What is the best way to earn big real estate profits in 2002? Let’s think together about the answer. Maybe we should acquire a brand new house in excellent condition. There probably won’t be much maintenance needed for a few years. But we’ll be paying top dollar for such a new home. Is there a profit opportunity in new houses (presuming you don’t want to become a contractor and incur all the unknown risks of development and construction)? Yes, there are profit opportunities if we can somehow buy a brand new house for a below-market bargain price, perhaps because the builder needs quick cash. But that’s not very likely, is it? Nor is it a formula we can repeat over and over.

Another way to earn real estate profits this year is to buy houses or other investment property, rent it to tenants for a few years, and watch our property’s market value go up. That’s what I’ve done, staffing with my first rental property 35 years ago. Lots of other investors did the same thing. It’s called the "buy and hold strategy." There is nothing wrong with this get rich very s-l-o-w-l-y technique, presuming properties continue to appreciate in market value.

David Schumacher wrote the famous book "Buy and Hold: 7 Steps to a Real Estate Fortune", if you haven’t read that great book, you should. Schumacher shares his many real estate profit experiences of buying for the long term and rarely selling.

However, most real estate investors are not so patient that we’re willing to wait 20 or 30 years for the market value of our holdings to substantially appreciate in market value. We would prefer to earn our real estate fortunes faster than that. One fast profit strategy is to "flip" properties. That means buy a property at a bargain below-market price, make some profitable improvements, and resell it for a nice profit in about six months. An excellent new book on this topic (it was named one of the "top 10" real estate books of 2001) is "Flipping Properties’ by William Bronchick and Robert Dahistrom. They recommend making a business out of buying, fixing, and flipping properties to earn big profits.

If you like this idea of reselling your renovated properties, why not make a tax-free business out of it? Uncle Sam even encourages it. Internal Revenue Code §121 allows up to $250,000 tax-free resale profits if you own and occupy your principal residence at least 24 months during the 60 months prior to sale. That means you can buy a run-down house, move in, fix it up, and resell it after two years for up to $250,000 tax-free profits per qualified seller (up to $500,000 for a married couple filing jointly). If you do this over and over, you’ll soon become known among your friends as a "serial home seller." But this tax exemption can only be used once every 24 months (with partial exceptions for selling sooner due to health reasons or a job location change).

But you probably spotted the big flaw in this plan. Living in a house while it is being renovated is no fun. Although I’ve renovated many fixer upper houses, I’ve never personally lived in one while it was under renovation. But some of my friends have. One couple, Mark and Laurie, have been renovating their kitchen for at least a year. They tell me it’s no fun "camping out with two children in their house while their kitchen undergoes major renovation. Ask any married couple who lived in their house dining renovation and they will tell you it is a miracle their mail age survived.

WHICH REAL ESTATE PROFIT STRATEGY IS BEST FOR YOU IN 2002? Most experienced real estate sales agents will tell you most home buyers want to purchase houses in near-perfect move-in "model home" condition. That’s the way to sell your house for top dollar. But buying a home, whether a resale or a brand new house, in fin-ton condition is not the best way to earn real estate profits. Why? Because the seller has earned the profits, leaving little or no profit opportunity for the buyer (except from long term holding while waiting for market value appreciation).

Can we agree the best way to earn real estate profits in 2002 is by acquiring sound well-located houses and investment property, which needs upgrading? Personally, I like single-family detached houses. But other investors I know prefer apartment buildings, commercial properties, hotels, and even warehouses because the dollar numbers are bigger. However, I wouldn’t want all my "eggs" in a few big "baskets" (properties). I’ve found if you make a mistake renovating a house, such as going over budget (which often happens), it’s not a huge error. But if renovation of a large commercial property goes over budget, that could lead to major financial problems. Whatever type of property you prefer, the same profit strategy works.

