May 1979
Vol 1 No 9
Last month we touched upon the economic commotion being caused by the Reagan budget. Looking at the “big picture” this seems to be a bloodless conflict of charts and graphs between economists of different hues and of little interest to ourselves as investors. Not so! Whereas the speculator might peruse the financial pages to see how his portfolio is doing, the long term investor must look to the front page headlines. These are the clues to the long term health of his invested capital. The headlines are turning grim!
The Congress hasn’t been able to respond to the President’s invitation to draft an alternate budget, and it’s likely that their final effort will be a patchwork crazy quilt of short term solutions which will create uncertainty for everyone. Not to be outdone, very few Governors and State Assemblies are coming to grips with the new Federalism. Rather, they’ve been spending their energies in non-productive whining and whimpering over the few bones being tossed their ways by the Federal Government. The effects of this will shortly be seen everywhere – even in otherwise healthy regions.
In Florida the new Federalism caught the state just after extensive property tax relief had been provided in a new homestead law. This law exempted up to $25,000 in assessed property value from taxation for owner/occupants. It effectively took about half the residential property off the tax rolls, creating undue strains on the budget. Every State will be affected to some degree as Federal revenues dry up. Unlike the Feds, states can’t print their own money. They’ll have to raise it through taxation or reduced spending. That means social services, maintenance, new construction, and businesses – in fact everything will feel the pinch at all levels.
LONG TERM CAPITAL MARKETS MAY BECOME A THING OF THE PAST
Investors like calculated risks. They leave speculative risks to the swingers. As the economy squeezes out more speculators and entrepreneurs, investors will flee to safer forms of investment such as T-Bills and T-Bonds. With City and State budgets in disarray, their bond issues will require higher and higher yields in order to attract the investors in the competitive capital markets. Remember, the U.S. Treasury must raise $30 Billion each day just to meet its own budget. The depressed economy compounds further the effects of the tax cuts, so the Feds borrow and offer yields in competition with the other borrowers. Spending must be reduced, so government-based business activity will also be reduced, depriving the Treasury additional taxes; hence, less revenue sharing with the state and local governments, less government backed financing for SBA, etc. etc.
Everyone is going to start scrambling for higher and higher yields to offset inflation caused by government deficits. In effect, they’ll be holding up the U.S. Treasury by demanding higher interest rates for their money. At some point the Federal Reserve will begin to print more money rather than have Uncle Sam pay too much interest. This will create havoc in the financial markets like nothing we’ve ever seen before. No one will want to invest long term at fixed interest rates. Banks and S.&L.’s with billions of dollars in long term mortgage portfolios will be unable to sell mortgages or mortgage backed bonds without Federal guarantees and deep discounting. Something will have to give. It will probably be the American public – investors and homeowners. The battle lines will have been drawn between borrower and lender. There won’t be any winners.
DUE-ON-SALE LAWS WILL FORM THE INITIAL BATTLE GROUND
On the one side are the real estate markets for existing homes, investors, retirees, homeowners, transferees, firms specializing in trade-in programs, etc. Their bread and butter is the assumable loan coupled with creative financing which enables one person to sell his property to another without any additional financing from lenders. Availability of existing low interest rate loans which new owners can have access to is of prime concern. Without these, this market dries up. Today’s moribund real estate home market is evidence of this. Without low interest rate Financing, the average American can’t afford the average house on his take home pay after taxes. In some 16 states, courts have ruled that lenders have no right to deprive owners and buyers of the right to assume these older loans. They claim constitutional property rights are at stake.
On the other side are the builders, local governments, lenders, and consumer loan markets. Lenders maintain that their operating losses, caused by their having to pay depositors current interest rates while receiving lower rates from their older loans, must be made up by higher interest rates to new borrowers. Thus they have dried up the markets for automobiles, new houses, commercial loans, and consumer loans. As a result localities can’t expand tax revenues from business activity and new construction and community services must be curtailed to the detriment of all. They base their claim contract law which, in many instances, says that old loans must be paid off on sale.
The Supreme Court of the United States and the Congress are each independently considering this dilemma. Their deliberations could go either way within months with far reaching effects. Prudence requires that we focus on the results and reasonable counter moves regardless of their decisions. It’s folly to guess at the outcome. Far better that we find ways to prosper and to adjust to either outcome in order to safeguard our capital.
