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Copyright 1999, 2000, 2001 John T. Reed

Definition of suitability

It is unethical to sell an investment which is unsuitable for the purchaser. An unsuitable investment is generally one which requires more sophistication and ability to lose money than the investor in question posseses. It is best defined by example. The National Association of Securities Dealers says:

A suitability violation occurs when an investment made by a broker is inconsistent with the investor’s objectives, and the broker knows or should know the investment is inappropriate.

Lease options and high-loan-to-value ratio seller financing

The ethical standard of suitability is violated in almost all single-family lease option and high-loan-to-value-ratio seller-financed deals. The lessee-optionee and seller mortgage lender almost invariably grossly underestimate the risk in the deals because they are unsophisticated. Furthermore, they are almost always not in a financial situation to withstand the losses likely to result from such deals.

Sub-prime and ‘predatory’ lending

So-called sub-prime and/or ‘predatory’ lending also generally violates the suitability principle. The lenders are making loans they know are likely to default to the detriment of the borrower but to the benefit of the loan broker if not the ultimate owner of the loan in question.

‘Know your customer rule’

In the securities industry (stocks, bonds, and commodities), this ethical standard is generally adhered to. There, suitability comes under the “Know your customer Rule” (National Association of Securities Dealers Rule 2310 of the Conduct Rules, Rule 405 of the New York Stock Exchange, Municipal Securities Rulemaking Board Rule G19). That rule says that a stock broker cannot sell you anything until he or she learns your:

This is done using a new account questionaire that solicits this information. An executive officer or general partner in the firm must review this form before any trading can take place. When clients file complaints based on suitability, the new account form is the centerpiece of the arbitration. The broker must refuse to sell you investments that are incompatible with those four attributes. For more on the issue as it pertains to nothing-down deals, see my article on them.

Lease-option customer

Take the typical lease-option buyer—usually a recently-married couple.

Typical lease-option buyer
Financial status small nest egg and entry-level salaries; not quite qualified for home mortgage, may have credit blemish
Investment objectives Own their own home
Risk tolerance Cannot afford to lose nest egg; do not really need to take much risk to achieve such a modest goal
Prior investment experience  None

What should this young couple do? Continue to rent while they repair their credit and increase their savings and income. In short, they should correct whatever is keeping them from qualifying for a home mortgage.

Along comes the sophisticated investor who has learned how to get rich using lease options. He convinces them their best chance at home ownership is a lease option. This is a lie. They give him their nest egg and agree to pay hundreds of dollars a month above and beyond fair-market rent for a house.

One to three years later, in the vast majority of cases (about 90%), lessee-optionees lose their nest egg and the extra hundreds of dollars they paid each month. Why? They were unable to exercise the option when it was about to expire, or they were able to exercise, but there was insufficient equity in the property to warrant their doing so.

Here is an article I wrote on the subject for the 8/00 issue of my newsletter Real Estate Investor’s Monthly.

The morality of lease options

A number of disturbing ethical trends have emerged in real-estate investment since the late ’70s.

‘Creative finance’

One is so-called “creative financing,” in which the word “creative” has the same meaning it does in the phrase “creative accounting.” “Creative accounting” is dishonest accounting.

One subset of “creative finance” is the lease option. There are a number of different varieties of lease options. In this article, I am talking about the one where an investor buys a house, then lease options it, typically to a would-be home-buyer who cannot qualify for a mortgage.

'Find a need and fill it'

The moral basis for all business is “find a need and fill it.” Traditionally, the way you made money in real-estate investment was to provide housing or non-residential rental space. There are other ways like building and renovating, but the basic premise is always the same. The market wants something. You provide it and you make a profit because the market value of the thing you provide is greater than your cost of providing it.

Not ‘seem to fill it’

Note that the “find a need” admonition says “fill it,” not “seem to fill it.” To fill a need is to make an honest living. Making a living by seeming to fill a need is dishonest.

A person who fills an injured or sick person’s need for a cure is called a doctor. A person who only seems to fill an injured or sick person’s need for a cure is called a quack.

In medicine, a cure generally must be “safe and effective” in order for it to be sold legally. Doctors sell cures that are “safe and effective.” Quacks sell cures that are unsafe, ineffective, or both.

One quack cure for cancer was laetrile. Many cancer patients, most notably movie star Steve McQueen, went to Mexico for laetrile treatments because such treatments were outlawed in the U.S. McQueen died of his cancer, as did virtually every other laetrile user because the U.S. government was right—laetrile is neither safe nor effective for curing cancer.

By using the lease option, a great many real-estate investors have turned to real-estate quackery as their way to make a living. They have become the real-estate equivalent of Mexican laetrile doctors.

The need

There are many people, most commonly young couples, who want to own a home, but cannot. The reason they cannot is that they lack an adequate down payment, adequate credit, and/or adequate income. If you can fill this need, helping such people achieve their dream of home ownership, you deserve to be compensated.

How do you fill that need? My How to Get Started in Real Estate Investment Special Report says to save cash by living beneath your means, and, if you have bad credit, to use part of the savings to pay off your debts. If your income is inadequate, you need to figure out a way to make more money, or move to where housing is cheap. Most want an easier way.

