and handyman for a living.
He agrees to that and he will provide the supplies.
Thus, you just paid for $7000 worth of work for only $200 * 16 + $300 which equals $3500.
Not bad, eh? Lease Options I can write an entire book on the ins & outs and dos & don'ts on doing a lease option, as this is my specialty since January 2004.
Let's first explain the details on a lease option.
A lease option is when the owner decides to give a prospective tenant the option to buy the home within a certain time frame.
This does cause the owner the inability to sell the home to any other parties during the valid time the option is in place.
Because of this the tenant, now called a "tenant/buyer", will be giving the owner a option payment in order to buy the right to buy.
The standard amount will depend upon the deal, the people involved, and the part of town or country the home is located.
As an example, my lease option company in Las Vegas, NV charges approximately 2% of the home value for the option payment.
In some areas you may require 5% to 10%.
The option payment is usually non-refundable and most, if not all, will go toward the purchase price.
You can also charge a higher rent than the normal rental market.
This additional amount of monthly payments can go toward the purchase of the home.
These monies are called a "rental credit".
Notice a rental credit is very similar to principal reduction in a standard P&I loan.
The standard option agreement can range from 1 year to 3 years in today's residential home market.
Now options can be used for many things (from buying land rights, to apartments, to just about anything) and I will discuss these in future blogs.
Since you are giving them the right to buy your home you must be willing to sell it when they decide to exercise their option.
As a home owner doing a lease option and a just purchased home you have to decide if you are okay with paying the capital gains tax talked about in part 1 of this blog.
If you are not, then you have to put in a clause into your lease option agreement stating they can't exercise until a certain date.
This is simply done by giving them the dates they can start buying to the last date the must buy before.
In most lease options the tenant/buyer is responsible for all repairs too, so that removes that headache from your mind.
You should still have a home warranty on the home for major issues and strongly suggest the tenant/buyer puts you on their renter's insurance so the minor things can be taken care of in case they decide not to buy, move out, and there are some damages which need mending.
The purchase price is often calculated in one of two ways.
The first is to offer a set value for the home.
This can be today's value, slightly higher than today's value, or whatever you and the tenant/buyer agrees to.
The second method is to sell the home at the appraised value when they actually exercise.
There are pros and cons to both.
The appraised value is the most fair and can be dangerous to either party.
If prices skyrocket like they did back in 2004 - 2006, then homes could double.
If prices plummet like 2007 - 2008 then the owner can be left owing money.
It is always advisable to set a minimum or maximum price when doing the appraised value method.
The set price method sets an exact price the home will be bought at, regardless of the market value at the time the tenant/buyer exercises.
If the value is higher than the set price then that tenant/buyer just got a home with equity.
Everyone should be happy.
If the market value is less then some form of renegotiation must occur.
For example, extending the option agreement, resetting the price, or start an owner financing scenario.
Oh, and another thing to consider is that the option payment and rental credit are usually non-refundable.
Prior to 2008 the national average for people exercising their options was from 10% to 20%.
Since then, the number may increase due to so many foreclosed upon homeowners moving into these types of homes as they are wanting to become home owners again.
Let's do the math for a lease option.
Some new values are going to be needed to figure out the math on this one.
Here they are: · Lease Option Length of Stay: 2 years · Option Payment: $3,000 · Rental Amount w/ Lease Option: $1,400 · Rental Credit: $200 · Purchase Price (set value): $150,000 We will both scenarios.
First will be the tenant/buyer buys at the 24th month.
The second example will be you get three sets of tenant/buyers and it is the third one who purchases.
We will ignore vacancy periods since you have no mortgage from paying cash initially.
Lease Option Scenario One: They BUY!!! Here is the math on the deal.
They are paying $50,000 for the home and paid you 24 months at the base rent of $1200.
The credits they paid initially just come to you over stages.
Thus, your profit is $50,000 + 24 * $1,200 = $50,000 + $28,800 = $78,800 They DON'T BUY in first year and move out.
$3,000 + 24 * $1,400 + you keep the appreciated house.
= $3,000 + $33,600 = $36,600 + house Lease Option Scenario Two: We already mentioned a 3% annual appreciation.
We will ignore the actual set values with your first two tenants because they become irrelevant if they don't buy.
Value at End of Year 1: $143,000 * 1.
03% = $147,300 End of Year 2: Year 1 * 1.
03 = $151,700 End of Year 3: Year 2 * 1.
03 = $156,300 End of Year 4: Year 3 * 1.
03 = $161,000 Okay now you are getting that next tenant/buyer for your home.
It is the beginning of Year 5 of ownership and you are giving them the two year option.
Let's also assume rental rates have increased $50 between each of the two contracts (means rents increased $25 per year).
If the trend for appreciation at 3% stands then you can expect the home to be worth around $166,000 at end of Year 5 and $171,000 at end of year 6.
This is a $10,000 increase in value from today at end of Year 4.
You decide to give them a break and add only $6,000 to today's value and set a price at $167,000 and they agree.
They buy at the end of the agreement.
Let's figure your profit.
