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Covered Calls vs. Rental Properties

“Covered Calls vs. Rental Properties”
“Things may come to those who wait…but only the things left by those who hustle.”
-Abraham Lincoln
 
Quick short story…
In Small Town, USA there lived a business savvy real estate investor by the name of Merle. Now, Merle was an entrepreneur by nature; he launched, bought, sold, fixed, and profited on any business he could get his hands on. Merle’s natural business instincts allowed him to achieve great success early on in his career. Since Merle didn’t understand the stock market and was never very comfortable leaving his money in the bank, he started investing in real estate as a way to grow and protect his wealth. 
In his twenties Merle bought close to 40 different houses in Small Town that could be rented out to the students around the towns college. In his thirties and forties Merle invested in raw land, where he strategically developed the towns first multi-level apartment complex, self storage units, and strip mall. By the time Merle was 55 years young he had created a portfolio of over 250 units that generated over $4 million dollars in annual income.
Now, I know what you’re thinking, “Not bad for a self-made man from the Small Town, USA.”  
But wait…there’s a problem!!! During the 30+ years that Merle built this real estate portfolio that even Donald Trump would appreciate (off camera of course), he refused to do one thing…. RENT THE UNITS! He didn’t want people to clutter up his storage units, he was fine with an empty strip mall, and why rent to college students, they don’t respect anything. 
So no, Merle did not generate $4 million dollars in annual income from his rental properties; on average he lost money because the cost to maintain the units was so high. Merle made the mistake of believing the properties he owned would appreciate enough each year to provide consistent, uninterrupted returns for the rest of his life. 
Merle didn’t truly understand the magnitude of his mistake until the real estate crash of 2007 and he realized just how wrong his views on investing were.   He should have been renting his units out all along to produce enough cash flow to help protect against any future downside risks his properties may incur. But he didn’t.  So, after 30 years of property taxes, maintenance, and insurance Merle finished his business career with significantly less than he had calculated and a false sense of security that only a non-income producing assets can leave you with….The End!
So you’re thinking Merle might be the dumbest investor you’ve ever heard of. Well you’re right, the guy made some poor decisions, decisions that turned a great portfolio into an illiquid burden. But, guess what? People are making the exact same mistake every day, not with their real estate investments, but with their stock portfolios. Yah, I’m talking to you Merle Jr. Investors, who have a stock portfolio and are not writing covered calls on those stocks during bullish and sideways markets, are no smarter than Merle and are leaving bags of money on the table. 
To begin, why is everyone so infatuated with owning rental properties? The reason people buy rental properties is to rent them out and bring in enough monthly cash flow to pay for the overhead of owning that rental, as well as some extra cash for the “Mrs.” Then, when the time is right, they sell that property for more than they paid for it. If by chance the real estate market goes down over a period of time, that’s ok, because they have been taking in positive cash flow from their rental income and this helps offset any losses they may have during the downturn. You repeat this process multiple times and “VUALA”, you have a great business. 
For all of the reasons above I love buying rental properties, however, the truth is, it usually doesn’t work out that way. The real life experience of rental properties has 10% overhead that you must cover before you take in a dime, which includes insurance, maintenance, vacancies, mortgage payments, and tenants that miss the toilet. However, fortunes have been made in rental properties, so let’s dig a little deeper. 
 
Since owning rentals is a business, let’s do a quick analysis of what buying an actual rental property in today’s market would look like. We’ll use real life rental rates, lending standards, and real estate listings.
 