EXAMPLE: I recall, back in 1997, on a trip to speak at a real estate educator’s conference in San Diego, sitting next to a man on the plane whose firm specializes in redeveloping "tired" run-down hotels, shopping centers, and apartment buildings. "The worse its condition, the greater its potential profit," he told me. "Bad management" and "excessive debt" are the primary reasons such commercial properties become run dawn, he explained. He said structuring the financing is the toughest pan of acquiring fixer-upper commercial property. "The renovation is easy," he emphasized.

The primary reason to consider fixer-upper sing1e family rental house opportunities is houses are the easiest to buy, finance, renovate, manage and resell at a profit. A secondary reason is there are so many houses available, compared to the limited number of commercial properties. Almost anyone can do it. Even women! A few years ago, Suzanne Brangham wrote the wonderful book "Housewise" about her experiences buying undervalued condominiums and houses, fixing them up, and then either reselling or holding them. Her book is now out of print, but you can still get it at public libraries through inter-library loan. However, I don’t recommend investing in condos (other than as your personal residence) because I’ve heard so many bad stories from investors who lost money on condo investments. Condos are easy to buy, but they can be very difficult to resell (Report #99293 explains "How to Avoid Buying a Bad Condominium").

HOW TO FIND AND ACQUIRE FIXER-UPPER "JUNKER" HOUSES AT WHOLESALE PRICES. A few years ago I wrote Report #99296 "How to Find Fun and Fortune With Fixer-Upper Houses." That report sold thousands of copies. It goes into greater detail than this brief summary:

1 - Look for the right things wrong. That phrase means to look for a run-down house, which has a need for profitable "cosmetic improvements." The criteria recommended by Bill Nickersan in his classic book "How I Turned $1.OOO Into $10 Million in Real Estate in My Spare Time" (now out of print but still available through your public library) is spending $1 on upgrades to add $2 in market value.

Examples of profitable upgrades include paint (the most profitable improvement of all), re-carpeting, fresh landscaping, and new light fixtures. Avoid houses needing major improvements, which won’t add market value, such as foundation repairs, new roof, kitchen renovation, and new bathrooms. However, sometimes I’ve found violating this rule can be very profitable, such as replacing an ugly worn-out roof with new composition shingles can often add profitable "curb appeal" to a house.

2 - Acquire a sound well-located house. A profitable location is usually in a working class "bread and butter" neighborhood. As my friend Jimmy Napier says, "Stay away from neighborhoods where you see joggers and BMWs!" Of course, avoid high-crime areas and areas with poor quality public schools - families with children don’t want to move there, thus holding down resale property values.

3 - Purchase at least 25% below "fixed up" market value. To allow room for fix-up costs and profit, it’s best to aim for a purchase price 30% below market value. To illustrate, if neighborhood homes usually sell for around $200,000, your target purchase price should be about $150,000. As the old saying goes "Buy the worst house in the best neighborhood you can afford." The market value of the better houses will pull up the market value of the smallest or worst house in that area after it is fixed up. If you spend $25,000 fixing up such a $150,000 house, your target resale price should be at least $200,000, perhaps more. Better yet, hold on to that house for probable annual appreciation in market value of at least 4% to 5%, often more.

4 - Buy from a highly motivated seller. In the current "buyer’s market" in most cities (meaning there are more homes for sale than there are qualified buyers in the market place), if you can find a highly-motivated house seller, such as one who must sell fast, perhaps due to a job transfer or a family situation, you can probably "buy right" However, if a fixer-upper house seller is just testing the market to see if he can get his "dream price," you probably won’t be able buy at least 25% to 30% below the fixed-up market value of nearby comparable houses.

5 - Use all possible sources to find sound, well-located fixer-upper houses. Working with a quality "buyer’s agent" is the key to finding fixer-upper houses. Such an agent will use all many possible sources; such as the local multiple listing service (MLS) for listed houses, for sale by owner houses (called "fizzbos"), foreclosures, and distress properties. Even if you have to pay your agent’s sales commission, because the seller refuses to pay any commission, don’t let that stop you from acquiring a bargain-priced fixer-upper house with profit potential.

