January 2007
Vol 30 No. 4
A BRAND NEW SHUFFLE BUT THE SAME OLD DEAL?
The voters have spoken. Despite the fact that since the Republicans gained control of Congress, Americans have enjoyed record prosperity fueled by low taxes and low inflation, both houses of Congress have been returned to the Democrats. The 60-day lame duck session revealed little of what we can really expect once the new crop of legislators settles in. There has been all that conciliatory talk between the “ins” and the “soon-to-be-ins” about cooperation, but like any good poker players, what people say and what they do may be a far cry from what they said they would do; or what they are able to do. Let’s look at the political realities:
The changes that have already taken place, could be illusory. Despite the fact that there‘s a brand new Secretary of Defense, the wars in Iraq and Afghanistan are still going on, and we still have no real exit strategy now than we had during the change of Administration during the Viet Nam war. It could take years to work out a political arrangement between all the opposing faction; or, we could simply walk away as we did in Viet Nam, leaving behind chaos and civil strife. A mitigating factor is the fact that our chief supporter has been England’s Tony Blair. He has announced his retirement from office, and we could easily find ourselves going it alone in Iraq and Afghanistan. Only time will tell.
All the hoopla about the new Speaker of the House overlooks the fact that most of the key committees in the House and Senate are going to be run by the same good old boys who ran them prior to 1994. It doesn’t take long for fresh, idealistic, middle of the road Congressmen to learn that their only hope for being re-elected is to be assigned to important committees and to go along and to get along with their Chairman. Survivors in the House and Senate who have become the new leaders long ago learned to heed the advice of rich and powerful lobbies that control the funds they’ll need to stay in office.
Then there are the political realities built into our system of government: Although Democrat gains in the House and Senate were impressive, they still only have small voting margins in both houses. They’re going to need support from Republicans if they expect to be able to get meaningful legislation passed, and that means both parties will have to compromise. Both parties have their eyes fixed firmly upon the Presidential election, and Presidential candidates are already staking out the political landscape. The Democrats have very little incentive to do anything to solve any real problems faced by Americans because the worse they can make the Bush Administration look, the more it favors a Democrat Presidential campaign. The Republicans will want to rack up as many points as they can so they can point with pride at the Achievements of the Bush Administration. This sets the stage for what could turn out to be a do-nothing Congress for the next two years.
And, lest we forget, George W. Bush may be a lame duck, but he is a powerful and opportunistic lame duck. He still has control over the Presidency and all Cabinet Departments for two more years. He can appoint judges, wage wars,
allocate government resources and funding to some, while denying it to others (i.e. Katrina relief funding), and he can boost the political careers of those who work with him while penalizing those who don’t. Ultimately, if the Democrats enact any bill he doesn’t like, he can veto it. Without a lot of Republican support, it will be impossible for Congress to over-ride his veto.
All this is going to be a powerful drag on sudden change that could upset the political and economic apple cart, but it pays to be prepared when change comes.
MORTGAGE LOANS, INTEREST, INSURANCE AND TAXES SHAPE THE MARKET.
As single family house entrepreneurs or investors, we are all affected by the availability and cost of credit in our areas. How would loss of institutional financing by entrepreneurs for acquisition and remodeling of houses affect the way you make your living? How would requirement for 10% down payment for new buyers occupants change your market? The length of time you had to hold houses in order to sell houses for cash? Your holding costs? The numbers of houses you could buy and sell in a year? Your annual income?
To illustrate; principal and interest on a 100% loan on a $300,000 house financed at 7% would cost $1995 per month. Property taxes based upon 1% of value would add another $250 or so per month, and insurance could add another $100. Let’s say the total payment might be $2345 to which must be added maintenance and upkeep. Now, let’s make a few changes: Let’s increase the down payment to 5% or $15,000. This historically has been required on owner-occupied homes in other periods. How many people in your area who live in $300,000 houses could come up with that down payment today? Suppose the down payment went to 10%, which it has done many times in the past? Can you see how your market would change.