 In a middle class neighborhood in Reno, NV, a 3 bedroom, 2 baths, 1,294 square foot house is listed for $180,000.  The same house down the street rents for $1,200/month. Since this is one of the smallest and cheapest houses in the area, it’s our best chance of finding a rental property that we can make cash flow positive. I’m feeling generous, so I won’t include Reno’s current rental vacancy rate of 9.08%, or realtor fees. If we were to buy this house and rent it out right away, this is what it would look like: 
 
 
Finance
Cash Deal
House Price
$180,000
$180,000
20% Down Payment
$36,000
N/A
Financed Amount
$144,000
N/A
30 year Fixed Rate
5.00%
N/A
Mortgage Payment
-$773
N/A
Taxes / Insurance
-$183
-$183
Maintenace/Misc.
-$100
-$100
Total Expenses
-$1,056
-$283
Rental Income
$1,200
$1,200
Net Proft
$144
$917
ARoR
4.80%
6.11%
 
 
As you can see from the table above, buying this house for the purpose of generating monthly cash flow is not the best investment at this time. The best you can hope for is just over 6% annually with an all cash deal, and this is after housing prices have come back to their pre-boom values. More importantly, you’re dealing with an illiquid asset that has very modest upside potential for the next several years. Now, I know, there are plenty of success stories in rental properties, this is just one example, and there are tax benefits that should be a part of our analysis, however for you to earn 10% annually on this investment, property values would need to decline an additional 50%. I don’t think any of us want that, and I know the tax benefits aren’t that great.
Now let’s take a look at our other side of this argument, investing in stocks. For those of you who have seen our Investment Brochure, you know that adjusted for inflation the buy and hold strategy in stocks, works about as well as Merle’s strategy of buying rental properties and not renting them out. Yet, that’s the problem. Most individuals are viewing their stock portfolio the way Merle viewed his real estate portfolio. They believe that over time the stocks they buy and hold will steadily grow year after year and when it’s time to cash out of the stock, they will be handsomely rewarded for their patience. This has proven true many times over, however in today’s world the buy and hold strategy in stocks is no longer effective, so you must marry the two strategies of owning rentals and owning stocks. It’s time to start renting out your stocks; it’s time to starting writing covered calls.
The strategy of covered call writing is the safest and most popular of all the options strategies and can be implemented in anyone’s stock portfolio or IRA. It allows an investor to lower the risk of stock ownership and reduce the volatility of their overall portfolio. The concept is simple; you own stock and lease another investor the right to buy that stock from you at a price higher than what you paid for it.    The writer should be mildly bullish to neutral on the individual stock and be willing to sell the stock if it closes above the strike price. This is what it looks like:
 It’s June 10th and you own 100 shares of ABC stock that is currently trading at $52. You think the stock will trade between $50 and $55 for the next couple months and you want to make some extra money on your stock. You pull up the July options list from your brokerage and find out you can sell a $55 covered call on your stock and receive $2.50 per share.  You realize this is equivalent to getting a 5% immediate increase in your stock ($2.50 / $52), so you “sell to open” the July 55 calls on your stock and instantly receive $250 in your account. 
Now three things can happen on Friday July 20th, the day July options expire. The stock stays below $57.50, which means you keep the $2.50 premium, keep the 100 shares of stock, and look to sell another call in August. Second, the stock could close down for that period of time, but you won’t lose any money until it falls below $49.50 your downside breakeven ($52 - $2.50 and finally, the stock can close above $57.50 and you are forced to sell it. You still keep the $2.50 premium and the $5 increase in the stock price from $52.50 to $57.50. Also, if you want ABC stock back, nothing is stopping you from going out and buying it again. As you can see with this example you are making a bet that ABC stock will not rise 11% or fall 5% within the next 30 trading days. I like those odds and you should too!
 It sounds easy, right? Well, it is, but there are a couple things you need to consider. First of all, you must be willing to sell the stock if it rises above the strike price of the call. Some investors hold “legacy stocks” or stocks their not willing to sell for tax reasons. No problem, there’s a solution that allows you to consistently bring income in on your legacy stocks using covered calls, just email me (Kyle@DracoFund.com).  Second, if you believe the stock is about to make a run to the upside in the next 30-60 days, then it is more beneficial to just hold onto the stock and let it appreciate. Finally, one of the best things about covered calls is you know your potential profit and loss going into the trade, so just like any other investment, nothing prevents your stock from going to “0,” so your maximum risk is always the amount you have invested in the stock, minus the premium you receive. 
Moving on, let me just say I hate (don’t tell my daughter I said “hate”) option books, blogs, and guru’s that give examples using unrealistic premiums and monthly returns for option strategies. So, like the real estate example above, let’s do a real life covered call example using the following parameters. 
·         We buy or own a stock that we like
·         We are slightly bullish to neutral on the stock. If we think the stock is going up in a hurry, let it ride, if we think it will move significantly lower, sell the stupid thing
·         We don’t care if we have to sell the stock
·         The stock has enough volatility that we will be rewarded with juicy premiums
·         We look 30-60 days out before the option expires, (on average I sell the next months calls)
·         The call price that we sell is at least 5% above the current price of the stock. This gives us a chance to make money on our stock as well as the premium, just in case it decides to move up
·         The premium we receive is at least 3% of the total stock price
 
