Cash on Cash Return - Part III - Lease Options

December 05

In the newsletter over the last two months, I have been writing about Cash on Cash Return (CCR), and how difficult it can be to acheive a good CCR. This is the third and final part of this mammoth article. (Next month will start the new year with a new property topic).

If you are a recent subscriber, it is probably worth reading the previous two articles, Part I (which outlined CCR), and Part II (which talked about one way to get better CCR.)

This article runs through the outline of a second, radically different way to improve CCR, through the use of so-called lease options.

Let us start by demolishing two of the common myths about lease options.

Myth 1: You cannot use them over here. They only work in the US and Australia. This is absolutely not true, there are plenty of people in the UK making good money from lease options.

Myth 2: Lease options are easy, you just look at the US websites, and download the contracts from there. Absolutely not, the UK legal framework is different, and you need specialised legal advice to put together a contract that protects every one.

So, what is a lease option?

To understand options, you have to understand futures contracts.

A future contract is a contract signed NOW, commiting both parties to exchange something, at a price agreed NOW, on a future date.

For example, when you exchange contracts on a house purchase, you are actually entering into a future contract, committing you to buy 1, Acacia Avenue, for £180,000 on the 1st February. Both parties are committed, and either party wishing to wriggle out has to pay a penalty.

An option is a future contract where only one party has the obligation, and the other party can pull out without penalty. Obviously, an option to buy 1, Acacia Avenue for 1st February is better than a future contract, since if something goes wrong between now and the excercise date, you can back out without penalty. On the flip side, however, it is normal in options contracts that the person buying the option pays a fee for the option - a so-called option premium.

This is a very common type of transaction in the stock markets. Today, shares in Kingfisher are trading at £2.39. If I believe that Kingfisher shares are going to shoot up in value, I have a couple of choices - I could either buy some at £2.39, and then wait and see. Alternatively, I could buy a option to buy them at £2.39 on the 1st March. Now, why would I make each decision? The option might cost me 10p per share now.

Suppose I had £500 to invest in shares spare. I could either buy 209 shares (at 2.39 each), or 5000 options.

Come the beginning of March, how much money I made or lost would depend on what happened to the shares.

Supposing the shares had gone up to £2.60.

If I had bought the shares, I would have made a profit of 21p per share, times 209 shares, so a total of £43.89.

If I had bought the the options, then I would have made a profit of 11p per share. (Because I would have paid not only the 2.39 to buy the shares, but IN ADDITION, the 10p per share to have the option.) However, I would have bought 5000 options, so 11p times 5000 is £550.00 profit.

If the shares went down by more than 10p, then the situation ALSO works out better for the options. If I had bought the shares, and they went down by 20p, then I would be sitting on a less valuable asset. However, if I had bought the option, and the price went down, then I would not take the loss on the shares - I would however, lose the £500 I had spent on the option fee.

It is when the shares stay in the middle that buying the shares works out better. If they went up from 2.39 to 2.45, then buying the shares makes a small profit, wheras buying the options makes a loss, since I have spent 10p in option premium to get a 6p rise.

Likewise, if the shares went down a penny, then buying the shares would only have lost me 1 penny, times 209 shares, or £2.09. Buying the (worthless) options would have cost me the full £500.

How does this relate to property then?

Well, in the case of a lease option, you give your tenants the right, but not the obligation to buy the house at a future date, for a price agreed now. (ie - you grant them an option to buy the property).

Typically, however, rather than paying a premium to you up front for the option, the tenant pays a substantially higher rent for a couple of years.

For example, rather than paying £800 in rent, the tenants might pay £1,000 in rent.

This, clearly, beefs up both the yield and the CCR.

To return to the example from part one. The property bought for £160k, with SDLT and Legal Costs, and let for £800 a week for 50 weeks of the year, with agents costs, maintenance and other fees generated a LOSS of £663 each year, and required cash in of £26,300 to give a CCR of -2.52% (see the Part 1 article on www.yourpropertyexpert.com to explain this in detail.)

By comparison, upping the cash in each month to £1,000 because the tenant has entered into a lease option gives a cash profit each of £1,372 instead of a loss of £663, and ups the CCR from -2.52% to +5.22%, a jump of 7.75 basis points.

Of course, there is a major potential downside to lease options - in a conventional buy to let, you make money (over the long, long term), by capital appreciation in your property. By entering into a lease option, if the tenant does excercise their right to buy, they THEY gain the benefit of this appreciation rather than you doing so.

The way around this, of course, is to set the excercise price (the price at which they will buy) to give you a profit. Of course, trying to persuade a tenant to buy at todays price plus 20% can be difficult, if they think the market is static. However, in a rising market, it can be of interest.

Of course, if the tenant ends up NOT excercising their right to buy, then you win - you have got the benefit of the higher cashflow for 2 years, without giving up the capital appreciation. (In a falling market, this still works out better than a conventional BTL, since you would have got the depreciation either way, but at least you get the higher cashflow.)

There is, however, another advantage of lease options. As long as the tenant is aiming to buy the property, they can think of it differently to a rental house. Most landlords running lease options report that tenants tend to look after properties rather better than BTL tenants.

Of course, a lease option needs to be put into your portfolio and weighed against your long-term goals. If you are intending to NEVER sell properties, but hold onto them for a 20-30 year time frame, then it may not be sensible to enter into a contract that could force you to sell up after only a couple of years, no matter how good the cash flow.

However, used correctly, lease options can dramatically boost your passive income provided you can find the right property and the right tenant. What I would NOT do, however, is buy a property that ONLY made sense on a lease option, and lost money otherwise. If you do that, you could find that your tenants move out after only a year, give up their right to buy, and leave you holding a lemon.

This is just the feature article from the December 05 newsletter. Subscribe for market comment, forthcoming events, and more.

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