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Selling an option to cover a cash flow gap

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THE SCENARIO This Money Blog is a little different than some of the others and covers a couple of things which may be new to you. It's okay, don't freak out, I'll try to explain everything in detail. However, I'm going to abbreviate some of the details to simplify the problem and make the concepts easier to grasp. I've got a friend (call her Jill) who has a HELOC (a Home Equity Line Of Credit) that's about to have its payment go up quite dramatically, and this will cause her some month-to-month cash flow issues for the next 10 years. I've got another friend (call him Tom) who wants to start investing, but doesn't have a pile of cash to plunk down. He does, however, make more money per month than he spends, and he'd like to invest the difference. Jill's HELOC payment is about to go up by about $750 per month, and Tom's got $750 per month to invest. Before we go any further, let's cover a bit of terminology. An 'option' is the right to purchase a 'thing' at some point in the future. When you 'exercise' the option, that means that you buy the 'thing'. Much of the time, the 'things' covered by options are securities (i.e. stocks), houses, or other types of real estate, but technically an option could be sold against pretty much any 'thing'. Generally, options have several components:

1. What you pay for the right to purchase (referred to as "Consideration")
2. A purchase price (or an agreement on how to determine the price at a later date)
3. A time frame in which you can exercise the option (maybe I'll have the right to purchase any time in the next 10 years)

For example, I could (a) pay you $10,000 now for the right to buy your house for (b) $500,000 between (c) 5 and 10 years from now. The Consideration is generally credited toward the purchase if the option is exercised (so in this example if I were to exercise my option, I'd only have to come up with $500,000 - $10,000 = $490,000 to actually do the purchase - I've already given you the first $10,000 when I bought the option in the first place). If I don't exercise the option within its time frame, it 'expires', meaning that it can no longer be executed. The consideration is not refunded in this case. Okay, back to Tom helping Jill out with her cash flow shortfall. Jill sells an option to purchase 20% ownership of the property to Tom for $750 per month. Tom's purchase price is $90,000 (which is $750 x 120), so his option consideration will completely cover his cost to exercise the option. This option will have no expiration, but will be exercised automatically if the property is sold. Tom and Jill will have to figure out what happens if the property is sold before the end of the 10th year, but that conversation is not part of this post.

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THE QUESTION If Jill sells the property at the end of the 10th year, how much would the property need to sell for in order for Tom to make 12% on his money? Assume that sales costs are 10% of the sale price (e.g. if you sell a house for $100,000, you walk away with 10% less, or $90,000).

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THE SOLUTION This seems more confusing than it actually is, but it does have a few parts. First, we need to figure out how much value Tom would need to get from the property if he wanted to make 12% on his money. Second, we need to figure out what the net proceeds of the sale of the property would have to be in order for Tom's 20% share to hit that number. Third, we need to figure out how much the property would have to sell for in order to net out that amount. Step 1 Let's restate the problem, from Tom's perspective. "If I invest $750 per month for 120 months and then receive a large cash payout, how large would the payout need to be in order for my investment to be worth at a 12% yield?" That's a relatively straightforward Time-Value of Money problem. First things first, make sure the calculator is using 12 Payments per Year. N: 120 (Tom's investing for 10 years, or 120 months) I/YR: 12 (Tom wants to get a 12% yield on his money) PV: 0 PMT: -750 (Tom's investing $750 per month) FV: (this is what I'm trying to find) For Tom's investment to yield 12%, his 20% of the property would have to be worth $172,528.02 after 10 years. Step 2 If Tom's portion of the proceeds of the sale is worth $172,528.02, the whole sale must net out $172,528.02 / 20% = $862,645.09. Step 3 Since 10% of the purchase price will be eaten up by sales costs, we need to sell it for a little more than that. Jill would need to sell it for $862,645.09 / 90% = $958,494.54 in order for Tom's portion to be worth his target amount. This one may have been a bit more confusing than some posts, largely because it combined the concepts of both an installment sale and an option. However, I've recently been considering the question of how people with smaller amounts of money to invest can get started investing, and this was one of the things I came up with.

What do you think? If you were Tom, would you make this investment? If you were Jill, would this sort of arrangement appeal to you? Let us know in the comments below!