March 1981
Vol 3 No 6
To buy houses in markets like San Diego where the average price of a house sold is now over one hundred and thirty thousand dollars, and a smaller eighty thousand dollar house will rent for only five to six hundred dollars per month?
Obviously it does not if you finance it at today’s high bank interest rates. An eighty percent bank loan at fourteen percent interest would have payments including taxes and insurance of over one hundred and fifty percent of the potential rent. This three hundred dollar plus loss would only make sense to an investor in the highest tax bracket, and then only in the event that he or she could feel comfortable with the monthly negative cash flow.
What about the same house, this time with an existing, assumable one year old loan at a twelve percent interest rate. By now the house would probably have around thirty thousand dollars in equity because of the appreciation in value it has enjoyed for the past year. This eighty thousand dollar house with a fifty thousand dollar existing loan has definite potential as an investment, in the event that you can structure the financing so that you can comfortably afford the down payment, if any, and the monthly negative cash flow, if any. The lease-option and single payment note formulas work well with these high equity, low payment situations. In addition to these basic formulas, we have added several new ones to the seminar, which deal with the high equity positions which are encountered so often in today’s market. In no event should you obligate yourself to make payments which are in excess of the cash flow that the property will produce, unless you are buying at a price substantially below the market, and you have the cash reserves to make these payments.
Areas where the average house now sells for over one hundred thousand dollars, have experienced much higher than average appreciation during the past ten years. When I say “average house” I am not referring to the price of the average house sold which will be far above where the average family lives. The price of the average house sold comes from statistics furnished by Realtors and bankers. These people are rarely involved with the very inexpensive houses (say thirty thousand and below) because they are all owned and sold without brokers and bank assistance. They are involved however, in the expensive sales, and the reporting of a few million dollar sales along with hundreds of average home sales, distorts the figures on the high side.
Investors who live in these areas are constantly bombarded with information which documents that the market has peaked and is now no longer viable for long term investment. One such pessimist, John Wesley English, (The Coming Real Estate Crash) claims that house values have already dropped drastically and supports his claim with statistics supplied by the Federal Home Loan Board. English points out that the “average” prices of single family homes is down from 1980 peaks as follows: Atlanta-down $6000; Baltimore-down $8800; Chicago-down $14000; Denver-down $20000; Philadelphia-down $16000; Kansas City-down $18000; Washington, D.C.-down $21500; L.A.-down $23000, and poor Seattle-down nearly $27000. Before I go further, anyone who purchased a house in an average area by my definition, in any of the above areas who would like to sell to me for what they paid for it at any time last year less the above stated depreciation in value, please call me collect, I am available.
Marshal Kaplan, an economist with the FHLBB, states that English has misused the actual facts to support his premise. He has taken an unusually high figure from last summer (remember the flurry of activity when the rates dropped from all time highs to a much lower rate last summer) and compared it with current sales figures (winter time and high interest rates). To quote Kaplan “We would never take an unusually high monthly sales price average – a sudden blip up to $125,000, say in a market where prices tend to be in the equity to ninety thousand dollar range and then define it as some sort of peak – That’s ridiculous!”
“Nor would we accept an unusually low monthly sampling figure for a market – like $75,000 in a city with a normal average of over $90,000 – as some sort of indication that prices were dropping through the floor.” In fact Kaplan stated that the average sales price in the Bank Board’s surveys went from $69,500 in 1979 to $78,800 in 1980, a 13 percent jump in 12 months. Through December of last year the average house nationwide was advancing in value at the rate of over sixteen percent. Remember, there is no way to make long term profits as a pessimist. You can sell short in the short run, but you will never pyramid to real wealth. Knowledge of your product and your area will give you the confidence to continue to buy when all around you are selling. These are the days which the confident will prosper, and the poor man who refuses to educate himself and plan his long term future will get what he most fears, a poorer tomorrow.
One of the arguments that most of the real estate critics use to convince their followers that the market will collapse is that everyone will bail out soon because the prices are artificially high. There is a lot of psychology that these writers miss, because they have never owned any good income producing real estate. (One even recommends land, preferably out of the country, as the best real estate to own).
What do you get when you sell good income property? Either cash, which must be reinvested, or a note which will produce income at a fixed, or variable rate, depending on how smart you are and how easy the buyer is. You must always realize that when you drive too hard a bargain, you will ultimately end up with the property again, and often in much worse shape than when you sold it.
Let’s analyze the results of the sale of an $80,000 house, which I purchased three years ago for $50,000, and on which I still owe $45,000 at 10 percent. This house now rents for $550 per month, and the payments including taxes and insurance are $475 per month. (The people in Massachusetts will have to adjust the cash flow figures to allow for your obscene property taxes). The house is currently net leased to a good tenant, and is not a management or maintenance problem. My original investment of less than $5000 is now worth about $35,000, but that is history. What can I expect from my investment next year?
