“The theory that land is property subject to private ownership and control is the foundation of modern society, and is eminently worthy of the superstructure.” – Ambrose Bierce
Did you know that you can rent a house, take none of the risks of home ownership, and still benefit from any appreciation in all types of markets (from bubble markets to bargain markets and anything in between)?
The Problem With a Traditional Purchase
Let’s say you are in the market for a $250,000 house. For a conventional loan of that size, you’ll likely be required to put down 20 percent, or $50,000. In addition, you would have to pay closing costs, origination fees, survey, appraisal, and points for at least another $5,000. So, at closing you’d be out of pocket around $55,000, with $50,000 in equity. (Since equity is the difference between what the home is worth and what you owe, the $50,000 down payment would create equity, but the $5,000 in closing costs would not.)
A $200,000 mortgage at an 8 percent, 30-year fixed rate would be $1,467 in principal and interest. Add insurance and taxes, and your future payment would be about $1,800 per month.
After three years, assuming (for the moment) no increase in the market value of your property, you will have paid your $200,000 mortgage down to about $194,500. Thus, your initial $55,000 cash investment is now worth $55,500 in equity. You don’t need a calculator to figure out that your return on investment (ROI) is just plain lousy.
Let’s look at an alternative scenario.
You find someone with a house worth $250,000. Her company has transferred her to another city and she needs a quick solution. Instead of buying her house, you offer her a full price “lease/purchase,” with $1,600 per month rent (about market for that price range) and 25 percent rent credit (an agreed-upon percentage of your monthly rent that is credited toward your final purchase price). You give her an additional $3,200 as option consideration (a non-refundable fee you pay for the option to buy at a later date), which is also applied toward your purchase.
You move in tomorrow – no points, closing costs, etc., so you’re out of pocket only the $3,200 option consideration fee. After three years, your equity is your option consideration ($3,200) plus your rent credit ($400 x 36 = $14,400), for a total of $17,600. That gives you a whopping ROI of about 500 percent.
“Yes, but I haven’t bought the property, yet,” you say. Even so, equity is still equity. Your equity in the first scenario is not realized until you sell. Likewise, your equity in the lease/purchase scenario is not cash until you exercise your option to buy and then sell the property.
Here’s the trick: Sell your option before the end of your lease term.
If you live in the property, wait until about six months before the end of your term and start advertising the house for sale. If the market is somewhat good, you should have no problem selling it. Once you have a buyer lined up, you simply exercise your option to buy and simultaneously sell it for a profit. (By the way, you don’t have to live in the house the whole time. You can sublease it if you find another house you’d rather live in.)
Why not just buy the house, as in the first scenario, and sell it three years later? The answer is simple: You would be back in the same position as you were in when you started. (Probably worse, since your $55,500 equity would be liquidated into less than $50,000 after closing costs.)
What about inflation? In either scenario, you would benefit from inflation, since the option price in the lease/purchase scenario locks in your purchase price. However, you would fare much better with a lease/purchase, since your ROI would be much greater.
940 Percent Greater Return on Investment?
Let’s look at some numbers. Suppose that over the next three years your home appreciates a total of 10 percent. The house would now be worth $275,000. In the buy/hold/sell scenario, your total profit would be $30,500 ($25,000 appreciation + $5,500 loan paydown), about 60 percent ROI.
In the lease/purchase scenario, your profit would be $39,400, but your ROI would be over 1,000 percent!
Now, let’s look at the downside. Suppose the real estate market drops 10 percent. In the first scenario, you would have trouble selling the house for a profit. You’d be just like the guy you bought it from. In the lease/purchase scenario, you wouldn’t win either. BUT YOU WOULD ONLY LOSE YOUR $3,200 OPTION MONEY. (Which could be deductible as a loss if you argue that the money you paid for the option was a business investment.) Isn’t it better to rent for a few years and walk away than to be stuck with a 30-year mortgage?
A Taxing Question
The final point you may be wondering about is the home mortgage interest deduction. In the first scenario, assuming you are in a 30 percent tax bracket, you would save about $14,200 in taxes over three years. However, you lost the use of the $50,000 you put up front to buy the house.
Let’s take the difference between the $3,200 option money in the second scenario and the $50,000 in the first scenario (total $46,800), and loan that money out as “hard money” secured by real estate. At 14 percent for three years, you would earn almost $19,656 in interest (not including the generous points you can usually collect on hard money loans). The benefit of the mortgage interest deduction hardly compensates for the poor ROI in buying, holding, and selling. And there’s always the chance that Congress may decide to take away the mortgage interest deduction. (History has taught us that we should NEVER buy real estate for the tax benefits.)
14 percent interest on your hard money loan may sound a little high – but the going rates are anywhere from 12 to 20 percent. And keep in mind that the figures I have used here are based on the best scenario for a buy/hold/sell purchase and the weakest scenario for a lease/purchase. You could probably negotiate a lower monthly rent and purchase price if you find a motivated seller.
Why Buying a Better, More Expensive House Is Even Easier
The lease/purchase scenario works fairly well with lower-priced homes, despite the fact that rents often exceed the typical mortgage payment. However, it works even better with very expensive homes. On high-priced homes ($500,000 and up), you’ll have to put down closer to 25 percent, and your ROI goes way down when you have to plunk down $100,000 or more. In fact, there really is no comparison, since the rent on that kind of house would not exceed $2,200, yet the mortgage would skyrocket to $3,500 or higher.
In my next article for ETR, I’ll be going into the legal considerations of a lease/purchase agreement. I’ll show you three important ways to protect yourself as the buyer, and a few strategies to employ should you decide to sell your own home this way.[Ed. Note: William Bronchick is a nationally recognized attorney, best-selling author, entrepreneur, and speaker. He has been featured in Money Magazine, USA Today, CNBC’s “Power Lunch,” CNN Money, The Los Angeles Times, and more.
Mr. Bronchick will be speaking to a select group of listeners in an upcoming teleseminar on using lease/purchases to buy and sell real estate.]