6 - Look for attractive financing, such as an assumable mortgage or seller financing. Buying a fixer-upper house is not the time to get a new mortgage. The reasons are (a) many lenders don’t want to make loans on rundown houses, (b) interest rates on non-owner occupied houses being bought by investors are often 1% or 2% above owner-occupied rates, and (c) it’s no fun filling out lengthy loan applications.

If the house seller will carry back a first or second mortgage, even if only for a few years, that’s a good signal. Equally good, if you can buy "subject to" an existing mortgage (without formally assuming it, thus avoiding assumption fees), you will save a small fortune on financing costs. Presuming the fix-up work isn’t too costly, you’ll probably need the seller financing only for six months or so before you either refinance or sell the fixed-up house.

BETTER YET; Instead of messing with a new mortgage, or taking over a "subject to" mortgage, lease the house with an option to buy at it’s current market value, not it’s fixed up market value after you make the cosmetic improvements. As we will see, a lease-option is the least expensive way to control a property, but without owning it!

HOW TO GAIN CONTROL OF A FIXER-UPPER HOUSE WITH A LEASE OPTION. As long-time subscribers know, one of my favorite methods for buying and selling houses is the lease with option to purchase. For buyers, it is far less expensive and much easier to lease a house with an option to purchase than it is to buy that house with mortgage financing. But be sure the lease-option gives you the right to fix-up the house!

EXAMPLE: Suppose you find a "fixer" house whose seller won’t sell for less than $200,000. Since nearby houses are selling for around $275,000, this is an attractive price. If you have $20,000 cash for the down payment and need an $180,000 owner-occupant mortgage at 7% interest, your monthly mortgage payment will be about $1,208.80, plus the PMI (private mortgage insurance) premium of around $150. But, because it’s a slow buyer’s market, you might negotiate a lease-option with that seller at $1,000 rent per month, thereby saving money on the monthly payments and eliminating the $20,000 (10%) down payment Equally important, if you negotiate a 33% rent credit toward the purchase price, each month you will be building a "forced savings account" of $333.33 toward your down payment.

LEASE-OPTION ADVANTAGES FOR HOUSE BUYERS. Some realty agents tell me all the lease-option advantages favor buyers. I disagree. Let’s look at some of the lease-option advantages for house buyers and sellers. Then you decide if the pros and cons aren’t about equal for both buyer and seller:

1 - The obvious primary lease-option advantage for buyers is little up-front cash is required. Cash conservation is very important for buyers who plan to upgrade a house, whether to live in or for resale profit. Instead of tying up money in a cash down payment, why not use that cash to fix up the house and increase its market value before exercising the option to purchase?

However, my experience has been most lease-option sellers will insist on some amount of nonrefundable cash up front. Although the nonrefundable option consideration can be whatever the pasties negotiate, typically it is 1% to 3% of the option purchase price. If the seller insists on a substantial option amount, try to re-characterize that money as prepaid rent in the lease-option.

EXAMPLE: That’s what happened when I negotiated the best lease-option I’ve ever done (actually, it was real estate broker Mark Benson who convinced the owner to accept my offer, but I like to think I did a great negotiation job). As long-time subscribers know, it was a 15-year lease-option with an absentee out-of-town owner (he lived in Sri Lanka!). It was a slow "buyer’s market" like the current situation in many cities and the seller wanted to either sell or lease the house. Instead of tying up nonrefundable option money, I offered the seller a year’s prepaid rent. He accepted! Wouldn’t you? As the buyer, my advantages were (a) no rent to pay for a year and (b) no option money tied up. Also, I offered to pay all the real estate brokerage commission so the seller wouldn’t owe any sales commission. Since the commission was a subtraction from my option purchase price, that really didn’t hurt me. We negotiated I would pay broker Mark $3,000 up-front commission and the balance when I exercised the purchase option. For the next 13 years (I exercised my purchase option in the 13th year), almost every time I saw Mark he politely reminded me what a great day it was to exercise my option! "Not yet. Not yet," I politely replied.