SUPPOSE EVERY SALE OF A HOUSE REQUIRED AUTOMATIC REFINANCING UNDER CURRENT INTEREST RATES?
It is estimated that, at the rate new families are forming and singles are entering the housing market that two million new homes and five million existing homes could be sold with 9% interest rates. But at 13% sales would remain 40% lower than they were in 1978. Bear in mind that the Government would still be competing for long term funding to offset Reagan’s budget deficits, so there’s little chance of lower interest. Corporations seeking to replace obsolete plant and equipment couldn’t raise capital in the resultant depressed bond market, hence be less competitive. With decreasing profits, they’d pay fewer taxes. They’d be caught in short term financing tangles that would cause even more business failures and bankruptcies. House sales and new construction will come to a halt, and banks might face hard choices of foreclosing or of IGNORING loan defaults.
Owners aren’t going to take it lying down! Politicians sometimes forget the fact that most people’s entire net worth is represented by their homes. It is estimated that $80,000,000,000 of capital is represented by homes of people over 65 years of age. This is their only source of financial security in the event of failure of either the social security system or of private corporate pension funds. Without a thriving house sales industry, and with home loans at impossible rates, they have no way to get their equity converted into income without non-institutional creative financing. I expect there would be wholesale violations of any law which forbade transfers of property without refinancing. And lenders would be faced with even more lawsuits and foreclosures.
What’s the logical effect upon landlords and investors in single family houses? Remember, 7 million people like to buy houses. Without access to them, they’ll do the next best thing. They’ll rent them. And rents will rise to the highest possible level that competing consumers can drive them to! Even now we’re seeing rent control laws being steam-rollered into oblivion in bastions of the most liberal constituencies. Places like Washington D.C. are experiencing housing pressures as a direct result of militant rent control advocates. Now they’ve run out of housing – and new construction as well. The same thing is happening across the nation. Vacancy rates average only 3%! Investors who have managed to acquire houses prior to restrictive legislation will reap unheard of profits from virtually unregulated rents until construction can be resumed. In the meantime, though the Rockies may crumble, Gibraltar may tumble, people will still pay what is necessary to live in decent housing – at the expense of almost everything else.
Conclusions: Investors should continue to buy as many low interest rate houses as possible until the laws are changed, in decent neighborhoods where middle class people would like to live. Afterwards, they’ll see fantastic opportunities in Mobile Homes and Manufactured housing – especially in parks where they are placed. As competition for fund heats up and the Government prints more money, inflation will drive both rents and values higher and higher.
BUT, WHAT IF THE SUPREME COURT RULED THAT ALL HOUSE LOANS WERE FULLY ASSUMABLE ON SALE?
That could happen in spite of the passage of a contrary law by Congress. The property rights of the individual are at stake in this question. That makes it a matter of constitutional interpretation which would supersede any congressional decision. Here’s what the situation would be: lenders would find themselves with portfolios that might be averaging 8% interest, with perhaps 25 more years before they’d be paid off. In their cries of anguish, they tend to overlook the fact that the money they formerly loaned at 8% only cost them 5%. Instead they, like Monday morning quarterbacks, want to replay the game once they’ve established the new rules. And they’ve placed themselves in jeopardy in expectation that they’d win the due-on-sale battle. They’ve borrowed short and loaned long on their current portfolios of new loans.
We could see a wave of bankruptcies unlike anything we’ve ever encountered! Our credit-based economy is going to administer a beating to its disciples in every walk of life. In the long term mortgage field, it could be a disaster. A person obtaining relief through bankruptcy may not have to make any payments at all on his house loan! Lender bankruptcies would surely follow as one lender bought the assets of a weaker one, the addition of a losing portfolio would in turn bring it down. Failure of a half dozen major banks could exhaust the insurance reserves of FDIC. It could happen over a weekend!
Here again, knowing where the fire exit is before the fire starts is helpful. When a lender is placed into receivership, assets must be sold off as in any other kind of bankruptcy to repay creditors. That means the portfolios of mortgages, property, and business loans would be sold too. As at any liquidation sale, only bargain prices are likely to be bid. It isn’t hard to see how those with liquid assets might take advantage of this situation. And it shouldn’t take a genius to see why we’ve been recommending that funds NOT be left in Savings and Loan Associations or Banks. They’re all vulnerable! As long as the Federal Government is willing to pay top prices to borrow our money, it’s plain good sense to invest in T-Bills (3 months) and Money Market Funds who restrict their investments to government securities. Short term maturities will provide the best flexibility and inflation hedging positions for these uncertain times.
