July 2008
Vol 31 No 10
I recently spent three weeks in Europe where I got a first hand look at the financial troubles of America from the perspective of those who take our dollar in trade for Euros. When the Euro was first introduced, it traded at about 87 cents to the dollar; thus, the U.S. dollar would buy about 115 Euros. I recently paid $1.68 per Euro. That’s a 193% change in the exchange rate over that period. Saying it differently, in the European Common Market, which represents about 20 modern countries, the dollar will buy only 52 cents worth of food, lodging, transportation, etc. compared to what it would have bought just a few years ago.
This isn’t lost on foreign vendors who sell services and products to us.
The drop in the value of the dollar is reflected in the cost of almost all foreign-made products. Today, the most notable effect of this is the rising cost of gasoline. Tomorrow, as we continue to paper over massive debt problems with more debt, the impact of this could result in a dramatic rise in the cost of credit.
Rising debt of the U.S. Government – mainly owed to China – used to fight wars on two fronts while trying to deal with sub-prime loans is creating a looming credit crisis. The Bear Sterns bailout was the first of what could be continuing bailouts of the major players in the credit markets. Stock prices of major banks are falling as they are forced to write off more and more debt against profits. The inevitable result of this is that interest rates on money we borrow is going to have to rise enough to overcome the loss of purchasing power of the dollars used to repay it. Despite this, for political reasons in this election year, America continues to run up massive debt that can only be repaid with taxes or inflation; both of which don’t bode well for borrowers or lenders.
Government appears to be oblivious to all this. Recently, in an effort to ease the sub-prime mortgage meltdown, FHA announced that, for those with FICO scores of 580 or more, it would insure refinancing of up to $729,750 and 95% of appraised value so long as the owner had made payments on time over the preceding 12 months. That’s almost twice as much as the previous maximum FHA loan amount.
In a move that is certain to further squeeze mortgage lenders, many States are enacting laws that hinder the efforts of lenders to foreclose houses. Ohio has drafted 1000 lawyers to help borrowers avoid foreclosure free of charge. Illinois is trying to get a law passed that will block foreclosure for 60 days. Maryland has passed a law giving borrowers 150 days to cure defaults. A contested bill in Minnesota would let sub-prime borrowers and/or those with negative amortization loans make only partial payments without being considered delinquent. It also makes lenders honor any formal request to defer foreclosure for up to 12 months so long as the borrower paid the lesser of his payments when the loan was originated, or 65% of the payments at time of default. Borrowers in Massachusetts have 90 days following a loan default before the lender can initiate foreclosure proceedings.
And as I reported in my February letter, because of all the slicing and dicing of home mortgages in the secondary market, for all except portfolio lenders, it is virtually impossible to foreclose mortgages when the party being foreclosed challenges the standing of the foreclosing party, citing the Ohio Federal court ruling; and the court requires the lender to produce the original Note or contract.
This is just the tip of the iceberg in the secondary mortgage market. As noted an authority as Multi-Billionaire George Soros has stated that the combined debt and interests created in all the mortgage loan derivatives comes to $45 Trillion. That’s more than the combined personal wealth of all American citizens.
SELLER FINANCING WILL BE THE ONLY GAME IN TOWN . . .
Credit crunches occur every twenty years or so. This is bad news for those who must use credit to buy goods to sell to others; as well as virtually every vender who must accept credit cards in order to sell, and who must use credit to buy. Newspapers all over America run car dealer and furniture store ads that promise “no payments until 2010” or “no interest until 2010”. Vendors fund their purchases with commercial credit provided by those from whom they buy, or from banks. They also use banks to clear credit cards and to extend credit to their customers who pay only minimum credit card payments. In the housing market, all but a tiny percentage of house sales depend upon mortgage financing. Most people equate mortgages with institutional financing, but when credit dries up, the most important source of house financing will be that provided by sellers.