 2 - Another major lease-option advantage for buyers is trying out the house before purchase. As an investor, I’ve bought several houses I wish I never owned. They turned out to be "money pits" needing far more repairs than I expected. By the way, if you didn’t see the great movie "The Money Pit," be sure to rent it at the video store. It’s lots of fun, but also very scary for real estate investors. While I’m diverting, another great movie for real estate investors to rent is "Pacific Heights." It’s about "the tenant from hell." I threaten to show it to my college "California Real Estate Law" students, but I fear it’s too scary.

3 - Negotiate as long a lease-option term as possible. If you want to earn big profits by controlling a house on a lease-option with very little up-front cash while you fix it up, negotiate as long a rental term as possible. Two or three years should be the minimum. Be certain the option price is locked-in with no inflation adjustment. Five or ten years would be better. Of course, you can always exercise the purchase option early (unless restricted by the seller).

4 - Insist on a rent credit toward the purchase price. One of the biggest lease option advantages for the buyer is the rent credit toward the purchase price. This is the major incentive for the tenant to exercise the option to buy. However, if the tenant doesn’t buy, the rent credit is lost. Always enter into a lease-option with the intent to buy. As a buyer, I’ve never NOT exercised my purchase option. As a lease-option seller, I only had one tenant who didn’t buy. That’s probably because, as a landlord, I always give my tenants at least a 33% rent credit.

Once, I even gave my tenant a 100% rent credit on a house in Pacifica, which needed major repairs, which I didn’t have the ability at the time to finance. My lease-option tenant fixed that house up beautifully during his one-year option period, greatly increasing its market value, before he exercised his option to buy. I made a nice profit because the option price was substantially above my nothing down purchase price, the tenant bought for practically nothing down, and everyone walked away very happy. However, looking back, I shouldn’t have been so generous with that 100% rent credit.

LEASE OPTION DISADVANTAGES FOR TENANT-BUYERS. The major perceived lease-option disadvantage for buyers is the lack of any income tax deductions for mortgage interest and property taxes during the lease-option term. When a tenant raises this issue, I emphasize the rent credit is a "forced savings account" which is far more valuable than the income tax deductions would be. Most tenants cannot save as fast as the rent credit builds up.

Another possible disadvantage, which has arisen several times for my lease-option buyers, is some mortgage lenders do not treat rent credits the same as down payment cash. Fannie Mae and Freddie Mac, the major mortgage buyers in the secondary mortgage market, have a stupid rule that lease-option rent credits count toward the down payment only if the rent paid was above market rent.

EXAMPLE: Suppose market rent for a house is $1,200 per month, but the tenant pays $1,500 monthly rent (lease-option rents are usually at least 10% above market rents - an advantage for landlords). If the tenant in this example receives a 33% rent credit of $500 each month, Fannie and Freddie will only count $300 of that amount as down payment. Isn’t that a stupid rule, especially when Fannie and Freddie tell Congress and the public they are flying to encourage home ownership? The easy solution is the lease-option buyer should obtain a mortgage from a lender who won’t be selling the buyer’s mortgage in the secondary mortgage market to Fannie or Freddie so the full rent credit can count as down payment money. I’ve found most major lenders will keep their adjustable rate mortgages and sell their fixed rate mortgages. The buyer can get an adjustable rate mortgage when exercising the purchase option and the rent credit problem is solved.

That’s about it for buyer lease-option advantages and disadvantages. As you can see, there really aren’t any serious lease-option disadvantages for buyers.

LEASE OPTION ADVANTAGES FOR HOUSE SELLERS. Many house sellers and their real estate agents erroneously think lease-option advantages favor the buyers. As stated earlier, I strongly disagree! Having sold dozens of houses on lease-options to my tenants, I think I benefited as much as they did. Probably more! Here are the house seller lease-option advantages, especially in a buyer’s market:

1 - There is always a strong demand from house buyers for lease-options. As you probably know, I hear from newspaper readers of my syndicated "Real Estate Mailbag" newspaper column all over the country. Some local markets are extremely depressed due to local economic conditions, such as a major employer closing a factory. Even in those unpleasant situations, when a highly motivated home seller must sell, lease-options work! Lease-options also work to "sell" just about any commercial property, especially to a "user" who needs the property for a business.

