I am amazed when markets turn soft the number of would-be real estate investors shrink. The common misconception people have is it's impossible to make money in down real estate markets. I try very hard to get people to understand that this is just NOT TRUE. I co-authored a book titled Making Hard Cash in a Soft Real Estate Market, with Justin Ryan. In this book we address why down markets are so GREAT and how to make big money in them. For this article I'm going to focus on one strategy for making money in a down market – Lease Options.
As you know, I've been doing Lease Options for about 203 years now. I've seen down markets, up markets and everything in between. Having survived all kinds of markets I can tell you I LOVE doing Lease Options in down markets. Why is that? Because there are SO MANY deals just waiting for me.
If you've invested in strong markets you know the competition to find deals can be fierce. Investors are fighting each other for the deals and ultimately some of them start making bad deals just to do any deals at all. In a down market the motivated sellers are plentiful. In my home state of Michigan right now, one of the most depressed markets in the country, I could go into a neighborhood and throw a stone in any direction and probably hit half a dozen motivated sellers.
So if there are so many motivated sellers out there and so many great Lease Option deals to be had, why are there fewer investors jumping into soft markets than hot markets?
I think there are two main reasons for this:
- The first reason is bad publicity
- The second is the Herd Mentality.
When a real estate market goes soft what happens? The newspapers and T.V. report on it endlessly. They keep talking about how bad it is. This actually scares buyers away. It also scares would-be Lease Option investors away. Effectively the media is making the problem worse. When markets are going great the media reports endlessly on how great it is, encouraging more buyers and investors to jump in. By the time they jump in though the market is ready to turn back down, so instead of making profits they end up taking a beating. Here's a new flash for you:
If you run with the herd you'll always be stuck with the herd. The herd mentality is really what keeps most investors from succeeding.
When investing with Lease Options you want to minimize your competition. Competition makes us work harder, and who wants to work their butts off just to get a deal or two? That sounds too much like a J.O.B. to me. If the media is reporting how great the market is it means you are going to have to work that much harder to find the deals, because there are so many other investors out there. If the media is reporting about how bad things are it means your life just got a whole lot easier as a Lease Option investor. It means you have many deals to choose from. Your task at this stage is to choose your deals carefully. You'll find that there are more deals out there than you can actually handle. GREAT! Pick the best ones!
If you run counter to the media, then they are actually helping you. If you are putting together lots of Lease Option deals when the media screams “It's a horrible market, sell!” then the media is providing you with a host of motivated sellers. If you are selling when the media is directing the herd with positive market news, “The market is great, buy now!” then the media has just provided you with more buyers than you can possibly sell to. Boy, talk about your free advertising.
So when the market is down you want to be picking up lots of Lease Option deals. When the market turns back around is when you want to be selling your Lease Option deals. How do you accomplish this? With TERMS. I've got another news flash for you:
If you pick up a Lease Option deal in a down market and only have one year to exercise the option and sell the property, you will probably still be selling in a down market.
That means you'll be competing with the rest of the herd to sell. Structure your Lease Option deal with TERMS that work for you.
Let's Look at Some Ideas of How to Structure Your Lease Option Deals:
- First, is the duration of the Lease Option agreement. If you are doing a Lease Option deal in a soft market, you need to make the length of the option longer. Give yourself time for the market to turn so you can sell the property easily.
How much time do you need? I would say at least 3 to 5 years. Can you go longer? It doesn't hurt to ask the seller. If the seller won't give you enough time, you need to pass on the deal in a down market. Yes, you might end up passing on a deal here or there that might have made you good money, but overall you'll probably save yourself from getting into a lot of deals you can't sell.
2. Another Lease Option term to consider of course is the price. What is the spread between the price you can get from the seller and what you can REALISTICALLY sell the property for. If that spread is too close and the other terms aren't that favorable then it's not really a deal. But don't forget the other terms when considering the price. What if the seller is firm on their price and their price is the same as what you could sell the property for? There is no spread there, but what if you can get them to agree to a 7 year Lease Option with positive monthly cash flow? Suddenly you've given yourself time enough for the market to appreciate with positive cash flow in the interim.
3. How about cash flow? This is an important term as well. If you do a Lease Option deal in a down market that has large negative cash flow, it had better have a huge price spread. You may be carrying that negative cash flow for a while. Another news flash for you:
In a soft market the rents may go down even more. That means the negative cash flow could get even more negative.
Take all the negative cash flow into your calculations when you are determining the profit margin. Another factor to consider with a Lease Option deal that has negative cash flow is how comfortably YOU can handle that negative. If a property is $500 per month negative, how much of an impact will that have on you? If it takes you 4 years to finally sell, that's $24,000 you'll have to pay. Now if that Lease Option deal is going to net you $60,000 after you've deducted the negative cash flow it's probably worth it. But if you can't COMFORTABLY handle that negative cash flow find a money partner who can. If you can't find a money partner, try to wholesale the Lease Option deal instead. The reason I stress making sure you can COMFORTABLY handle the negative cash flow is because as soon as it becomes uncomfortable you start making poor decisions to end the discomfort as quickly as possible.
