Vol. 24  No.  1

September 2000

BUYING “BARGAINS” CAN BE EXPENSIVE . . .

 

Everybody likes a bargain, especially me; but how do you know the investment you’re making is a bargain or not?  When you’re able to buy something for less than you could have at another time?  When the price you pay is less than the price at which it is assessed for property tax purposes?  When you can buy it for a price that’s less than the price your friends paid?  When you buy it for a lower price than something similar to it?  When the seller tells you you’re getting a real bargain?  When it sells below appraised value?  Suppose I told you that all or none of the above could be true?

 

It’s not necessarily a bargain when you’re able to buy something for less than you could buy it at another time.  What we perceive as a bargain may represent merely our willingness to pay for less in order to get less.  If we buy close-out merchandise, we don’t get much choice as to selection of color, model, style.  We may wind up with shop-worn articles, and there may not be an owner’s manual or a dealer warranty.  If we buy at the end of the season, we don’t get much use out of what we buy until the next season.  If we buy on “sale days”, we have to compete for what we want with other buyers, or may have to settle for something that isn’t exactly what we would have bought at a higher price; such as discount airfares.

 

When we purchase a product, what we are really buying are various economic benefits that it confers upon us.  These benefits are broken down into various kinds of “utility”.  For instance, if we buy a tool, it has “functional” utility if it makes a job easier, faster, or more economical.  If we are able to buy a product just at the time that we need it, this is called “time” utility.  If we buy a part to fit a particular assembly, this is called “form” utility.  If what we buys performs satisfactorily, that represents “function” utility.  If we can have it delivered where it is needed, this is “place” utility.  Production costs of American workers are the envy of the world primarily because of our capital equipment and the concept of “just in time inventory”.  The right parts and materials are delivered to fit into products precisely where and when we can use them to produce other products.  Thus we can see “time”, “form”, and “place” utility in practice.

 

To illustrate further:  A farmer walked into his rural general store to buy a hand pump because the pump at his farm had failed, and they were short of water.  When he asked the cost, he was told $109.  He complained to the owner that he could order one just like it on sale from Sears for $85, the store owner asked him why he didn’t buy it.  He replied that it would take Sears two weeks to deliver the pump.  This wouldn’t do.  He needed a pump now.  That illustrates why a bargain isn’t a bargain unless what you buy meets your needs.  I still find myself chasing sales to buy things at bargain prices that I might not use for years.  With relatively inexpensive goods, timing isn’t too costly, but what about a car?

 

Suppose you routinely bought a car every four years.  If you buy a 2000 car after the 2001 cars come out at the end of the model year, you will pay less, but you will get less when you sell it or trade it in for a new car in the same month in late 2004.  Why?  There would have been a 5 model years between your car and a new car; 2004, 2005, 2006, 2007, 2008.  Your car price will have been discounted by the market as if you’d driven it an entire year longer.  Dr. Lucas had all kinds of charts and grafts to prove that the best new car bargain is to buy the first model you can as early as it comes out.  You’ll pay more, but if you had bought a 2000 car in August of 1999 and sold it, or traded it in on a brand new 2008, you would have had an additional year’s use out of it while it depreciated at the same rate as if you’d bought it in late 2000.  In terms of rates of depreciation, you can buy a car coming off lease with about 25,000 miles on it every two years and pay a lot less, but you’ll be driving a car that will have had 2 years of service and value used up.

BARGAIN HOUSES MAY NOT BE ALL THEY SEEM . . .

 

Place, form, function, and time utility also apply when buying houses.  Place is most important, so we’ll deal with that first.  The place where a house is located usually has more influence on why people buy than other factors.  Families like to buy homes within their budgets near work or good schools.  Despite this, developers in search of cheap land have created housing tracts that extend for 20 miles from the city center.  Although the initial cost of rural agricultural land when bought by the acre costs less, what about the infrastructure costs of roads, curbs and gutters, sewers, gas lines?  What about the time required to obtain necessary zoning changes and permits?  Impact fees?  Interest?  Property taxes?  These all add to the costs of converting undeveloped land into housing tracts.

 

Once a tract has been developed, it is then sold to builders.  The price they pay must have all the other costs factored into it.  In some areas, builders have to build parks, schools, and even low-income housing in order to get building permits.  They’ve got the same costs of interest and land taxes to which insurance, OSHA, payroll, marketing, and financing and interest rate “buy-downs” must be added.    Because of their distance from urban amenities, these homes can’t command the higher prices that more conveniently situated homes can.  Still, they sell fairly well because the ultimate home-owner/consumer perceives them to be a bargain compared to homes for sale that are closer in to the city center, and financing is easier.