Suppose interest rates rose to 8%; which has been very common over long periods in normal times. Keeping taxes and insurance constant, the payment on a $300,000 house after a $30,000 down payment would be $2356. In some counties in Florida, because of hurricanes, casualty insurance could rise to as much as $250 per month on this house, bringing the monthly payment to over $2600. For those consumers who bought homes with HOA fees or who bought condominiums, these fees rise with increasing costs, which are also affected by taxes and insurance to a degree. Is it any wonder that the market has stalled in many areas at the $300,000 mark?
Underlying all the economic factors of home ownership is the way houses are treated under the Internal Revenue Code. Currently, houses are the most favored of any real estate. They can be depreciated over shorter lives than commercial properties. Homes with under %500,000 profit can be sold tax-free by couples. When part of a home is used as an office, or rented out, that portion can be exchanged tax free. And when most homes are sold, taxable profit is taxed at lower long term capital gains rates. The downside is that depreciation previously taken will be taxed at 25% and for many, a special 26% Alternative Minimum Tax could be tacked on.
Clearly, the more you make, the more you‘ll pay. As your income rises above $150,000 per year, your personal tax exemptions are phased out. So are any losses in excess of income that you can deduct from rental property. Social Security is taxed. Bills have been proposed to make Medicare a “means-tested“ entitlement. In short, if you make too much money, your entitlement will be cut off. Any or all of this can be modified by Congress. As the balance of trade with other countries gets further and further out of whack, America sinks deeper and deeper into debt. Eventually, this will be paid off with higher costs and inflation which will be taxed at higher rates; or by increased taxation, or a combination of both of them.
The foregoing was just a theoretical exercise which may or may not apply in your area in the near future. It’s purpose was to bring things into perspective for those who want to speculate in housing before it is clear how the new political paradigm is going to affect the market. When fortunes are being made in a matter of months, people don’t focus on the costs; but when profit margins return to historic levels, expenses of home ownership and taxes on profits will change the house business for many. House profits will be based less upon buying low and selling high than having the skill and insight to capitalize on opportunities that present themselves in local markets.
INVESTING IN DEBT COULD PAY MORE THAN INVESTING IN EQUITY . . .
Just after the end of the Carter housing boom, Jimmy Napier wrote a best selling book he titled “Invest in Debt”. His timing was perfect. In most areas of the country, interest earned on money loaned exceeded by far the profit earned on equity appreciation. It’s pretty easy to figure out why: Suppose you bought a house financed at 8%. Every $100,000 of loan would earn $8000 per year. A $300,000 loan would pay the lender $2000 in income per month in interest with little or no effort on his part at all; and virtually none of the liability associated with real estate ownership.
Suppose an “interest only” 8% loan were written with the balance due at the end of ten years. During this time, let’s assume that the lender had been able to collect all payments on time, and had immediately invested the payments so that they would continue to earn 8%. The 120 payments of $2000 each would have compounded to $366,000 in addition to the return of his principal.
The price paid for this income would be loss of depreciation, which would be recaptured at the 25% tax rate if the house were sold; and loss of appreciation. On the other hand, there would be no property taxes, maintenance, or insurance to buy. The borrower’s house would have to appreciate at 8% per year — plus $2000 per month, plus the costs of holding the property in excess of income –to produce the same net return to the owner as it did to the lender; and it would have to have no other expenses.
To keep everything equal when comparing profits, we’ll assume that the lender was a Pension Plan, IRA, or Tax-free Trust that paid no tax on its investment profit. Let’s look inside the numbers: If the house were the personal residence of the borrower, it couldn’t be depreciated. Other than providing shelter, the only benefit of ownership would be tax free appreciation. The cost would be the loan payments. The $2000 per month cost of interest plus property taxes, insurance, HOA fees, and maintenance would increase the investment. These would have to be repaid prior to any profit being realized. Using the same figures as before, these are as much as $375 per month for some people not counting maintenance. This could easily add yet another $200 per month. Over a decade, if everything remained constant, about $309,000 would have been spent on this house. If it were sold tax-free, net profit over the mortgage would have to be about $366,000 in excess of $308,000 in expenses just to keep pace with the profit the lender would have realized.