4. Here's another term for us to look at: Principal Pay Down. If the spread on the purchase price and the selling price of your Lease Option is close (or even if it's far, you can still ask about this) you can ask for reduction in the principal balance with each month's rent paid as part of your Lease Option agreement. If the monthly rent is $1250 and you get $1000 per month in principal pay down on a 3 year Lease Option, you've just increased your profit margin by $36,000.
I've talked about some great ideas for getting favorable Lease Option terms here, but I know what you are probably saying, “Wendy, I could never ask for all of that! I'd be too embarrassed.”
This is a big reason why many investors end up in bad deals. They are too afraid to ask for a better deal. Here's a task for you if you are afraid to ask for good Lease Option terms. Go out and make 50 EMBARRASSING OFFERS. They should be offers that you are truly embarrassed to give to the seller. You can tell them, “I'm sorry, I'm embarrassed to make this offer to you, but in this soft market it's truly the best I can do.” If you make 50 embarrassing Lease Option offers I can virtually promise you two things will happen:
- First, after all those offers you will no longer be embarrassed to ask for favorable terms. You will have built up some immunity to it.
- Second, if you make 50 embarrassing Lease Option offers to motivated sellers, I'll bet you get a deal from them. I'll bet you'll find one motivated seller who accepts your offer, despite the fact that you were so embarrassed in making it.
Aside from the media publicity and herd mentality scaring investors away in soft markets, I think the other reason there are fewer investors is that in soft markets you have to work harder to find buyers and tenants. It's easier to find motivated sellers and put deals together in down markets but you do still have to find the end Lease Option buyer. In hot markets the buyers are plentiful.
Lease Option investors have to find the end buyer. That's how you get paid. The common misconception when the media is screaming about how bad the market is, is that there are no buyers out there. That is almost true. There are fewer buyers in a soft market. Does that mean it's impossible to find them? Not at all.
Let's Take a Look at Some Ways to Find Lease Option Tenants & Buyers in Soft Markets:
1. First, is the asking price. If your asking price, either the sale asking price or monthly rent asking price, is too high for your Lease Option, you'll scare away most buyers. Yes, it's common that on a Lease Option the rent and purchase price are marked up due to the flexibility you are offering the buyer. However, if the market is soft you'll find these marked up margins shrink. This especially applies to the monthly rent. If you are asking too much for rent you will have a VERY hard time finding tenants. If you want to place a quality tenant quickly make sure the rent is competitive, maybe even slightly less than the competition. If you have two properties near each other and they are basically identical in all other ways, but one is renting for $50 less than the other, which one do you think will rent out first? The cheaper one. If you rent it for $50 less per month for 3 years on the Lease Option and then sell it to make a $30,000 profit, how much did it cost you to lower the rent? $600 per year! Or a total of $1,800 for 3 years to make the $30,000 profit. Is it worth it to make sure your rent is competitive? I think so.
2. Second, make sure the house is attractive. It doesn't matter how low the rent is if you are trying to Lease Option a really ugly or functionally obsolete house. If the house needs repairs or improvements to make it appealing, make sure you have money budgeted for them. It will take you a whole lot longer, and cost you a lot more in lost cash flow, to rent an ugly home than to spend a bit to make it beautiful. Plus you'll get higher quality tenants in the beautiful home.
3. Third, stage the house. This goes along with making the house beautiful. If you have some simple staging props in the house to give it some class, some charm and also help the Lease Option tenant buyers to visualize living in the house, you'll rent it a whole lot faster.
4. Fourth, think long term. If you have structured a longer term Lease Option deal with the seller, like 3 to 5 years, consider just renting the house initially. Rent the house out for the first couple of years before you try to place a Lease Option buyer. This will give you time to weather the soft market and start moving towards rebound. If you get stuck with the mindset of only looking for Lease Option buyers you'll be following the herd, trying to sell in a down market. Just rent the house in the down market and try to sell it when the market picks back up.
5. Fifth, cover your cash flow. If you put together a great Lease Option deal and have it start right away, who covers the monthly rent until you find a tenant? News flash: You Do!
What just happened? You became a motivated seller! You are much more likely to make a bad decision in Lease Optioning that house than if you weren't having to pay the monthly payment. You are also reducing your profit margin for every month the house sits vacant. Instead, structure the deal to give yourself some time (a few months at least) to find the buyer or tenant. You could even have the Lease Option begin only once you have found a tenant. Be fair to the owner and let them continue to try to sell their home on their own during this time.
6. Sixth, cover your bases with advertising. In softer markets you need to spread the word that the house is available. Put up signs, put it on the MLS both for rent and for sale, post flyers at nearby employers, run classified ads, put it on the Internet. Get creative in finding ways to advertise the property.
Pretty much everything but the classified ads won't cost you very much money either. If you have to run classified ads for a long time, the price can add up. It's important to factor your advertising cost into your deal calculation. You'll move the property faster that way and it won't come out of your profit if you plan for it in the beginning.
Taking all of this into account I think you'll see why I LOVE Lease Options in soft markets. If you put together the Lease Option deals when the market is soft you'll find it easy to get the kinds of deals you really want. Then if you structure the deal with strong terms and use the selling techniques I talked about, you'll be selling when the market has improved and find it a whole lot easier to move your properties and make handsome profits.