Of course the above scenario is great for those with lots of liquid assets. But what about the little guy? If every house loan in the United States suddenly becomes assumable, think of all those houses in all those states where buyers and sellers have been restricted in their transactions by artificially controlled markets. Consider how the market reacts when price controls are lifted. Prices usually rise at first, and then they subside as competition starts to work. Look at the effect of no-growth moratoriums and condo-conversion moratoriums on markets. When they’re lifted, prices behave in the same way as above. There are two ways to play these events, depending upon your nerve.
What we’ve been experiencing the past 3 years or so has been an INTEREST RATE MORATORIUM which has effectively restricted the supply of housing for millions of people in the market. Brokers who can structure transactions in which low interest rate loans can be assumed will do land office business. Similarly, investors will be able to buy as never before, providing they know how to structure financing which will permit feasible terms. A review of prior letters would be instructive. We’ve illustrated many ways to buy without using much cash, and with terms which will provide monthly cash flow. Let’s not forget sellers. It might pay us to unload houses we’ve depreciated using the split wraparound mortgage formulas to obtain installment sale tax treatment. We’d use the money generated to replace our houses with others on which we can obtain preferential tax treatment under the new ERTA depreciation schedules.
Timing might be critical if we plan on selling, then buying. We should sell on the first blush of unrestricted accessibility to the lower loans while the market is hot, and buy replacement houses when the market cools off a little as demand slacks. Don’t forget that interest rates on new houses will continue to be higher as lenders are placed into financial straits. Therefore, builders will have even more unsold inventory which will be eating up ever more profits as they carry construction financing. With buyers flocking to the assumable loans, prices of new houses should slump, enabling investors to pick up bargains from distressed builders providing they’re willing to pay higher interest rates on any new loans they might have to obtain.
THE GOOD NEWS IS: THAT THERE’S BAD NEWS. . .
The key to being a successful investor is to learn how to make money against the trend. Fortunes were made in early 1929 by those who sold short in a rising market. When the general public perceives an opportunity to make money, that’s not a bad time to consider selling to them at high prices and moving on. I wonder how many people sold their gold, silver, diamonds early enough in 1980 to reap a true profit and sell out? Today, when money is tight and rumors of the real estate crash abounds, decent houses in selected neighborhoods at bargain prices with assumable loans could be the best of all possible worlds for the long term investor. We may be seeing the end of such markets for all time, depending upon the legislation and court rulings.
Right now, good sound mortgages and trust deeds at high discount levels are coming on the market. Beware! Many of these will go into default, or be included in bankruptcy filings. It’s not a bad rule to look carefully at the PERSON who has promised to pay before you look at the PAPER! Don’t lend on anything you wouldn’t mind owning. And don’t lend to anyone you wouldn’t be willing to foreclose on. Sympathy and charity will be avidly sought by many people in the coming months. Give each in full measure, but keep both of them out of your business and financial dealings if you want to survive. Check out all the details of ownership, value, title liens, credit history, security, etc. when buying mortgages. A few dollars spend early could save gross losses later.
It’s not inconceivable that courts, besieged by foreclosure suits, might take a permissive attitude when it comes to enforcing creditor’s rights. I think it a better policy to BUY something rather than to LEND to someone. If you can’t buy a distressed owner’s house outright, then consider buying the ground beneath it, and allowing him to pay ground rent rather than interest. Your security would lie in being able to evict and to possess the property. Plus, as inflation runs its course, you’ll be able to maintain parity by increasing your rents through an indexed ground lease pegged to property value.
And let’s not ignore Option potential. For someone who doesn’t want to borrow, selling a long term option would provide tax-free cash without the drain of repayment. Builders, Brokers, Salespeople, Developers, Mortgage Loan Officers whose incomes are pegged to housing activity would be logical people to approach this way. They’d be able to raise cash discretely while maintaining their lifestyle image. When they make their financial recovery, they can negotiate to repurchase the option. The investor would be able to reap capital gains rather than interest, providing it were structured properly. On the other hand, if it were not repurchased, the investor would get a management free investment, high leverage without much risk, and capital gains when he sold the option to someone else. Or, if he exercised it himself, he might be able to depreciate the property during the life of the option under recent tax rulings.
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