The good news about seller financing is that the seller/lender is a lot more motivated to do business than conventional institutional mortgage lenders; especially when, without seller financing there will be no transaction. Thus, there is rarely any need for the buyer/borrower to produce a credit report, or to personally guarantee repayment of the debt. Quite often, the down payment can be financed. The transaction can be closed very fast. There is no padding of the loan costs with origination fees, warehousing fees, points to the mortgage, surveys, appraisals, document preparation, etc. The bad news is that the buyer must know enough about financing to be able to calculate payments and the repayment period for a loan at a range of interest rates. To complicate matters, when the transaction is being handled by Brokers, Attorneys, or other middlemen, they tend to get in the way of negotiations because of their ignorance of creative mortgage financing terms.
As a rule, in order to get attractive financing terms, the buyer has to make concessions to the seller. The easiest concession to make with a house that is going to be kept to produce rental income is to agree to pay a high price, but with low monthly payments and a low – or zero – interest rate. For a house that is going to be sold fairly shortly, a low price and a relatively short term high interest rate loan combined with a high monthly payment can motivate the seller. With a lease/Option, a high lease payment can be coupled with a high percentage rental credit toward a high price to build equity fast. Alternatively, price, rents, and credit can be scaled down to produce more cash flow from the lease by relieving the seller of management burdens.
Seller financing can produce much higher profits more safely than institutional financing because it can incorporate unconventional terms. Let me give you a couple of examples:
The first office building I bought was with a Lease/Option that required no payments for 2 years so long as an amount equal to monthly payments on an interest-only 8% loan was spent on improving the building.
My second office building loan provided that for every $1000 of additional principal paid, the monthly payment would be reduced by 10%.
My first apartment building was bought with a lease/Option that credited 100% of my payments for 1 year toward the purchase price, at which time, the final price and payments were based upon its demonstrated net income under my management.
I was able to get houses to produce net cash flow from day 1 by buying the equity in segments. For example, an owner with a large equity needed to sell because he was leaving the area. I made him the only offer he got. I paid for 40% of his equity by taking over the existing loan payment. In five years, I could have paid the remaining 60% equity by selling or refinancing the house. In the interim no interest accrued nor were payments required. On the other hand, he got his full asking price. All during the five year period I bombarded him with offers to pay off my note at a discount. After 3 years I paid it off for $20,000 less.
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CREATIVE FINANCING CAN BE TAILORED TO SOLVE PROBLEMS . . .
“Creative Financing” is a phrase that describes terms that aren’t available from institutional financing. By definition then, except for deals made between professionals, creative financing depends upon financing provided by a motivated seller. It follows that the more a buyer knows about the needs and goals of the seller, the wider the scope of financing possibilities. In turn, the more time and effort the buyer invests in discovering the needs of the seller, and meeting these needs in the transaction, the more successful he or she will be in getting seller’s to accept a creative offer.
While it’s usually dangerous to impute motivation to the other party, it is safe to say that seller problems tend to follow along similar paths. These might include the need for the following:
CASH to settle pressing debts, or to pay for future foreseeable expenses such as medical expenses, balloon Notes, law suits, maintenance and repair, college, business expansion, etc.
INCOME to support life-style needs such as retirement, payments for personal or mortgage debt, transportation, insurance, health or dependent care, alimony, tax.
PROPERTY MANAGEMENT and MAINTENANCE: Burned out Managers and absentee owners are the most distressed sellers in the market. They need to protect their equities and make their payments, but lack the skills, patience, or intestinal fortitude to manage their rental properties. They desperately need to find a capable manager who can and will take over the management burden and restore lost income.
SECURITY: Many people will voluntarily opt for a lower, more secure return on their investments rather than to take a chance on future possibilities. They are those who invest in bonds, insurance annuities, interest-bearing bank and money market deposits, and guaranteed returns based upon various financial contracts.
EGO SATISFACTION: Some people would choose a transaction in which they appeared to have made a good deal in lieu of a transaction in which the bragging rights were less obvious. For example, they might accept an offer that met their asking price based upon 2005 values, but with zero interest and low or deferred monthly payments rather than taking a low cash price.
TAX AND TIMING CONSIDERATIONS: Many times an Option can be obtained when a seller can save taxes by delaying the sale. This would be the case where ordinary income might be converted to capital gains; or a property might qualify for a tax-free Exchange or Section 121 residential sale in the near future. In other cases, principal payments might be deferred into a time when gain would be taxed at a lower rate such as from 2007 to 2008; or a transaction sped up when tax on gain is about to increase dramatically, such as what happened from 1986 to 1987; and which might happen again when the Bush tax breaks expire if a Democratic candidate is President.
