January 1986
Vol 8 No 4
Over the past few months I've concentrated on 'THE B-I-G PICTURE' – macro economic phenomena, Banking, Taxes, sunbelt and regional opportunities. What about the little guy? Where does he fit in? That's what many of your letters have been concerned with when you've written to me. You're not interested in MILLIONS. You want to know how to survive, to get started, to earn a small profit today, to protect what you have, to avoid scam-schemes promulgated by the quick-buck artists on T.V. This letter's for those of you who haven't made your million dollars in your spare time yet.
So what has this got to do with cockroaches? When it comes to being able to survive and to expand its base of operations, nothing has ever surpassed the lowly roach! Despite massive chemical warfare, I still find them in every house that's vacated. In New York's Museum of Natural History, they used to point tourists' attention to a pickled roach installed between the toes of their biggest dinosaur to demonstrate that roaches had survived virtually in the same form from the period BEFORE dinosaurs stalked the earth.
How has it survived so successfully for millions of years (Remember, man hasn't been here 1% as long as roaches.)? There are several factors involved that we can all learn from. (a) It never challenges anything bigger than itself. (b) It stays out of sight. (c) It can survive for long periods under adverse conditions or in a hostile enviroment. (d) It's fast and elusive. It doesn't leap tall buildings. Rather, it slithers through small cracks. (e) It forms large colonies and reproduces itself swiftly. And last of all, it can make a meal out of almost anything that's organic, regardless how unappetizing.
What can we learn from all this? That the small investor/entrepreneur has to be adaptable, maintain a low profile, be prepared to move quickly when either an opportunity or danger presents itself. Be willing to consider a range of opportunities rather than specializing on 'paper' or 'houses' or 'multiples' or 'foreclosures' or 're-habs'. And we have to avoid hostile environments which are high on risk and low on reward.
I receive hundreds of calls over the year from people who ignored that last line. Possibly the most hostile of all enemy territory can be found in lending institutions! We've been pointing that out for years, yet readers persist in flirting with disaster and in getting wiped out because of bad financing or because they bought property encumbered by mortgage loans with due-on-sale provisions. Why? I think it's because they aren't patient enough. They're in a hurry to secure 'bragging rights' to a large number of assets They use NEGATIVE CASH FLOW to generate zero income taxes. They fail to realize, when one has zero income, zero taxes automatically follow. So does poverty and financial ruin.
Several years ago I wrote a booklet called WINNING which I've been giving away to those who bought complete sets of back issues. It isn't for sale, so please don't ask. In it are some basic axioms for business. Maybe I should quote some for you in regard to this month's letter. Here are some. I've numbered them as they appear in the booklet.
32. Winners not only achieve success; they retain success in good times and bad.
41. Success rests on patience as much as on skill, talent, nerve, money or energy.
47. When there's low inflation, lay-away is more profitable than leverage.
51. Anytime interest costs more than after-tax net income PLUS growth, you go broke.
Copyright 1986 CommonWealth Press, Inc.
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Jack Miller's CommonWealth Letters are published monthly.
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61. Institutional financing locks borrowers into the most competitive sector of the market.
CASH FLOW REMAINS THE KEY TO SURVIVAL AND PROSPERITY . . .
Be patient! Be willing to run down myriad opportunities and rumors finding good deals, and TURNING DOWN marginal propositions. Regardless of any changes in the tax laws, a house should be capable of supporting itself from income it produces. TERMS ARE MORE CRITICAL THAN PRICE when it comes to cash flow. Here's what I mean. Mr. Wheeler can buy with nothing down a $75,000 house for $70,000 in a distress situation. He gives the owner a Note secured by a 2nd lien on the house for the entire amount at 12% with payments of $700 per month plus taxes and insurance which cost another $100. Rents are $650 but with nothing down, he's only paying $1800 per year in negative cash flow each year, right? Wrong!
He's forgotten bad checks, vacancies, maintenance, vandalism, eviction costs. And he is prone to continue buying more houses using the same logic, forgetting that his RISK will be COMPOUNDING with each subsequent deal. He'll probably structure in BALLOON payments in 5 years or so, and if he's like many people, they'll all fall due within a short period of time. He's forgotten that he'll look less and less attractive to the lenders as his loan liability continues to increase with each deal. If he's typical, he'll have creatively financed his ventures to evade the due-on-sale clauses and locked himself out of all but the refinance market. That will limit his ability to sell his property or to refinance it. In the last few years, this type of entrepreneur has been wiped out and forced into BANKRUPTCY by the thousands. He didn't understand that 'NET WORTH' won't pay the bills. Only CASH will.