Profit from tenant#1: Option payment + 24 rental payments $3,000 + 24 * $1,400 = $36,600 Profit from tenant #2: $3,000 + 24 * $1,450 = $37,800 Profit from tenant/buyer #3: 24 * ($1,500 - $200) + $67,000 = $98,200 Total Profit from all 3 tenants $36,600 + $37,800 + $98,200 = $172,600 In summary, the most important thing to your investing career is knowing what your Exit Strategy is going to be.
Are you looking for short-term profits (with higher taxes) which can get you to close more deals, or are you looking for long-term wealth.
In theory, you should do most to all of these.
Each deal will be different.
Being able to switch from one method to another can be always a possibility.
Maybe market to multiple methods and go with the one which comes first.
And remember..
..
the numbers don't lie.
Happy Investing!
Buy and Hold article we discussed the pros and cons of flipping and other short-term or near short-term strategies for buying real estate.
We covered the advantages of flipping and the tax ramifications of selling properties in less than 366 days.
Now let's discuss all of the long-term strategies.
Recall they include:
- Renting them out.
- Rehab and rent
- Lease Option
Recall the buying values were as follows: Purchase Price: $100,000 Market Rent: $1200 Purchase Price to Value: 70% Actual Value: $143,000 Equity Value: $43,000 Local Appreciation Rate: 3% Estimated 1 Year Future Value: $147,300 Long-Term Strategies The classic concept of investing is to buy and hold the property for a long time.
Length of holding may change upon individual taste.
The ideal way is to buy and hold forever.
Thus, you buy the property then simply rent it to various tenants over the years.
In some cases you may have tenants for a few years or even over a decade or longer.
Let's discuss the three above long-term strategies.
Renting out a home In this traditional scenario you buy a home and either rehab it or have the tenant rehab it for you for sweat equity.
When you did your first analysis of the property for a rental there is a rule of thumb that many investors use to determine if a property will fit their buying criteria.
This is known as "The 1% Rule".
In the 1% Rule you are measuring if a property will cash flow assuming you are getting a loan.
Even though you are paying cash this is still a good rule to use.
The 1% Rule simply states that the monthly market rent must be equal to or greater than 1% of the purchase price.
In this case 1% of $100,000 is simply $1000 (you are moving the decimal to the left by two - or simply crossing off the right two zeros).
Well, anyone can see that $1200 rent is greater than the minimum $1000 rent which a $100,000 home will require.
Thus, this is a good rental purchase.
One item you must consider is there will always be periodic maintenance on the rental unit over the years so you do have to account or hold reserves aside for those repairs.
On a side note, I always recommend purchasing a Home Warranty for your rental properties.
This covers may things an insurance policy doesn't cover and you can search on the Web for local companies and how they operate.
Also, when purchase rentals there is always another item known as the vacancy factor.
This is how often your home may remain vacant between tenancies.
You can check local census information on the web also.
The aforementioned 1% Rule can help account for some of this if only vacant for a month or less.
In this scenario which has no loan, the rental profit will be equal to $1200 per month times twelve months.
The profit is $14,400 per year in steady income.
In future months, inflation can result into higher rents and higher profits.
The only downside is the occasional maintenance and the usual repainting and recarpeting every few years between tenants.
$14,000 a home per year is not a bad form of retirement.
Renting out a home where tenant does the rehab Often landlords are more distant to their properties and don't want to put up with the repairing of the homes between tenants.
This can sometimes be an advantage to you.
If you are getting a new tenant into the home you can use something known as "Sweat Equity".
This is exactly what it sounds.
The tenant is using their own skills and know how to make repairs to a property with either reduced rents or in lieu of a security deposit.
If you do go this route you must hold them accountable for the repairs.
If they don't do repairs on time or on schedule or they even fall behind then the rent for that month should be at its normal level.
This requires a little bit more time since you or your representative must visit the home periodically to ensure the work is getting done.
Other than that, you not only get to make the monthly rental but your monies from your purchase price (let's say $7,000) is now being performed by the renter and usually for a stronger discount since labor is usually dropped.
As an example, let's assume your home needs basic painting, carpeting and a few holes in the wall and some fixtures.
Instead of a $1200 security deposit you take only $900.
The rents are reduced to $1000 for the next 16 months.
The prospective tenant is a painter and handyman for a living.
He agrees to that and he will provide the supplies.
Thus, you just paid for $7000 worth of work for only $200 * 16 + $300 which equals $3500.
Not bad, eh? Lease Options I can write an entire book on the ins & outs and dos & don'ts on doing a lease option, as this is my specialty since January 2004.
Let's first explain the details on a lease option.
A lease option is when the owner decides to give a prospective tenant the option to buy the home within a certain time frame.
This does cause the owner the inability to sell the home to any other parties during the valid time the option is in place.
Because of this the tenant, now called a "tenant/buyer", will be giving the owner a option payment in order to buy the right to buy.
The standard amount will depend upon the deal, the people involved, and the part of town or country the home is located.
As an example, my lease option company in Las Vegas, NV charges approximately 2% of the home value for the option payment.
