Property Options are a buying method, not a strategy

You want more property in your portfolio but the deposit money is running out, or worse still has been spent completely – all is not lost as you can still buy property without much of your own money can’t you?

Options was the buzz word of 2011 as people trying to get into the property investor arena or those who didn’t really want to share the profits with JV partners spread their wings and declared that their strategy for the year was ‘Options’.

Sorry to disappoint you, because buying any property using an option process needs just as much thought and consideration as buying a property using a traditional method. You can still end up with ‘lemons’ if you’re not careful what you are committing to, or will take on any property as long as you don’t have to part with a substantial deposit.

How then can options help us to build our portfolios? How can we find these ‘holy grail’ properties in the first place? And how do we avoid the pitfalls of falling for a cheap deal without having done sufficient due diligence before taking the plunge?

Firstly, let’s be clear what Options are and the types of options available.

The Purchase Option

An ideal scenario might be to have access to a run-down property in order to refurbish it prior to getting a valuation from the lender. If a property does not have suitable kitchen facilities or toilets for example the lender is unlikely to lend and the property may need to be bought for cash, and pay by cash again for the renovation before finally re-financing the property at the time of taking out a mortgage.

Instead if you can arrange a purchase option with the seller then you can take control of the property and do the works on it prior to approaching a lender for finance and they are then in a position to grant a mortgage as the property is fit for habitation where it wasn’t before.

Does this leave the seller in a vulnerable position? The reality is that you can pay the £1 and get going on the work, but any sensible seller would want further precautions to be taken that they will get paid, and any sensible investor is going to want security to ensure that the seller isn’t going to sell the property to someone else for a higher price when the work is done. Taking out a basic property option contract may cost around £600 for each party but is considered good practice (by the Solicitors at any rate). Taking out a restriction via the Land Registry could be considered by the investor to ensure that the seller doesn’t sell on the property and holds to the agreement.

What if the seller isn’t very happy with this arrangement or needs to get their hands on some cash quickly? It may be worth looking at using an ‘Exchange and delayed completion’ (EDC) contract instead, where the investor pays a deposit (not the usual 10%) at an agreed fee which allows the seller to move on, and then the remainder is paid on completion which could be several months later, again when the mortgage is taken out on the property.

The benefits of using a Purchase Option are that you can use your cash to do the works instead of tying it up in the deposit to start off with. In contrast to the exchange and delayed completion you would not be liable to pay stamp duty, if this applied, until the time of purchase, whereas with EDC you would pay the stamp duty at the time of exchange.

If the property is not suitable for a mortgage then you would be able to get started and transform the property thus draw a higher valuation when you take on the mortgage, and therefore releasing more cash from the deal.

If you know that you can increase the value of the property significantly, then you would be able to offer the asking price or near the asking price for the property based on the fact that a mortgage cannot be obtained, and know that you will still have significant equity in the deal on completion as well as possibly get your renovation money back too.

The benefit for the seller is that they know there is a fixed time frame during which the property will be sold. The chances are that you will be able to renovate within a 3 month period and this is a common time frame for any sale to go through in any case, so the seller doesn’t lose out.

Purchase Options are commonly fairly short – 3 to 6 months is usual. This can also tie in with bridging finance should you require this to allow you to do all the renovation work that is required.

If you know that you will make a significant increase in value and it isn’t necessarily the best property to rent out then you might want to consider selling it. This type of renovated FLIP is used in order to gain a lump sum of cash which can then be put towards the deposit of a more suitable or more highly cash-flowing rental property.

Just to be controversial, you could persuade a reluctant seller that you will give them 10% of the sale profit as a bonus when you sell the property – that way you can get a good deal, get started quickly and then reward the seller when you get the money back. Word of mouth would bring you in other potential deals this way and they may even know others who want to get rid of their properties quickly.

The best policy is to keep in mind ‘What’s in it for them’ rather than ‘what’s in it for me’ because the seller is far more likely to entertain your creative solutions if they can see how they will benefit from taking on board a system they have probably never heard of before. Remove their insecurities in any way possible in order to ensure you get the best deals.

Purchase Lease Option

In contrast to the Purchase Option, the Purchase Lease Option (PLO) is usually for a longer period of time – the reason for this is the main purpose of a PLO is to extend the time in which you have to decide whether or not to actually purchase the property.

If there is a very buoyant market then you may see a trend of increasing prices and be able to have a PLO for 2 to 3 years with a substantial increase, however at present due to very low and stable interest rates and also low (though rising) inflation we are not likely to see very big increases in property prices in the near future.

In an ideal situation you will be looking for the price of the property to go up by about 30% over the period of the lease so that you will be in a better position to buy at a 25% below market price at the time of purchase. Why 30%? If you agree a price of £100k to purchase in 5 years’ time and that is the real value today (not below market value) then you would need an average of about 5% to 6% property price increase over 5 years to reach the figure of about £130k. If the property is worth £130 when you are purchasing it, and yet you still owe the seller £100k then you would be in a position to acquire a mortgage for 75% of the new value which would release £97,500. This amount pays the seller in full and leaves only the fees and a small shortfall outstanding. Be aware that you would still need the deposit to be proved in order to purchase, but over the period of 5 years you can plan for this, or if you are not in a position to buy, or need to enlist a Joint Venture (JV) Partner then you have plenty of time to prepare.