Your ‘cure’

Morally, you have an obligation to make sure your “cure” for inability to own a home is both safe and effective. That is, your would-be homeowner customers indeed do become homeowners on sustainable terms, or at least the vast majority of them do.

What would an unsafe and/or ineffective “cure” be in this context? A significant percentage of those who bought your “cure” for becoming a homeowner not ending up owning a home or ending up owning a home, but quickly losing it because they were unable to make the payments. If, in addition to not ending up owning a home, those people were even worse off financially than before they bought your “cure,” your “cure” was actually harmful. In fact, that’s the norm in lease options.

Based on the research I did when I wrote my Single-Family Lease Option Special Report, the percentage of lessee/optionees who end up owning the house they lease option ranges from 5% to 50%. That is unacceptably low. It’s not even close to acceptable. Furthermore, the lessee/optionee has typically laid out $5,000 to $15,000 up front and $100 to $300 per month in extra rent above and beyond the market rental value of the house in question. Over a three-year lease-option period, they would typically pay out $9,000 to $25,000 above and beyond what renting the same house would have cost. What do they have to show for all that money if they do not exercise the option? Nothing.

Disclosure

Many lessor/optionors would protest that they fully disclosed the terms to the lessee/optionee. That means they said something to the effect of, “If you make all the payments on time including paying the purchase price (less any credits we give you) before it expires, you will own the home. If you don’t, you have to move out.”

Is that adequate disclosure?

No. Adequate disclosure would also cover two other major areas: the probability that the lessee/optionee is going to be financially able to exercise the option and the probability that the option will be “in the money” net of transaction costs.

Can’t or won’t

There are two reasons lessee/optionees do not exercise their options: They are either unable to or it would not make economic sense to do so.

Why unable?

Why would they be unable to exercise the option? Because their financial situation is little changed from when they began the lease option. They could not qualify for a mortgage then and they still cannot. This is the rule rather than the exception.

It is immoral to sell a lease-option deal to a person or couple who cannot now qualify for a mortgage unless there is some specific reason to forecast that they will be able to qualify before the option expires. Acceptable reasons include anticipation of a certain inheritance, graduating from school and getting a job, full amortization of a debt, restoration of bad credit as a result of the passage of time, pending marriage, and so forth. On the other hand, a mere vague belief that “things will probably be better” in a year or two is absolutely insufficient to permit entering into a lease option.

‘In the money’

The phrase “in the money” refers to whether an option has any equity. An option to buy something has equity if the option price is less than the fair market value of the property in question. In the case of real estate, an option to buy is not really in the money unless the equity exceeds the substantial transaction costs of exercising the option.

Whether a single-family lease option is in the money is a function of the amount of credit the lessor/optionor gives the lessee/optionee for payments made, the option price, the duration, and the market value of the property.

Rent credit

The lessee/optionee ought to get full credit for the front money plus any rent paid above and beyond the fair-market rent value. But some lessor/optionors drive a harder bargain and maybe only give partial credit for the excess rent. That increases the chances that the option will not be in the money.

Option price

Optionors typically want the highest possible option price. Lessee/optionees are typically too ignorant to bargain hard for a lower price. The typical three-year lease option on a $100,000 home probably carries a $120,000 option price.

The credits for up-front money and excess rent roughly only offset the transaction costs. Consequently, the option still probably will not be in the money until the market value of the house goes up to $120,000 or more. And the optionees may still feel it is not worth the bother unless the market value hits $125,000 to $130,000. That much appreciation in three years has been a relatively rare occurrence. So, most lease options end up never being in the money.

Appreciation rates are totally unpredictable, so there really is no sound way to value an option. One internally logical approach, if you insist on dealing in options, would be to use market opinions about expected future appreciation in your local market. I suspect that the typical lease option is unlikely to have any equity before its expiration date based on market expectations. In other words, the optionee is not going to have any economic incentive to exercise the option unless appreciation significantly exceeds expectations during the option period.

Proper disclosures should leave the lessee/optionees fully understanding both the likelihood that they will be able to exercise the option and the likelihood that the option will be in the money before it expires.

Is disclosure enough?

Adequate disclosure, which has not been taking place, would not be enough even if it did. Unsophisticated people do not comprehend even full disclosure. This is well established in the securities industry.

It is called “suitability.” It is improper in the securities industry to sell an investment that is unsuitable for the investor in question, based on the buyer’s financial status, investment objectives, risk tolerance, and prior investment experience. There, suitability comes under the “Know Your Customer Rule” (National Association of Securities Dealers Section 2 of Rules of Fair Practice, Rule 405 of the New York Stock Exchange, Municipal Securities Rulemaking Board Rule G19). See www.johntreed.com/suitability.html).

The only suitability standards I have ever seen in the real-estate industry were in limited partnership and REIT prospectuses. The fact that the real-estate industry does not make the slightest effort to adhere to suitability standards in deals involving lease options is a disgrace. No investor should do lease options unless he makes full disclosure, the lessee/optionees meet appropriate suitability standards, and they have a 90% or better exercise rate in his program.