Options are one of the most interesting yet misunderstood tools in an investor’s tool box. And how you think of them depends on whether you’re a Wall Street investor or a Main Street investor.
Wall Street investors use options (puts, calls, LEAPs, etc.) to create profits, hedge positions (stop losses), and to speculate on uncertainty. And while many people consider Wall Street options to be highly risky, ironically, options were actually created to and serve the very useful purpose of mitigating risk and providing pricing stability.
But we’re real estate guys. So we want to know if there’s anything real estate investors can learn from options traders. And is there any way to use options trading to improve the performance of our real estate portfolio?
To find out, we flew to Scottsdale, Arizona and stepped into the Rich Dad radio studios to chat with a guy who’s big (and he is!) into options trading.
Exploring our options behind the purple Rich Dad microphones:
- Your intrepid host, Robert Helms
- His erstwhile co-host, Russell Gray
- Big man on campus and Rich Dad’s Paper Asset Advisor, Andy Tanner
Long time listeners to The Real Estate Guys™ radio show know we like to get off the beaten path and go on conversational safaris. It isn’t that termite reports and title insurance aren’t SUPER interesting, but that’s what your technical professionals are for. So while we’ll have those kinds of subject matter experts on the show from time to time, we like to talk about big picture stuff we think investors need to know.
And speaking of “big”…
If you’ve never seen Andy Tanner live, he’s a BIG dude. Something like 11′ 3″. But he’s one of the smartest, nicest guys you’ll ever meet. And he’s VERY funny. Plus, he’s a great teacher. So who better to help us understand a somewhat confusing topic?
An option is a great tool because it gives the option holder the right, but not the obligation, to do something. So an option to purchase in a real estate contract allows the option holder to effectively control a property (have the right to buy it) without the obligation to do so.
Why would you want that?
Actually, there’s a few reasons…
Options can be used to control a property without buying it.
Maybe you’re waiting for another deal to close and you need the proceeds to buy the new property. With a purchase contract, you’d be obligated to buy the property even if the other deal didn’t close. And if the other deal doesn’t close and you don’t have the money to close the new deal, you’re in breach of contract. The other party is damaged (so is your reputation) and you lose your deposit. Not good.
With an option, you have the right, but NOT the obligation, to close. So if the other deal doesn’t close, you just walk away from the new deal. Or maybe you assign the deal to another investor for a fee.
Which brings up another use of options – assignment.
The option is actually an asset to itself. As such, it has value and can be sold to willing buyer. This is usually done through a process called “assignment”.
When you assign an option contract, you’re giving the assignee the right to step into your place and control the property. It’s a version of “wholesaling”, except you’re not using purchase contracts. Again, this is important, because with options, the buyer isn’t obligated to close, so if the deal doesn’t happen, it’s less damaging to the seller and your reputation.
Options can also be used to speculate (invest on the potential of an event outside your control).
For example, let’s say you hear a rumor that a new amenity is going in that will likely increase the value of adjacent properties. Something like a freeway overpass, a sports stadium or a hospital. But it isn’t public yet. (Remember, inside information is legal in real estate !).
So you buy options on the adjacent land, while waiting for the news to be confirmed. Once it is, you can either close on the land or assign it to someone who now wants it at a higher price because of the new amenity.
And yet another use of options in real estate is to control a property to preserve a 1031 tax-deferred exchange. (Remember, we’re not tax guys, so be sure to consult with yours before acting on anything you hear on the radio or read on the internet!).
In this case, you may have an “up-leg” property you want to exchange into, but don’t want to sell your current “down-leg” property until you know for sure you can get the up-leg. If you can get the option on the up-leg, then you can take your time preparing to sell and marketing your down-leg property without getting into the dreaded trap of having to buy whatever is available when you need to close simply to avoid the tax.
In short, options can be used to control timing.
We could cite more examples of how you might use an option as the option holder, but you get the idea.
But what about the option giver?
Again, an option is the right, but not the obligation, which is great for the option holder. The option holder has lots of flexibility, as we’ve described. But the guy on the other side of the deal has the obligation to perform IF the option holder exercises his right.
So WHY would give someone an option?
The obvious answer is money. Options aren’t free (usually). They cost money. So if you’re promising to someone (obligating yourself) to sell your property, but the other person isn’t promising to buy it, you need to compensated for the uncertainty. This is called “option premium”. Just like insurance companies collect premiums to compensate them for taking risk, so can you when you sell someone an option.
But what if you’re giving someone the right to buy your property (whether it’s a stock or parcel of dirt) and the “strike price” (the price they agree to pay) is profitable for you? How much risk are you really taking?
Sure, you risk the lost opportunity of the asset going up higher than the price you sold it for. Maybe you’d say it’s a risk that you can’t sell the property during the option period and it drops in value, but then the option holder doesn’t exercise (in this case, they usually won’t). So certainly, selling options isn’t without risk. (But you do get to keep the premium!)
But assuming you think through those risks and are willing to take them, options provide a great way to create sometimes instant cash in your bank account.
Maybe you give a tenant in your property a lease with an option to purchase. For that he pays you rent, plus a little bit more each month. Maybe he pays you a chunk when you sign the deal. Some of the extra may be credited towards the purchase, which is effectively an interest free loan to you against your equity. And maybe some of the extra is “option premium” which is pure compensation (profit) to you for taking the risk of uncertainty.
Either way, it’s more money in your pocket NOW. And when it comes to getting more money in your pocket, NOW is always the best time.
Crossing over from Main Street (real estate) to Wall Street (stocks), options trading is truly instant gratification.
You can sit down at your computer and in just a few mouse clicks, end up with cash being placed in your account TODAY. As much as we love it, usually real estate cant’ do that for you.
So if you’re educated in options trading (obviously, this is a very important consideration), you can use your options trading account to supplement cash flow during a vacancy or an unexpected expense. While it might take days or weeks to get a new tenant and rent coming in, your option trading account can refuel your checking account right away.
Of maybe you want to use your options trading account to churn out down payments for your rental properties!
In any case, we think it’s a skill that investors ought to consider developing. When it comes to creating instant cash, you can never have too many options!
So listen in to this episode of The Real Estate Guys™ radio show featuring Rich Dad’s Paper Asset Advisor, Andy Tanner.
If you like what you hear and want to learn more about how paper asset options trading can help you with your real estate investing, then exercise your option to join Andy Tanner, along with Ken McElroy, Peter Schiff, Tom Hopkins and the rest of our fabulous faculty on the 2014 Investor Summit at Sea™!
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