In order for a PLO to work for you then the circumstances need to be right for the seller and the most important elements to establish are:

  • What price are they looking for?
  • What is the amount of the outstanding Mortgage on the property?
  • Is it interest only or repayment?
  • Are they in arrears at all?
  • What interest rate are they currently paying on the mortgage?
  • Are they tied in for a period to that particular mortgage?

There are several other questions which will be important, but in order for you to make a quick assessment of whether the deal stacks up for you and for them as a PLO then you will need these questions answered.

From your perspective you will also need to do your due diligence on the area to ensure you know the reality of the property prices for similar properties in that area, and also the rental amounts that such a property would attract.

When you are equipped with all this information then your assessment is easy.

  1. The rental amount needs to exceed the mortgage payment – this will be your gross profit
  2. The interest rate needs to be favourable, and ideally well below about 4%. We work on an average interest rate of 6%, and we need to make sure that there is some room for interest rates to increase over the next few years so that an interest rate rise doesn’t wipe out any cash-flow you have anticipated.
  3. If the owner is in arrears then you will need to be able to pay this off before you take over payments of the mortgage and then keep on top of payments to prevent repossession whilst you have control of the property.
  4. If there are arrears, then please take care to check what other debts the owner has, as they will have a bigger bankruptcy risk the higher their outstanding debt. The banks will still come after the house you are ‘controlling’ in order to pay back any outstanding money owed to them.
  5. If there is a substantial amount of equity in the property then a PLO is less likely to work as they will probably want to release the cash at the point of sale. If you are not in a position to do this then they are better off with a buyer who will buy now. You may be able to negotiate a reduced price, but not a 3 to 5 year delay in purchase.
  6. The best situation is if the mortgage is similar to the value of the property – in this situation the seller won’t actually realise much cash when they sell the property, so as long as their mortgage is being paid they will be more interested in discussing new opportunities with you.
  7. If the property is effectively in negative equity then this opportunity will hold even more interest for the seller as you will be able to offer them the full amount of the mortgage outstanding as a purchase price, and make a suitable suggestion as to when you believe the property will be back in an equilibrium position. If you delay the purchase date on the PLO then you can have a good agreement with the seller. Beware that if the mortgage currently exceeds the value of the property then the rental income may well not match or exceed the mortgage amount, so there may not be much cash-flow in the deal.

The PLO works very much in the favour of the buyer, and you will need to make this clear to the seller. This type of contract gives you the option to buy the property for the price you agree at the end of the contract date. If however the property prices have not increased sufficiently then you can re-negotiate to extend the lease for a further period of time (usually a couple of years). If you decide that this is really not for you then you can decide not to buy, or you can find an alternative buyer to satisfy the contract which helps the seller and helps you to complete the contract.

The seller on the other hand is obligated to sell to you at the price and date agreed.

Look out for this type of deal amongst people moving overseas and who don’t really want to be accidental landlords; people who are relocating in the UK for jobs; houses that are taking a long time to sell; houses that are advertised as to rent or to let; houses advertised with many for sale boards outside; potential repossessions.

The biggest mistake people make when they are looking for ‘Options’ is that they will negotiate to take a PLO on any property where the seller is interested.

Beware that this may well work very well for the sell, but it may not bring you in very much cash-flow. This process does attract some capital growth, and it can bring in cash lump sums in the longer term if you sell on the property, but unless it generates cash-flow then be wary of taking on a property type that is unlikely to rent in the area in which it is situated.

Larger houses can be used as Multi-let non-licensable properties or HMO’s requiring a license and you will have to ensure that the seller is happy for you to fit the requisite fire alarms, fire doors and any other elements recommended for letting to multiple tenants.

A PLO contract will cost around £700 to £800 plus VAT and there are a few very reputable companies which understand these contracts and can act for you very professionally. They can be done quickly, but this isn’t always the reality of the situation. The main Solicitors used for PLO’s are Alexander Lawyers; MS Law and BPE Solicitors. You will find their details if you Google them. They will put you in touch with the other solicitor whom they prefer to work with which both speeds up the process and also ensures that both solicitors are used to the documentation and aren’t going to be spending your money analysing each clause.

What to do if the mortgage is a repayment mortgage

Rule of thumb: You pay the interest part of the mortgage only so that the rental amount provides you with cash-flow. However this is not always practical.

If the seller can’t afford the repayment mortgage, then the easiest way to proceed is to pay the full amount, but reduce the purchase price by the amount of repayment made each month. You can always agree to pay at the completion of the contract the amount that is left outstanding on the mortgage. This way you benefit each month from the amount you pay towards the repayment mortgage.

Of course you can always split the repayment part 50/50 or 30/70 or whatever works for both you and the seller. If the seller does pay any part of this, then they will benefit from an amount of cash coming back to them at the point of sale – some sellers think this is a great way of getting some savings in place and are prepared to pay a little to get an amount back in a few years’ time.

This is your PLO – you can design it your way and indicate what you have negotiated to the Solicitor to put the right clauses in place for you.

And finally, beware – the PLO is only one way to purchase – make sure you check all the other buying methods as well to see which one suits each property / buyer and seller best.