Mr. Walker, on the other had, patiently goes about his task of finding houses he can buy 'right'. He uses cold-canvassing of neighborhoods by telephone and on foot, 'bird-dogs' whom he pays to find him deals, loan servicing agents, Brokers, etc. He turns down many more properties than he buys when he can't get the financing he wants. He too finds a house like Mr. Wheeler, but he pays $5,000 down. He raised it by selling a previous house he'd bought and keeping a 'spread' between what he'd agreed to pay and what he required of his buyer. Because he's using cash, he gets a $65,000 price and owes $60,000 at 9%. His payment is $535 paid out over 20 years plus $90 for taxes and insurance. It's less because of his lower interest rate, lower loan balance and lower price against which taxes and insurance are based. Each month he builds in a spread of $35 which he saves as a buffer against costs.
Sure, these are just ficticious examples, but I think they represent true market situations you'll encounter. Remember, Mr. Wheeler wants 100% leverage. Mr. Walker wants SAFETY. With the same management results, they have a spread of $2220 per year in CASH FLOW. Put another way, Mr. Walker realizes $2220 more than Mr. Wheeler for his $5000 down payment, or 44.4% return on his cash invested PLUS a much more viable investment. And he'll continue to get it EACH YEAR while he owns the property. When rents increase enough for Mr. Wheeler to break even, Mr. Walker will be receiving $2220 per year cash flow. Mr. Wheeler will never catch up because he didn't understand the arithmetic Of course, there are many other ways Mr. Walker might enhance his position by structuring even better terms. If you'll take a stroll down memory lane in your back issues, you'll see almost a hundred of these. We'll be discussing them in detail at our 1986 CommonWealth Conventions announced on the back page.
I GET BY WITH A LITTLE HELP FROM MY FRIENDS . . .
Networking is the name of the game for the little guy. By cooperating, instead of competing, small investors can survive among the giants. In each of my seminars I stress the importance of getting to know one another and staying in contact after the class. Locally, this means sharing leads on purchases, good tenants, bad tenants, reliable workmen, managers, and emergency sources of funds. Out-of-area contacts are also important. One of my most profitable transactions was between myself and another investor I'd met at a seminar from Massachusetts. There's no way I could have made that profit without his help. In my town I regularly share opportunities, information, experience with those who share with me. I know if I expect to get help that I'll have to give it too. That's the real key to cooperation.
LEARN TO BE A SWITCH-HITTER . . .
Some pitchers have trouble striking out batters who bat left handed. Ditto for other pitchers against right handed batters. So to get on base and to score more runs it pays to be able to bat right and left handed. It can work the same way for the small investor/entrepreneur.
Let's take two obvious scenarios: INFLATION and RECESSION. Both are possible in the next 3 years. They breed each other over a time, so you need to know how to work with each. Today, we're sort of in the eye of the hurricane. Relatively calm but ominous. If recession should strike first, and IF WE'VE PREPARED FOR IT, foreclosure opportunities will abound. Some 'paper' will be good and some will be bad. How can you tell? It depends on several factors. QUALITY, QUANTITY, and DURABILITY. Quality refers to the probability that you'll get both your principal and interest repaid. And this in turn relates to the desire and ability of the person who owes the money to make required payments on time. Why will he? Here again from the WINNING booklet:
3. Lend money first on CHARACTER, then on collateral and finally on yield.
68. Marketable paper must be transferable, guaranteed, secure, seasoned, personally endorsed by a good credit risk, have no problem loans senior to it, have a high yield.
86. Greed speaks louder than logic. If it sounds too good to be true, it might be.
89. Nobody ever bought groceries with yield. It takes cash or credit.
90. Generally, yield and cash flow are at opposite ends of the seesaw.
The bottom line is, that your paper is only as good as the payor and the property securing it. So you have to decide when buying 'paper' whether you expect to receive the income or the property. Money owed by a person with an excellent credit record and enough income to make ALL THE PAYMENTS on time will probably be purchased for its cash flow yield. On the other hand, money owed by a poor credit risk who is in financial trouble will only have a value equal to the property interest which secures it. So it should only be bought at a price reflecting a small percentage of that value LESS any legal costs which might be incurred during the foreclosure process and rehabilitation of the premises if they're in need of repair. The true value will relate to the present value of AFTER SALE NET CASH.
Let's talk about QUANTITY. The magic of 'paper' is that it isn't worth what's written on it. Each investor has alternative opportunities to spend money in the market. Recently the stock market has presented the highest profits for those who guessed right. In the paper market, one must first establish the yield one wants. Then this is applied as a DISCOUNT factor to arrive at the PRESENT VALUE over the life of the loan. So you have to focus on the AMOUNT OF EACH PAYMENT and the NUMBER OF PAYMENTS as well as your desired YIELD in order to find the value. You'll need a calculator which does mortgage amortization to compute this. And the value you arrive at should be the MAXIMUM price you'd pay for 'paper'. Anything you can do which would cause the 'paper' to be paid off early can increase your yield IF you intend to re-invest the money in another investment of equal or greater yield. Beware though. Yield computations are valid only if all payments received are re-invested at the same rate. If you intend to live off the proceeds of your paper they'll be too high.