AVOIDANCE AND/OR ELIMINATION OF RISK: There is considerable variation in risk tolerance among buyers and sellers; especially when confronting the liability risk of defaulting on personally guaranteed loans; or when facing the prospect of recession, depression, deflation, or inflation. When the entrepreneur is willing to undertake more liability and risk in order to relieve the other party of perceived risk, a profitable transaction can often be made.
ESTATE PLANNING, SETTLEMENT, AND DISTRIBUTION: Real estate is often illiquid and indivisible just when an estate must pay estate taxes. Sometimes settling an estate can be simplified by having a buyer with an Option waiting in the wings to buy a property at the end of a seller’s life. Alternatively, heirs, who are eager to get their hands on their bequests are happy with an offer that combines a low offer with cash and terms that will provide cash for taxes, and a windfall for them.
CREATIVE FINANCING IS JUST AN IDEA AWAY . . .
When structuring a creative purchase or sale, the first task is to determine the needs of the buyer or seller, as the case may be. This is done by slow, patient inquiry that takes place only after the parties are comfortable with each other. Most people are motivated, directly or indirectly, by an emotional response to fear or greed; or a combination of these. If you’ve taken the time and trouble to discover true motivation, whether fear or greed, then you can channel your creative efforts to allow the other party to meet as many of his needs as possible at a cost that will enable you to meet as many of your needs as possible.
The negotiating mode that has the most potential for success is called the “cooperative mode”. To get into this mode, a buyer or seller might say, “We’re too far away from an agreement, but if we are willing to spend some time trying to work the details out, we might be able to make a deal.” One way to visualize this situation is to imagine the parties seated on the same side of the table trying to work out a deal that meets their needs rather than seated across from each other lobbing pot shots trying to score negotiating points at the others’ expense.
It’s a mistake to try to structure a creative transaction using conventional financing terms. The process of creation involves “brainstorming”. When both parties participate in “brainstorming” a solution, it is much easier for each to accept and to justify a solution in his or her own mind when one is proposed. “Brainstorming” is simply a process whereby all parties verbalize their spontaneous ideas as they occur, and to write them down prior to subjecting them to any form of critical examination. This encourages otherwise reticent people to advance their ideas. Ideas can later be critiqued to see if any of them will solve a problem or increase a benefit in order to complete a transaction.
Once both parties to a transaction work to put it together, there are often many ideas. The good will needs to be sorted out from the bad. By doing this after the “brainstorming” phase, those that aren’t feasible can be deleted without stemming the flow of creative ideas. One way to proceed in the creative idea sorting process is to use what Warren Harding called a “T-Bar”. This is a variation on the old Ben Franklin approach in which the various advantages and disadvantages of any decision are arrayed side by side on a piece of paper and discussed thoroughly to see how well any would work. As objections are raised, advantages and disadvantages can be compared, and the proposed transaction adjusted accordingly.
If a seller needs cash, and is willing to accept a lower price to get it, an easy remedy is for me to sign a non-recourse note secured solely by the property in question with terms that will enable the note to be sold to an investor to get the cash he needs. If he doesn’t know how to find a Note buyer, I’ll help him find one. This saves me the need for borrowing, and gives the seller the cash he needs.
If you’re going to be able to do this, you’ve got to pin down you own minimum requirements for a transaction. For example, I won’t personally guarantee payments on a promissory Note. If the property alone isn’t adequate security, I might add another property to the mortgage, but I won’t place myself or my assets at risk to buy another property. If I see real profit potential, I would Option it, or lease/Option it rather than to buy it with full loan liability.
I’m also leery about projections made by an out of area enthusiast who wants me to invest in a property. I will not buy property out of my own area unless I know of a competent manager or entrepreneur who will take care of it, and who will share my risk in order to get paid. In a recent transaction involving a number of properties, the entrepreneur who found the opportunity has an Option to sell each property that rewards him fairly. If he fails to sell at a profit, he gets nothing. If I must become involved with the management, repair, or sale of a property because of his failure to perform, I get all the profit that I am able to generate.
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.
