January 2001
Vol 24 No 5
Welcome to the first month of the next year of your life. If you're tempted to write down some new year's resolutions one might be to make 2001 a better year than 2000. If the Wall Street Journal is to be believed, this won't be much of a challenge for a lot of people who speculated in high tech stocks last year. By now, to their dismay, many have discovered there is a fine distinction between true investment in contrast to pure speculation in the stock market.
Let me define my terms: I regard speculation as the process of betting time, money, or talent in hope of realizing a profit as a result of something that one can't control. For most people, buying stocks is pure speculation. The vast majority of those who have seen their fortunes climb in the rising market, only to fall as the market ebbed, know very little about the companies their stocks represent. They're not investing for a known yield so much as they're betting that at least one more person will come along and buy their stocks for more than they paid for them. By way of contrast, Warren Buffet is a stock market investor. His enviable track record is the result of intensive study of the management, internal financial structure, products and markets of the companies he invests in. Stock market investors like to talk about “total return”, which is a combination of dividend yield and capital gain. Using these criteria, single family houses clearly out-paced the S&P 500 Index in 2000. In many places in America, it wasn't unusual to see an 8% net rental return and 14% increase in market price over the past 12 months. Single family house prices and rents rise because people NEED homes to live in; they DON'T NEED to invest in stocks. Thus the stock market investor is merely a passenger in high-risk roller coaster who must ride out the peaks and valleys with no control over the outcome. In contrast, the single family house investor can improve his investment return through his own effort.
One of the most lucrative areas of the real estate business today is in the fixer-upper business. The returns for most people in this business far exceed the returns that stock market investors have enjoyed. No doubt, buying, financing, fixing, and selling houses requires considerably more involvement and effort than dialing up an on-line brokerage, but it carries a much lower speculative component. Why? Because as a rule, compared to passive stock market investors, dealers who buy and sell houses know a lot more about the details of their business.
In spite of this, dealers run risks that investors don't. They live and die by the caprice of credit markets that they don't control. Their profit depends upon private financiers and institutional lenders. When credit dries up and they can't buy “inventory”, or finance sales, their profit can disappear overnight. To offset this, even the most successful buy/sell entrepreneur still needs to provide a source of income during slow periods. One way to do this is to sell houses on wrap-around notes or installment contracts that contain a profit “spread” between both cost and sale price, and between the rate of interest paid and charged. For example:
A bargain house costs $40,000 cash plus $10,000 for repairs and marketing. The funds are borrowed through a combination of institutional and private financing. The house sells for $75,000. In our example, the average cost of credit is 10% and the property is sold with a $3,000 down payment. The remaining $72,000 is financed by the dealer at 12%. Let's recap: $52,000 was borrowed to pay for the property and fix it up. The loan interest costs $5200 per year. $3000 in cash is paid down, plus $8640 annual interest plus principle; that's $3440 per year net interest plus $23,000 in gain. But, there are several flies in this ointment:
Copyright © Sunjon Trust All Rights Reserved, www.CashFlowDepot.com. (888) 282-1882
Quotation not permitted. Material may not be reproduced in whole or part in any form whatsoever.
MAKING MONEY ISN'T THE SAME THING AS HAVING MONEY . . .
Many of those who “wrap” underlying loans they have signed rarely realize that they are using their personal credit rating to finance a buyer who may be less credit-worthy. In every down-turn, when these borrowers can no longer make payments to them, dealers must consume their own funds to make the payments on their own loans. Most of them are driven into bankruptcy. So, in the final analysis, in the process of creating income, they are speculating on an economy they don't control.
Income tax on dealer profit is due in the year of sale, whether he receives cash or whether he receives promissory notes. Thus, he'll pay ordinary income taxes on money he has yet to receive. If he's in the 28% income tax bracket, he'll pay $8960 in income taxes. That will use up all his $3000 in cash, plus $5960 in personal funds. After paying these taxes, he's gambling that the borrower will continue to make promised payments. If he doesn't, our dealer friend must spend a portion of his paper-profit to foreclose and ready the property for resale. He doesn't get a refund from the IRS of previously paid taxes. He just adds previously recognized profit to his basis to use in calculating his profits on the next sale.