Today IOC (International Oil Company) is trading at 51.10. December’s implied volatility is low because of the Holiday’s, making the premiums lame, so I look out to January because I believe oil itself is in a trading range and most likely won’t go to the moon, or fall out of bed before January 15th, the day options expire.  Since, we were willing to put $36,000 down to buy a rental that only makes 4.08% annually, lets’ put $36,000 into our IOC trade. Here’s what the numbers were on November 23rd:
Important Info.
Stats
Notes
Company
IOC
 
Stock Price
51.1
 
Call Strike
Jan. 60
17.42% above the current price
Days to Expiration
53
 
Premium
$3.30
 
Shares Owned
704
$36,000 / 51.10 = 704
# of Calls sold
7
1 contract per 100 shares
Premium Received
$2,310
 ($3.30x7x100) Deposited in my account immediately
Downside Breakeven Price
47.8
6.46% away (51.10 - 3.30)
Forced to sell stock @
63.3
23.87% away (60 + 3.30)
Maximum Gain
$10,898.80
Premium + Stock Appreciation
Maximum Loss
$33,630
If IOC goes to zero in the next 53 days
 
 
 
 
For the purpose of comparison towards our rental business and the unfortunate reality that we don’t know what IOC will trade at in the future, we will assume that IOC will close at its current resistance price of 54.30 on January 15th. Here’s how we would have done on our $36,000 in less than 2 months:
 
Stats
Notes
Profit on Stock
 $                  2,252.80
(54.30-51.10) x 704 Shares
Profit from Premium
 $                  2,310.00
$ We keep no matter what happens
Total Dollar Gain
 $                  4,562.80
 
R.O.R. on $36K
13%
Return on our $ in 53 days
 
As you can see, this would be a great trade if IOC went up just a little in the next 53 days, but even if it stays flat we will still generate a 6.5% return from the premium alone. In this example I would buy this stock with the purpose of selling covered calls on it. If IOC goes up over the next 53 days I would either repeat the process and take in another premium, or sell IOC and look for another stock that met the same parameters from above. However, like I mentioned, you can do this on the stocks already in your portfolio, and on average generate an additional 3% gain or downside protection for your stocks each month, without taking a lot of risk.
 The covered call example above took 53 days, or roughly 2 months. So what kind of rent would we have to collect on our rental property from above to achieve the same return over a 2 month period?
In order to achieve a 13% return in a 2 month time period on the house we paid $180,000 for, we would have to find a person in Reno that was willing to pay $3,400 dollars a month in rent for that house, or a seller that is willing to lower the price of his house from $180,000 to $14,000 and then, take in $1,200 in monthly rental income.   Both highly unlikely scenarios and need I remind you stocks don’t require you to mow the lawn, replace the roof, or call Bubba every month and remind him about the rent.
So, is the covered call strategy better than buying a rental property? In the words of my favorite movie character of all time, Rocky Balboa, “ABBSOOLUUTELY”! It’s obvious where we stand in the covered calls vs. rental properties argument here at The Draconian. Our ultimate goal with any stock is to achieve the total return concept, which is a balance that maximizes income from all sources, including option premiums, stock ownership, and dividend income, all while providing down-side protection. Not only do covered calls allow you to do this, but they are the first step in taking your stock portfolio to the next level using options. Good luck!


Disclosure: I currently do not own any of the stocks mentioned in this article.