March 1993
Vol 6 No 7
We've seen the election promises beginning to shatter and have been stirred by the State of the Union address (more promises), now lets see what's really happening. Over the past few months, more and more dollars have been injected into the economy by the Federal Reserve, and this trend is continuing. Meanwhile, higher taxes are being proposed on estates, large corporations, the wealthy, foreign corporations, selected Social Security recipients, energy and some imports.
These are being offset by plans to restore investment tax credits, relax the Passive Activity Loss rules, and to lower capital gains tax rates. None of us can predict which of these proposals will be enacted into law or exactly how they'll be implemented, but it's possible that we could wind up with net benefits overall. Here's why:
If wage earners' net income continues to be used to pay down personal debt, there won't be much change in the economy until they feel confident of their future jobs and income. But as the economy turns up, they'll begin to buy once more, and we'll be off to the races. The FED might slow the increase in the money supply, but the dollars that are already out there will begin to pass from one vendor to another, adding further stimulus.
This will eventually cause interest rates to rise, the stock and bond markets to turn down and investment funds to flow into the banks and U.S. Treasury – and into the housing market. Why? Because that same inflation will be seen in rising prices for single family homes as pent up demand kicks in.
On the other side of the coin, when investors once more are given tax incentives to invest in leveraged real estate, they'll flock to it just as they did in 1981 when ERTA was passed. This will provide the liquidity and credit that has been missing for the past 10 years in most markets. As taxes on the wealthy increase, they'll be just that much more willing to consider investments which they can shelter from rising taxes. Let's take a look at an example:
In 1979, passive earnings were taxed at a top rate of 70%. I owned a nice house in a subdivision which was worth about $75,000. It had a payment of about $800 per month including principal, interest, taxes and insurance. I sold it with nothing down to an investment syndicate composed of people in the 70% tax bracket. I agreed to lease it from them for $400 per month for 5 years so there would be no management or vacancy problem. Actual market rents were about $600 per month. Here's why it worked out for everyone:
Leaving maintenance and amortization out of the picture, they were spending $9600 per year and receiving $4800 per year in rents. They could also deduct $4000 per year in depreciation. The combination of tax losses in the 70% bracket meant $6160 more in net after-tax income. Remember, they were only paying $4800 out of pocket, so they realized $1360 additional in net cash flow. Plus, the property was appreciating at about 14% per year because of inflation. That amounted to another $10,500 in non-taxed equity profit.
We're probably not going to see a resumption of the 70% income tax bracket, but the concept remains the same. As inflation and taxes increase, so does the appeal and subsequently the value of real estate. That's the ground work that Clinton seems to be laying. That's why I've spent so much time going through the reasons this happens.
WHEN THE ECONOMY STARTS UP, HOUSES LEAD THE WAY . . .
Last month we covered why Clinton needs a housing recovery to help expand the tax base to pay for his new programs. And I think we made a persuasive case for the way that recovery will spread through many other industries, creating jobs, consumers, taxpayers. But, getting the benefit of an economic recovery isn't automatic. If we expect to share in the fortunes this will create, we have to prepare ourselves and to start now to lay the foundations for our own success. That's the topic of this month's sermon. Read on:
When we fail, most of the times we fail because we haven't mentally and emotionally prepared ourselves to succeed. Think of all the people you know who win the lottery, or at Bingo, or in Las Vegas. How often do they wisely put their winnings away for the future? How many times instead do they foolishly squander them? Why is this true? It's because they never expect to win. Don't feel they deserve to win. Don't value their winnings as much as they value their earnings from their employment. They aren't prepared to win. If we expect to be winners in this administration, we have to be prepared.
It all starts in your head. You have to expect to succeed and to be willing to invest in that success, knowing full well it will come. Why aren't people willing to work and invest for success? Isn't it because they really don't believe they'll succeed? They feel that money, time and effort spent will just be wasted. I see this all the time in people who won't take the time to learn the fundamentals of real estate prior to jumping in and losing their money. They don't seem to have any clear objective – unless it's a financial death wish.
If you expect to succeed at something, you need to determine your objectives, whether they be financial, personal, psychological, or whatever. That means you'll have to ponder your own fate. Are you content with your future prospects, assuming you don't change anything in your life? Is your personal trend line up or down? Would financial independence make you any happier, if not now, at some point the future? When? How? Why? Where? With whom? Until you wrestle with these questions and find answers, you may just be on a treadmill to oblivion. Positive long and short term goal setting is the key to ultimate success in all aspects of your life. You need to do it now.