Properly marketed. A lease-option always works to find a tenant who will nay the owner rent for a property which the owner really wants to sell. However, some owners get greedy. Then lease-options won’t work for greedy sellers who ask too much up-front money or won’t give good lease-option terms.

EXAMPLE: Years ago, I spoke to the local Association of Realtors at their breakfast meeting about lease-options. In the audience was long-time San Francisco Realtor, Frank Lembi (he’s now in his 80’s and I understand he’s still as enthusiastic about real estate today as he was then). He had a condominium conversion project, which wasn’t selling. So he decided to take my advice and advertise his condos for sale on lease-options. But he advertised, "$50,000 moves you in." Nobody bought. He phoned me the next week to tell me "Lease-options don’t work." I politely replied, "Frank, you asked for too much up-front money. $5,000 would have been more appropriate." That’s the last time I heard from Frank.

2 - Lease-option tenants are usually excellent tenants. My experience has been lease-option tenants usually see themselves as future owners of the property. The result is they treat it as their home or as a future investment property they will someday own. I’ve only had one lease-option tenant who didn’t exercise their option (yes, I admit I had to push - OK, shove- some of my lease-option tenants to exercise their purchase options).

The unmarried couple who didn’t buy on their lease-option split up. But, as their landlord, I wasn’t sad. I got to keep their $6,000 rent credit. However, I had to use part of that money to repair the damage done by their ferret, which they acquired in violation of my strict "no pets" policy. In case you’ve never seen a ferret, you don’t want to see one. They are cute little "rats" which are illegal in most states.

3 - Lease-option tenants will pay top rent. Lease-option tenants know they have a very "good deal." The result is they are willing to pay higher than market rent. How high? I don’t know. At least 10%, often more. Most lease-option tenants realize this is a great way to acquire the home they always wanted to own. It may not be their dream home, but they’re willing to start with something less than perfect.

Investors seek out lease-option purchase opportunities because of the low cash requirement and the potential to profit if they can negotiate a bargain option purchase price. Paying higher than market rent is compensated, of course, by the rent credit toward the purchase price. Also, lease-option tenants will usually agree to a top of the market value option price. If you are the lease-option seller, of course, don’t get greedy. Buyers are usually very smart. My experience has been they will agree to the current market value as the option price, but they won’t overpay.

4 - Lease-option landlord sets to keen the income tax deductions. I saved the best lease-option advantage for sellers until last. During the lease-option rental period, they get to keep the income tax deductions, such as mortgage interest, property taxes, and depreciation.

LEASE-OPTION DISADVANTAGES FOR SELLERS. In a nutshell, there really aren’t any serious disadvantages for sellers. If the property skyrockets in market value during the lease-option period, the landlord loses this appreciation and the tenant benefits. However, if the property loses market value, or doesn’t go up in value, the tenant suffers. That’s why I recommend using lease-options to gain control of run-down fixer-upper houses and then immediately force the market value up by making profitable improvements, which add more market value than they cost.

A possible disadvantage for some lease-option sellers is they don’t get an immediate sale, if the seller really wants or needs an immediate sale, a lease-option in not the solution, if a house hasn’t sold or at least received any purchase offers within 60 days after being put on the market, the solution is usually a price reduction. However, many sellers don’t want to hear those awful words. A lease-option is a good alternative for sellers in a buyer’s market when houses aren’t selling well.

HOW TO FIND FIXER-UPPER HOUSES, WHICH CAN BE PURCHASED WITH LEASE-OPTIONS. Very few lease-options are advertised in the newspaper classified ads or the local MLS. My experience has been lease-options must be created! There are several methods that work well:

1 - Read the newspaper "houses for rent" ads. Follow up on these ads. Many landlords would really prefer to sell but they are hesitant to put their rental houses on the market for sale, especially in a buyer’s market. Smart lease-option buyers of fixer-upper houses follow up on these rental ads. When you inspect a rental house, which has potential profit possibilities, ask the owner "Would you consider a lease with option to purchase?" Then explain all the seller advantages, such as prepaid rent, higher than market rent and continued income tax deductions.