Some dealers have resorted to selling properties on Lease/Option contracts under the illusion that somehow this isn't taxable, since title to the house hasn't changed hands. Unfortunately, under their Doctrine of Substance Over Form, the IRS may take the position that this is in reality a disguised sale if it appears to be one. If it looks like a duck, quacks like a duck, and walks like a duck, the IRS says it's a duck no matter what you call it. In such case, all of the above taxes will apply plus various penalties, interest, etc.
Dealers often seek to avoid having to pay taxes out of personal funds by selling their notes to investors – which may include their own corporations – at a discount. This way, they pass on the credit risks and reduce the speculative component of their business, but at the cost of their profits and income. They still have to pay taxes on the profit that remains, but can use some of their note-sale cash proceeds for this purpose. Selling notes to their own corporation could open up another can of tax-peas in the form of Personal Holding Company taxes.
There remains a simple way for a dealer to reduce taxes, speculative credit costs, and potential losses. From time to time, he could select from his inventory a house that he fixes up to keep. He'd expend extra effort to obtain long-term non-recourse, level payment, fixed rate interest, self-amortizing mortgage financing. Then he'd rent the house to a qualified tenant without offering an Option. For many years, the income from the house would be largely sheltered from income taxes. Over time, the combination of loan amortization and appreciation will create a growing untaxed equity. At an appropriate point in the future, the house can be exchanged tax-free, or sold, with profit taxed at low capital gains rates.
Real estate Brokers and dealers have a tremendous advantage over passive investors who are willing to pay retail prices, and to accept lower profits rather than take an active role in building assets. Entrepreneurs are able to acquire houses at wholesale prices in which they have “instant equity”. They have often have access to lower cost credit. Over time, they often cultivate above average negotiating skills. The combination of these skill makes building a single family house portfolio a cinch. It all but remains to learn how to manage tenants, and a safe, prosperous, and secure future is virtually guaranteed to them.
Why don't they do this? A few do, but the vast majority of dealers and Brokers focus on gross pre-tax profits without considering the risks they run for the net profit they actually receive. And some won't take the time to learn how to negotiate price, terms, and credit that will provide them the most benefits over the long term. In many instances, dealers, brokers, and passive investors alike are just too busy making money and paying taxes to become rich.
THE OLD WAYS STILL WORK BEST . . .
Throughout the past quarter century, and from that very first prototype seminar on ways to acquire, hold, manage, and sell single family houses that I presented in Denver, Colorado in April, 1976, I emphasized two secrets that are the key for entrepreneurs to be able to consistently make a profit:
First, decent, livable houses have to be selected in stable, safe neighborhoods that will have long term appeal to tenants who can afford market rents. Second, they have to be financed with economically feasible long-term, low interest rate, non-recourse mortgage financing; preferably provided by a combination of existing loans and credit provided by motivated sellers.
For years, it has remained one of the great mysteries to me why so many Brokers, dealers, and investors just won't follow those simple rules outlined above. Consequently, they don't seem to be able to amass much in the way of free and clear assets. As a result of my conversation with a friend, I think I've finally figured out the problem. It isn't as though they hadn't been told what to do; but, they have listened to false prophets who have lured them with promises of quick, effortless wealth from the path of righteousness.
What I see people doing wrong is they try to save time and trouble by riding around with real estate brokers who show them houses listed at retail prices and terms. As a result, they pay too much, finance too expensively, and have limited choices. My personal breakthrough came when I discovered quite by accident that I could turn up more houses than I could afford to imply by canvassing the neighborhoods I wanted to own houses in, then negotiating directly with the owners to get the terms I had to have to create feasible cash flows and long term gain. This has been the theme of my acquisition seminars from the very start.
Recently, a long-time subscriber from California became desperate enough to actually try walking the neighborhoods looking for a house to buy. Within the space of one week, in one of the hottest markets in America, he was able to find three houses that he put under contract to buy. As of this writing, he has sold one of his contracts for more net cash in less time, for less out-of-pocket expense, and with far less risk than he could have ever have done by fixing up houses.
On another occasion, I spent a little time with an entrepreneur who attended one of our earliest seminars in the 1970s. After decades of buying and selling hundreds of houses, he had acquired only a relatively few to hold as investments. and these were encumbered with debt. He is a gifted and energetic entrepreneur who has fallen into the trap of consuming his profit rather than re-investing it. As a result, he is constantly searching for, investors and lenders who will provide the funding to enable him to run faster and faster in a squirrel cage of his own making. The more he does, the more he has to do. He doesn't have time to work smarter, so he's condemned to repeat unsuccessful patterns of the past.