 

So, the homeowner moves in to his “bargain” home and starts spending more money immediately.  He may have to buy another car, with all the additional costs of fuel, maintenance, financing, fuel, etc. to use to haul kids to distant schools, or for everyone to get to work.  Trips back and forth for groceries and social activities may rob the family of hundreds of hours a year.  And when he sells, even though shopping and schools may have moved closer as the population grew, he will still have to pass on a “bargain” to the next buyer in order to get him to buy a house that’s not in a more convenient place.

 

Possibly a properly managed and financed mobile home community is the most rewarding real estate investment.  Depending upon State and local restrictions, within this community there can be myriad profit centers.  New mobile homes can be sold and financed.  Older homes can be taken in trade and re-sold.  Profitable mobile home maintenance and repair services, sales and services of appliances and accessory equipment, mini-storage, lawn maintenance and landscaping services, electrical, gas, water and sewer utilities, child and elder care services, recreational facilities, boat and RV storage, mobile home rentals and/or rent to own operations, tours, etc. can be offered at a price.

 

Why doesn’t everyone own a mobile home community?  Because land use, density, and zoning restrictions in many areas make developing a mobile home park too expensive.  In other areas in which a mobile home community would ease housing and enhance the tax base, local residents vote against them.  In one instance, after almost two years of planning and courting of the local residents, approval for a planned mobile home community was denied by one vote of a council member because of feared political repercussions.

 

For this reason, quite often, the areas with the fewest restrictions also are sparsely populated; and/or located outside of normal commuting distances from work for the residents.  Trying to walk the knife edge between locating a mobile home park where costs of development are feasible, yet being convenient enough to residents to make them want to live in it is tricky.  I recently turned down a chance to buy a park for under $4000 per a space.  It was located just a little too far away from jobs to attract residents, and had been vacant for 16 years.  The original developer hadn’t understood “place” utility value.

 

Land speculation involves the same kind of arithmetic.  It has to be close enough in for growth to reach it in a reasonable time, yet be far enough out to be relatively inexpensive to buy, and to hold until it can be sold for a profit.

TIME WAITS FOR NO MAN . . .

 

Money has the capacity to earn money every day.  Anytime that we don’t employ it to do this, there’s a cost whether or not we perceive it.  One persistent myth is that, without regard to income taxes, free and clear property costs less to hold than leveraged property.  The pre-tax costs of holding each is roughly the same; but free cash flow produced by each will be different.  Let me explain:

 

Suppose two people owned two identical $100,000 houses; one free of debt, and one is 100% leveraged at 8%, the prevailing long term mortgage interest rate, whether borrowing or lending.  Each rents for $850 per month.  Operating costs on each are the same.  Monthly principal and interest payments on the leveraged house are $733.78.  On a yearly basis, the first year, interest alone will cost $8,000.  Let’s assume that after all operating costs and financing payments, that income exactly matches outgo.  The free and clear house will produce $733.78 more pre-tax cash flow than the leveraged house.  If the income isn’t reinvested, but held, holding either cash or equity will cost 8% per year in the form of foregone income.

 

When an asset isn’t producing a return, there are costs of ownership.  These might include physical deterioration, functional obsolescence, inflation, insurance, repair and maintenance, insurance, management, property taxes, down-zoning, loss of market value, demographic changes, etc.  Although these may not all be prevalent in all kinds of properties, some of these are always a factor of ownership in every investment.

 

Making a profit by investing in land, precious metals, non-dividend-paying stocks, and a free and clear personal residence depend upon the occurrence of a rise in price that you can’t control, then being able to sell in time to capture gain.  While you’re holding land, interest and taxes have to be paid.  When you do sell, you trigger income taxes on your gain.  In the interim, there are “opportunity” costs to consider.

 

What are opportunity costs?  Once, I had an opportunity to buy a fully rented small mobile home park that produced $1200 net annually per rental space for only $2500 per lot.  A balloon payment was overdue and the owner was forced to sell.  A month earlier, I’d spent all my cash buying raw land “in the path of progress”.  Otherwise, I could have snapped up this park.

 

In so many words, the opportunity cost of speculating in land was 48% per year return.  It’s doubtful that land anywhere would produce that long term  yield.  The moral of this story is, that if you’re going to speculate in something that doesn’t produce a return, it should be highly liquid, or you should only hold it a short time.  Otherwise, the opportunity cost could be far greater than your profit.