If the landlord is reluctant to sell or won’t even listen to your lease-option offer, tempt the landlord with a net, net, net (triple net) lease. That’s what I did when I got that 15-year lease-option! I offered to pay all the expenses, including mortgage payment, property taxes, insurance and maintenance. That was the "clincher" for the out-of town seller! No management with a net. In fact, after my first year of prepaid rent, I sent him a year’s post-dated rent checks, which he could deposit in the local Bank of America in Sri Lanka. While he thought that was great, my attitude was he could never say I was late with the rent check. All he had to do was remember to deposit my check on the first day of each month. Yes, it was a chore writing out 12 post-dated rent checks every December when I sent his Christmas card by Federal Express (just to be certain it didn’t get lost in the mails).

2 - Run Your Own "House for Rent Wanted" Classified Newspaper Ad. My investor friend Jimmy Napier suggests running a 30-day newspaper classified ad under "houses wanted" or "houses for rent wanted." He recommends, "Executive needs 3 BR, 2 BA home on five-year lease with option to buy. Call Jimmy 555-5555." You’ll only get a few phone calls. But all you need is one good call from a highly motivated owner (or their realty agent).

WHERE TO LEARN MORE ABOUT LEASE-OPTIONS AND OBTAIN THE LATEST LEASE-OPTIONS FORMS. I realize in this very limited space I just barely covered the basics of profiting from fixer-upper houses and lease-options. But I’m running out of space. You’ll find more details in my special reports #99300 "How to Buy or Sell Your Home (or Investment Property) With a Lease-Option," #99296 "How to Find Fun and Fortune in Fixer-Upper Houses" and Report #97273 "Today’s Best Realty Profit Opportunities: Fixer-Upper Houses and Investment Properties." The best lease-option forms I’ve found are available from Professional Publishing Co., 365 Bel Marin Keys Blvd., Suite 100, Novato, CA 94949. They have a "long form" (which is too complicated for me) and a "short form" (which my tenants seem to like). Give this excellent company a call at 415-884-2164 or 1- 800-288-2006 to place your credit card order. Also, ask about buying samples of all their outstanding real estate forms, which are good for use in all states.

A FEW CLOSING WORDS. When acquiring fixer-upper properties on a lease-option, you can’t be too careful, If you’re acquiring in California, or another state requiring seller disclosures of known defects, be sure the seller uses a Transfer Disclosure Statement (TDS) to disclose all known defects. Also be sure your lease-option is contingent on your approval of your professional inspector’s report on the property. If your inspector discovers any significant defect you don’t want to accept, then you can cancel the purchase or lease-option and get your money refunded. Of course, be sure to accompany your inspector to discuss any defects he or she discovers.

If you’re the seller of a fixer-upper house, or the landlord of a lease-option house, be sure to sell "as is." That means you have disclosed all known defects, but you are not liable for any defects, which become evident after entering into the transaction. This is especially critical for lease-option sellers. If a defect develops after the contract is signed, and the seller had no prior knowledge about it, then the seller has no repair liability to the lease-option buyer because the house is sold "as is" at the time the purchase option is exercised.

During the lease-option term, as a landlord I’ve learned it is best for the landlord not to pay for any appliance repairs (if appliances were included in the transaction). In the Terms and Conditions section of the lease-option, I write "When the option is exercised, the property is to be sold in its then ‘as is’ condition and the seller is not responsible for any appliance repairs during the lease-option term." That means the seller is not obligated to pay for any repairs, including appliances. Of course, as a landlord I’m responsible for normal repairs, such as a roof leak. I also include weekly gardener service in my lease-options, at a cost of about $50 per week in my area, so the landscaping is well maintained during the lease-option period.

CONCLUSION: Buying fixer-upper houses on leases with options to purchase can be an excellent way to earn significant realty profits in a buyer’s market. This method combines the best profit opportunities of both sound, well-located fixer-upper houses and lease-options. Please consult your tax advisor and/or real estate attorney for more details.