In some areas you may require 5% to 10%.
The option payment is usually non-refundable and most, if not all, will go toward the purchase price.
You can also charge a higher rent than the normal rental market.
This additional amount of monthly payments can go toward the purchase of the home.
These monies are called a "rental credit".
Notice a rental credit is very similar to principal reduction in a standard P&I loan.
The standard option agreement can range from 1 year to 3 years in today's residential home market.
Now options can be used for many things (from buying land rights, to apartments, to just about anything) and I will discuss these in future blogs.
Since you are giving them the right to buy your home you must be willing to sell it when they decide to exercise their option.
As a home owner doing a lease option and a just purchased home you have to decide if you are okay with paying the capital gains tax talked about in part 1 of this blog.
If you are not, then you have to put in a clause into your lease option agreement stating they can't exercise until a certain date.
This is simply done by giving them the dates they can start buying to the last date the must buy before.
In most lease options the tenant/buyer is responsible for all repairs too, so that removes that headache from your mind.
You should still have a home warranty on the home for major issues and strongly suggest the tenant/buyer puts you on their renter's insurance so the minor things can be taken care of in case they decide not to buy, move out, and there are some damages which need mending.
The purchase price is often calculated in one of two ways.
The first is to offer a set value for the home.
This can be today's value, slightly higher than today's value, or whatever you and the tenant/buyer agrees to.
The second method is to sell the home at the appraised value when they actually exercise.
There are pros and cons to both.
The appraised value is the most fair and can be dangerous to either party.
If prices skyrocket like they did back in 2004 - 2006, then homes could double.
If prices plummet like 2007 - 2008 then the owner can be left owing money.
It is always advisable to set a minimum or maximum price when doing the appraised value method.
The set price method sets an exact price the home will be bought at, regardless of the market value at the time the tenant/buyer exercises.
If the value is higher than the set price then that tenant/buyer just got a home with equity.
Everyone should be happy.
If the market value is less then some form of renegotiation must occur.
For example, extending the option agreement, resetting the price, or start an owner financing scenario.
Oh, and another thing to consider is that the option payment and rental credit are usually non-refundable.
Prior to 2008 the national average for people exercising their options was from 10% to 20%.
Since then, the number may increase due to so many foreclosed upon homeowners moving into these types of homes as they are wanting to become home owners again.
Let's do the math for a lease option.
Some new values are going to be needed to figure out the math on this one.
Here they are: · Lease Option Length of Stay: 2 years · Option Payment: $3,000 · Rental Amount w/ Lease Option: $1,400 · Rental Credit: $200 · Purchase Price (set value): $150,000 We will both scenarios.
First will be the tenant/buyer buys at the 24th month.
The second example will be you get three sets of tenant/buyers and it is the third one who purchases.
We will ignore vacancy periods since you have no mortgage from paying cash initially.
Lease Option Scenario One: They BUY!!! Here is the math on the deal.
They are paying $50,000 for the home and paid you 24 months at the base rent of $1200.
The credits they paid initially just come to you over stages.
Thus, your profit is $50,000 + 24 * $1,200 = $50,000 + $28,800 = $78,800 They DON'T BUY in first year and move out.
$3,000 + 24 * $1,400 + you keep the appreciated house.
= $3,000 + $33,600 = $36,600 + house Lease Option Scenario Two: We already mentioned a 3% annual appreciation.
We will ignore the actual set values with your first two tenants because they become irrelevant if they don't buy.
Value at End of Year 1: $143,000 * 1.
03% = $147,300 End of Year 2: Year 1 * 1.
03 = $151,700 End of Year 3: Year 2 * 1.
03 = $156,300 End of Year 4: Year 3 * 1.
03 = $161,000 Okay now you are getting that next tenant/buyer for your home.
It is the beginning of Year 5 of ownership and you are giving them the two year option.
Let's also assume rental rates have increased $50 between each of the two contracts (means rents increased $25 per year).
If the trend for appreciation at 3% stands then you can expect the home to be worth around $166,000 at end of Year 5 and $171,000 at end of year 6.
This is a $10,000 increase in value from today at end of Year 4.
You decide to give them a break and add only $6,000 to today's value and set a price at $167,000 and they agree.
They buy at the end of the agreement.
Let's figure your profit.
Profit from tenant#1: Option payment + 24 rental payments $3,000 + 24 * $1,400 = $36,600 Profit from tenant #2: $3,000 + 24 * $1,450 = $37,800 Profit from tenant/buyer #3: 24 * ($1,500 - $200) + $67,000 = $98,200 Total Profit from all 3 tenants $36,600 + $37,800 + $98,200 = $172,600 In summary, the most important thing to your investing career is knowing what your Exit Strategy is going to be.
Are you looking for short-term profits (with higher taxes) which can get you to close more deals, or are you looking for long-term wealth.
In theory, you should do most to all of these.
Each deal will be different.
Being able to switch from one method to another can be always a possibility.
Maybe market to multiple methods and go with the one which comes first.
And remember..
..
the numbers don't lie.
Happy Investing!
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