 

Because the time interval between investment and return of and on investment has a direct bearing on yield, buying and selling at the right time must be balanced against obtaining the best price and terms.  When buying at deep discount, you have to take a hard look to estimate when you’ll be able to sell in order to be able to calculate how much to pay.  The later you’ll be able to sell, the less you should pay.  Here’s a case in point:  In 1987 I was able to buy 20 acres of land zoned for apartments from a bankrupt lender for $50,000.  That represented about 25% of appraised value.  I thought I could sell it quickly for about 75% of fair market value for $150,000, tripling my money and giving me a quick $100,000 profit.  As frequently happens, my plans didn’t work out quite that way.

 

I allowed greed to blind me to the realities.  What I failed to perceive was that the same economic downturn that had caused the lender to fail, had made it impossible for builders and developers to borrow the cash to buy my land at any price.  Consequently, I held that land for 13 years.  If I were able to sell it today for $200,000, my compound annual yield would only be about 8% once 13 years of property taxes were deducted.  I’d have done much better paying more for something I could sell more quickly.

BUY HOUSES; BUT SELL OR RENT HOMES . . .

 

Usually, in the ideal home, “form follows function”.  The floorplan is laid out to create the most practical and enjoyable living environment within the limitations of budget and building code requirements.  Designs are a compromise between the most desirable plan and living and lot space limitations.  But, architects can make mistakes when they design floorplans at random for magazines.

Here’s what I mean:  I live in a house with a view, but, others on my street live in houses that fail to exploit it.  Why?  Because the plans were drawn up by an architect who didn’t know the site and the potential view.  I’ve been watching a small manufacturing firm try to bring a new concept manufactured home to market.  Somewhere along the lines, the engineers took control of design.  As a result, they’ve designed a sturdy little house that can be built at a competitive price, but they left out the human factor.  Homeowners buy houses, not engineers or accountants, thus, when a house doesn’t appeal to a potential homeowner, it doesn’t sell.  In other words, function hasn’t followed form.

 

When they use standard plans, for all of the above reasons, builders sometimes build houses that people just don’t like for one reason or another.  It’s very tempting for the unsuspecting opportunist to swoop in and buy these “left over” houses at a price below builder’s cost, but this often backfires.  If a builder, with the advantages of financing and marketing can’t sell a house, there’s every possibility that the entrepreneur won’t have any more luck.  Time again becomes a factor in how much profit will actually be gained waiting for these houses to sell.

 

Adapting form to function offers fixer-upper opportunities.  One fellow I know bides his time rather than rushing in to bail out builders.  He let’s the opportunist try his luck, then, if he fails, buys from him in turn at even lower discounts.  He only buys houses that he can reconfigure to make them more livable.  A small house with three tiny bedroom and one bath built for a young family might be converted to two larger bedrooms and two baths and marketed to empty nesters and the retiree generation.  A small kitchen and family room might be converted into a “country kitchen” and sold to large families.  Or the reverse could be done to appeal to those with fewer children, and the need for a family room.  Garages can be turned into extra bedrooms, rec-rooms, or separate living facilities for elderly relatives; even rental space to generate extra income.

 

Improving form and function by adding space can also increase value and income. I once owned a 4 bedroom, 3 bath vacation home situated on a steep hill.  It had a partially completed cellar with an additional bath and outside door.  At a cost of less than $10,000, I cut windows into the “down-hill” wall, replaced a large window with sliding glass doors and a small balcony, and cut back into the hillside to add 600 square feet for a bedroom, kitchen, and work space.  This increased the value of the property by $60,000.  I added $8000 per year to my own income by renting the space I’d created, and at the same time acquired a paying caretaker and watchman for when I wasn’t there.

 

A capable manager might buy a bargain that could be overpriced to a neophyte manager.  A true bargain occurs when a property can be bought at a price, or on terms, that will enable the buyer to recognize more profit than the market usually provides.  In order to achieve this, the buyer has to be aware that he may be getting less than bargained for once all the various property “utilities” have been summed up.  The total return from a house would include both the net income stream and profit on sale.  Much of this will depend upon sale terms as well as management skills.  Many variables must be factored in to arrive at the total:  Location, price and terms, general appeal and suitability of what has been bought, timing of the transfer of purchase money, production and receipt of net rent, principal and interest on sale, and any lost opportunities that might have been a better investment.

 

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.