What does DURABILITY mean? It's a measure of the constancy of the income. And relates to the certainty that the income and purchasing power will be predictable over the life of the loan. Even after you've certified the character and ability of the maker to pay the payments, you still have to deal with natural disaster, war, inflationary impact, currency devaluation, etc. It's folly to think 'paper' is less complex than 'property'. But, as long as the income remains constant, 'paper' is an ideal vehicle with which to ride out a recession. However, if the maker loses his income you'll probably lose yours too and he forced to foreclose the property. Then you'll either have to rent it or sell it in the same recessionary cycle. That's why you have to take care in buying 'paper'.
In a recent case, a $14,000 2nd Mortgage was offered for sale at $1,000. It was secured by a owner occupied house in another state. Payments on both the 1st and 2nd were too high to make the property practical as a rental. This made it imperitive that both the value of the property as well as the payment records be examined closely. This revealed that NEITHER mortgage loan had had a payment made for 6 months, however the property seemed in good condition which might justify a sale price well in excess of the mortgages. Thus, the only reason to buy this 2nd mortgage at such a drastic discount was to generate a sale through foreclosure. Why hadn't the 2nd mortgage holder done this? Because he was out of the area and couldn't determine these facts for himself. More importantly, he hadn't made an effort to cultivate the acquaintance of others who could do it for him. Here's where the entrepreneurial network paid off. By sharing the profits among local people, what seemed a hopeless situation to the 2nd mortgage holder became a true profit opportunity to others.
In an INFLATIONARY scenario, 'paper' is a no-no unless it's been INDEXED to the inflation rate as has been explained in prior letters. Why? Because the dollars loaned today are repaid with dollars which can buy less at a later date. Inflation drives DOWN the value of fixed income and drives up the value of TANGIBLES such as houses. Lenders pay the price of inflation and borrowers profit from it so long as they don't sign indexed loans. This has the effect of drying up the foreclosure market somewhat, increasing interest rates, drying up credit while making houses more and more expensive for the buyer/renter. It makes sense to control as much inflationary profit as you can through leverage. And the least hazardous leverage is obtained through the use of OPTIONS, low fixed interest rate loans which are fully assumable (obtained from owners who carry back the financing) and purchase contracts which are contingent upon some future event such as re-zoning, financing, or some improvement. This is a great time for the small investor to get involved in RE-HABS.
Most foreclosed property needs repair. Most lenders don't like to tie up funds to do it. Most amateur buyers are 'turned off' by run down property. Most young people and retirees find house prices to be too high for their budgets. Some of the best buys are in the area of 'as is' houses which need repair to be habitable. Tax laws are favorable in the case of someone who buys a property to fix up and sell, but who occupies it or has a family member occupying it during the renovation. Put these all together and they spell PROFIT from fixing up properties to use as rentals or to re-sell.
Here are some things to remember: First, don't over match yourself against the job. Avoid massive repair jobs and concentrate on cosmetic touches. Remember, you'll need to find financing or use your own money during fix-up and you'll need to find financing when you sell for your prospective buyer, or you'll have to carry back financing yourself. Don't look for older obsolete houses in run down neighborhoods. These can be real traps in which you have to up-grade EVERYTHING to new code specifications at great expense only to find no one wants to pay the price to live in an older property. One of the most lucrative deals I've heard of involved NEW HOUSES taken back by the lender from a defunct builder. They had to be finished. And the bank loaned the money on assumable financing for fix-up to get them sold.
THERE WILL BE TERRIFIC OPPORTUNITIES IN 1986.
Hopefully, by now, you've refinanced all those bad loans with the lower interest rate fixed financing now available or sold the properties and bought others with better in-place financing you could assume without personal liability. Investment analysts are saying we'll have both inflation and recession, high and low interest rates. They're arguing more over TIMING than as to the probability of only one scenario versus BOTH in the next year or so. With this in mind, you'll be able to work both sides of the street, buying from those who won't chance recession and selling to those who are betting on inflation. We'll be there with you. We've got a new line up of seminars starting in Ft. WALTON BEACH in FEBRUARY we'll plan on a dozen MILLER TIME 2-day courses on the basics. We'll do only 2 or 3 HANDS-OFF MANAGEMENT classes in 1986. There will be a PORTFOLIO STRATEGIES class in ORLANDO in June, and by popular demand, we're bringing the OPTIONS old class back in late fall near L.A. We'll have 2 COMMONWEALTH CONVENTIONS for subscribers only, in S VEGAS MARCH 7-10 and in the Fall in the East. Your survey results are going to bring us into new areas with different material to help you to cope with the changes in our markets in 1 profitable way.
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