If both lender and borrower paid federal tax only on their profit, assuming each paid 25% of their income out in taxes, the lender would have only been able to re-invest $1500 per month at 8%. This would have totaled a little over $274,000. Ignoring Alternative Minimum Tax and selling costs, the borrower would have had to be able to net about $777,000 before tax to match this.
The essential difference between the investment yield of the house and the mortgage is the speculative gamble on appreciation and liability versus regular monthly income from a secured loan. When leveraged appreciation compensates for risk and possible negative cash flow, it pays to buy houses; but when it does not, it makes a sense to consider being a lender. When a house is your residence, there is little tax shelter per se. For rentals, at best, only $25,000 per year expenses in excess of income can be deducted against non-passive income. Any excess expenses must be carried forward until the house is sold. This could amount to many years.
There are many ways to become a lender, even when you have very little cash to work with. The essential requirement is that you find houses you can buy by combining existing financing with seller financing; then to sell them on wrap-around contracts or on wrap-around loans at higher prices and interest rates
CREATIVE FINANCING WORKS FOR BOTH SELLERS AND BUYERS . . .
When I first went into the real estate business, my office building sat next to a little wooden shack. The proprietor, Frank, drove an old Toyota and seemed to have no means of income. One day he explained to me that he’d made over $100,000 per year for 30 years simply buying houses on low interest terms from owners and selling them on installment contracts at higher interest rates rather than renting them. Borrowers, who were owner/occupants took care of all expenses, taxes and insurance, and paid him interest for the privilege of doing so. When loans were defaulted, he foreclosed and resold the property at a price that reflected any appreciation in value. Thus, he captured income, appreciation, investment yield, leverage, and loan amortization. By giving up all depreciation, he also avoided all repair expenses. As a new Broker, I didn’t pay much attention, but when the real estate market slowed down and Frank’s income continued to come in while I worked harder just to stay even, I vowed to learn more about financing.
In the housing market buyers need credit to buy, and sellers need it to sell. When mortgage loans become hard to get, many more houses come into the market owned by highly motivated sellers. This can be a cornucopia for entrepreneurs who can find ways to buy and to sell. There’s usually very little competition and very strong demand for credit. So long as buyers can afford the down payment and monthly loan payments, they are usually willing to pay higher prices and higher interest rates. Let’s look as some of the ways this situation can be exploited.
1. Do what Frank did: He bought houses using minimum cash. When he offered them for sale, he kept the down payment and price low, but marked up the interest rate. When inventory is sold on interest-only installment terms, the profit is immediately taxable, but Frank didn’t make much profit by raising the price; he made it on the interest. By stringing out interest payments for years, he avoided tax on his profit until the loan was paid off. This gave him plenty of cash to pay taxes with.
2. Use idle self-directed retirement plan money to finance speculators, rehabbers,
and people confronting balloon payments they can’t refinance. Structure “interest-only” terms, and wait until the loan is paid off realize any taxable gain. Rather than charging interest, secure your loan with a Purchase Option which will convey a percentage of the profits. By sharing the risk, you should get at least half of the net profit. On more speculative deals, structure a preferred position. Charge a specified yield plus half of the remaining profit. Never take so much money off the table that the borrower has no profit incentive to repay you, but bear in mind, there’s lots of potential profit when the market slows down.
3. Create a market for seller financing by buying the debt sellers carry at discount for cash. You can dictate the terms, collateral, credit score of buyers, etc. to the buyer prior to the sale to create the yield you want.
4. Option a seller’s house at a low price with very little cash, then mark up the price and finance a retail buyer by buying the Notes he uses to pay the seller at deep discount. This benefits the seller by creating a market for a slow-moving house; and the buyer by enabling him to buy the house; and yourself because of all the profit centers you’ve created.
5. When you’ve demonstrated that you can produce high-yielding transactions, you can divide profits with investors by using, or re-lending, their funds to finance houses; or to help others sell and buy houses. The profit potential far exceeds normal brokerage fees.
Copyright Sunjon Trust (888) 282-1882 www.CashFlowDepot.com
Quotation not permitted. Material may not be reproduced in whole or part in any form whatsoever.