Fortunately, is isn't too late for him to mend his ways and to start doing things right. He's not much older than I was when I found out how to increase my cash flow, and at the same time, increase my invested equity. Here's the secret in a nut-shell: Instead of buying houses that you intend to re-sell, put them under an assignable purchase contract that is contingent upon your finding a buyer within a reasonable time, then use your cash to increase the value of the property. Sell the contract itself, and let the home-buyer finance with an institutional loan.
I tied up many houses with a $100 bill and an assignable contract. I usually tried to negotiate a 20% gross profit out of which I willingly spent 10% for improvement and marketing. I pocketed the other 10% as a cash profit. This technique has been a staple of all of my house-buying and Option seminars, yet relatively few people actually work at doing this on a consistent basis.
WALK THE WALK AND TALK THE TALK . . .
I can already hear the muttering from those who have never really tested this technique. I've heard it from nay-sayers for many years. And they're still trying to find out why they haven't achieved the financial success they wanted. In order to make this work, the entrepreneur has to invest some “sweat equity” by getting out into the neighborhoods and meeting people who live there to find out for himself, first hand, what true market values are and how the homes are financed. He has to get the word out throughout his target area that he is able to either buy or sell houses, or advance cash or make mortgage payments until a sale can be closed.
How does one get started doing this? Let's take it from the top. Initially, I simply had a business card made up which contained my name, office address, and telephone number. Initially, I'd devote two hours a day to knocking on doors and passing these out. Then, I had this message printed on the reverse in my hand-writing? WANT TO SELL? CALL ME. ANYTIME! I was a Broker at the time, and this seemed a pretty good way to advertise both my Brokerage and my desire to buy houses. Later on, I came up with a brochure that did a much better job.
My brochure attempted to motivate those who wanted to sell their homes in order to move, or who wanted to raise cash without having to move. I printed my motivational message in large black letters on goldenrod 100lb card-stock. Those of you who have attended my “Buying Houses From A – Z” seminar have a sample in your work book. I made it a point to distribute 1000 of these each month. Instead of attempting to talk to people in the neighborhoods, I placed these in the crack between the front door and the door jamb near the door handle, and let those who were motivated call me. Then I made an appointment for them to bring all their house papers and to visit with me in my office. This gave me a “territorial” advantage during ensuing negotiation, and having necessary documentation, copy machines, and notary services nearby enabled me to close a transaction swiftly.
Because I was using techniques that were outside the realm of conventional real estate brokerage, I had zero competition. Indeed, today, there still is no competition for the person who really gets out on foot to work the neighborhoods this way. Initially, I substituted selling contracts for selling houses much the same as any dealer. But, from time to time, when the wind was with me, I was able to buy a house with seller financing. Many of these transactions were at a zero interest rate. When we hit economic slumps and house sales faltered, I was able to buy at lower prices with extremely favorable terms. When real estate came roaring back, I sold at high prices. It was a classic “buy low. sell high” situation.
By avoiding institutional financing, I was a buyer in a seller's market, and a seller in a buyer's market. While awaiting the return of the sellers' markets, I learned how to rent my properties, and eventually, to manage and maintain them too. Income from rents provided steady, reliable cash flow to tide me over between sales. Within just a few years of buying, selling, holding, and managing, I was able to retire from brokerage. Only then did I begin to teach seminars.
What's the point of this letter? To get you to set some goals for the new year. All by yourself, without the aid of any listed properties or brokers, set a goal of buying at least four nice houses in good neighborhoods to keep for the long term. Avoid signing on new institutional loans. Instead, combine non-recourse seller financing and take title subject to existing financing. If you need money, ally yourself with someone already investing in real estate, and get him to put up the seed money to enable you to negotiate a bargain purchase with below-market terms. Don't worry about limitations that might seem to be imposed by “non-assumable” loans, or imputed interest rates that brokers are fond of. If you still haven't learned how to avoid “due-on-sale” issues from my seminar, once I've received a FAX copy of your signed contract, I'll tell you what to do next.
Copyright © Sunjon Trust All Rights Reserved, www.CashFlowDepot.com. (888) 282-1882
Quotation not permitted. Material may not be reproduced in whole or part in any form whatsoever.