O.K., O.K. So you've written down specific financial goals which you honestly believe you can attain with dedicated perseverance;how do you expect to reach them? What will your time frame be? What sort of vehicle will you use? We've offered seminars on starting your own business, and that's certainly a viable route to financial fortune, but since this letter is for single family house investors, let's focus on these. Here's how I used the 70's economic recovery:
I set a 5 year time frame. I decided to contact 10,000 home owners each year. These would be people who were NOT trying to sell their homes either with a broker or privately. They'd be people to whom I could offer an easy sale without any trouble on their parts. So I mailed, delivered, deposited, and had delivered handbills to their doors.
I timed these deliveries to occur a few days prior to my following up with telephone calls and visits to those who showed any interest at all. I averaged four purchases per 100 personal contacts. That sounds simple enough, just a numbers game. But I had to know house values and understand negotiation, financing techniques, management and documentation to avoid making financial mistakes. Furthermore, I had to be familiar with real estate and tax law. I spent over $20,000 going to professional seminars in 1974 alone.
The first year I bought 5 houses. The next year 9. Then 23. Some of these I sold to raise money with which to buy others, but within two years, the rental cash flows each month gave me the income I needed to buy a house a month. In each purchase, the owner had to be my banker, carrying the financing because (a) no bank would make a loan to someone whose income depended on rents (b) to buy another rental house (c) with a small down payment.
By accident, I discovered a fantastic secret. Owners would sometimes finance 100% of my purchase with a payment schedule that the rents on the property would generate. That's the equivalent of nothing down and nothing out of pocket a month. The key wasn't so much not making a cash down payment as it was in building a portfolio of houses which didn't drain my cash reserves as I kept adding houses.
The essence of fortune-building techniques is to find a way to use other people's capital – cash or equity – at the lowest possible cost over the longest period of time prior to repayment. Any self respecting bank robber knows this, but we have to find ways to do it without breaking the law. This brings into play all of your past experience in dealing with people, negotiation, financial concepts, finding and locating motivated sellers, sales and marketing, and asset management. The technique is simple, but making it work is the real art.
Over the next few months, we'll concentrate on more of the ways in which you can play the emerging market for both current income and future profit. In the meantime, here are some of the procedures you need to learn how to do well.
(1) Locate a motivated owner. I prefer working in the distress markets to find someone who must relocate for business or personal reasons and who hasn't time to find a buyer in the conventional markets. As I said before, I use direct mail, telephone and delivery techniques to sift through thousands of owners to find truly motivated sellers before I invest any time in putting a deal together. This eliminates ruinous competition from others – a real key to profit.
(2) Focus on cash flow at the expense of price. Profit is a function of time. You can try to buy today at a low price and create instant equity or you can pay a higher price to motivate an owner, but over a longer period. During that time, you'll be earning profit from income rather than from gain.
Meanwhile, the property will be increasing in value. This way, the time that it takes for your equity to build through appreciation also produces net income with which to buy other properties. Furthermore, there's no theoretical limit to the number of houses you can acquire, since each one will be generating cash flow, assuming that you can manage them effectively.
(3) Understand the effects of interest payments. It takes payments of $1000 per month for 216 months to amortize $100,000 at 10% per year. If you decrease that to 7%, it only takes 151 months. At 5% you'll make 130. At zero interest, it takes 100 payments to free and clear a house. Assuming that you can average $750 per month year around for a house with a loan that large on it, you'll still be paying $3000 per year out of your own pocket plus taxes, insurance, maintenance and management.
It might pay you to negotiate a 7% interest rate rather than a zero interest rate if the seller would reduce your payments to $600 per month. The bad news is that it would take you 221 months to pay for the house. The good news is that you would be saving $3000 per year in cash flow. Interest rate negotiation is vital to you.
(4) Buy for total return, not merely potential appreciation. That's controlled by government one way or the other. Amortization and income are more certain. Zero interest provides the fastest pay down of a loan, but usually at the expense of price and income. As interest rates increase, amortization decreases over the same period. At some point or other, zero amortization is reached with 'interest only' financing. The only time this is feasible is when you are generating cash flow income from the property and/or the property is appreciating sufficiently to overcome the loss of amortization.
(5 Limit your growing exposure to liability and to taxes caused by tenants and increasing cash flows. So you'll want to understand ways to use trusts and corporations to reduce both of these, and for estate planning. For now, just consider holding title to property in another legal name. Absent of the need for tax strategy, I prefer holding title in TRUST.
Trusts are relatively simple to form and they're legal everywhere, but their legal form and the way they work varies from state to state. In those states which don't have a specific statute which implements them it pays to do some research. If tax considerations play a part in your strategy, C corporations are my personal choice for holding property despite the fact that gain could be doubly taxed.
While it may seem early, learning how to use these vehicles before you have too many assets makes more sense than just jumping in without knowing what you're doing. Which brings us full circle to preparation. We'll cover these in more detail next month together with other insights into the opportunities the near future holds for you.
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