This Year Next Year
Market Value $80,000 $88,000
Cash Flow $900 (75 per mth)* $1500 (125 per mth)*
Taxable Income ($1100) ($500)
Tax Savings
(50% Bracket) $550 ** $250 **
*All tax sheltered
**In addition to cash flow
In the event that I decided to sell the house several thousand dollars of my equity will disappear to the tax man and to closing cost and commissions, not to mention the amount of rent I will lose as a result of displacing the tenant and sprucing up the property. It is a real mistake to try to sell a property which is rented, unless of course you sell it to the tenant. The only exception to this rule I have found is when you rent your house to a hot shot real estate salesperson, with the understanding that it will always be listed with them for sale. Of course you list it at an optimistic price and raise the price every six months or so to keep up with inflation. In the event that the salesperson has nice furniture and is a good salesman, he will more than earn his commission. An average tenant on the other hand will resist a sale, as it is costing them their home. No one likes to move, and especially from a nice home at low rents, into the cruel world at higher rents.
Below is the probable net result of a sale of the house, on cash to mortgage terms at full retail price.
Gross Sales Price $80,000
Less: Commission of 7% $5,600
3 Months Payments 1,425
Spruce Up Costs 1,000
8,025 8,025
Gross Sales Proceeds 71,975
Less: Capital Gains Taxes
Est. $28,000 Gain x 40% x 50% – 5,600
Existing Loan Balance – 45,000
Net Cash Available for Reinvestment $21,375
In the event that I chose to keep the house this year, it would have yielded $1,450 in after tax cash flow ($900 cash flow plus $550 tax savings) plus a projected increase in value of $8,000 (using a 10% simple appreciation factor). That totals $9,450, so that in order to match this investment, I must reinvest the $21,375 I realized from the above sale at a rate of over forty-four percent.
I concede that forty-four percent is not an impossible return to obtain using leverage in a buyer’s market. But why would you want to disturb an investment which is doing you so much good, with such little effort? Intelligent investors who own properties like those described above will continue to refuse to sell their properties and hide their money under a rock somewhere in fear of an economic disaster for one simple reason. They are making money so fast and furious that no one can afford to ride out a depression. Plus, many of them share my opinion that the chances of a severe depression this year are about one in fifty, and in the next four years maybe one in ten. Anyone who bets against those odds is the real gambler.
At a recent meeting of investment advisors from across the country Don Tauscher, a converted bank president who instructs an excellent class on creative banking techniques, had several comments on the recent changes in the law which effect the operation of banks and savings and loans. In addition to the much publicized interest bearing checking accounts, the savings and loan associations can now offer installment loans and lines of credit, similar to commercial banks. This is breeding much competition between the banks and the S & Ls for these loans which are much more profitable than the long term mortgage loans which the S & Ls were previously restricted to.
We traditionally think of installment loans being used to purchase cars, equipment, and other items which are relatively liquid in the event the lender has to repossess them and which have short term useful lives. Don has discovered a new use for these loans, and is now using his installment loan department to hypothecate paper. Hypothecate in this context means to pledge as collateral without giving up the title to the paper.
For example, let’s assume that you sold one of your houses which was a management problem, to your tenant or another buyer, on terms. Using a contract for deed, a wraparound mortgage, or all inclusive deed of trust, you sell the house on the following terms, at a relatively high price and for a relatively low down payment:
Sales Price $50,000 (Real Market Value Mid Forties)
Down Payment – 5,000
Balance Due You 45,000 @12% payable $450 per month
Balance You Owe 32,000 @ 8% payable $250 per month
Cash Flow Each Month $200
You have sold your problem house for a nice profit, and have increased your monthly income substantially from the gross rental income you realized before. However, now you have thirteen thousand dollars equity in a piece of paper will be ravished by inflation. In the event that you approach the commercial loan department of your bank they will make you a loan only for one year, and probably will loan you only half or less of your equity in the note. The installment loan department will evaluate the paper on not only its security, but on the cash flow it produces each month. They typically have loan limits of twenty-five thousand dollars, and look for an 80% loan to value ratio. In our example the property is worth $50,000, the sales price, and I owe $32,000. The bank will want to limit their loan to 80% of $50,000 or no more than $40,000.
Approach your installment loan department on the basis that you have a contract or note receivable which pays you $200 each month for five years, and that you would like to pledge those payments and the contract for an installment loan with equal payments. They will then compute using the current increase rates, say 20%, that a loan in the amount of $7548 will be completely paid off in five years with the income from the contract. In the event they loan you that amount, their total exposure will be only $39,548 (the total of what you owe $32,000, plus their loan to you), less than their 80% limit, based on the value of the house.
This money comes to you tax free, as it is borrowed money. Should you have sold the contract to a mortgage broker, you would have a tax liability for your profits, and would probably sell to them at a much higher yield than 20% you are paying the bank. In addition, you still have a balloon coming in five years of over $15,600. In the event that you know an investor who does not need the use of their money for five years and would settle for a 25% compounded yield, they would pay you over $4,500 cash today for the right to collect that balloon. A pension plan would be a natural buyer. Should you sell off the remainder interest in the balloon, you would have pocketed over $12,000 cash, just a little less than your full equity in the contract. That is powerful and we thank you Don Tauscher for that contribution. For information on Don’s class where you will get a day and a half of goodies like this write Don at Box 1384, Winter Park, FL 32790.
Many students have called in recently with plans to implement a form of the SAM, shared appreciation mortgage, which has received much publicity in recent months. Be aware that several state attorney generals are studying this new concept to determine whether or not the usury statutes will apply. The penalty for usury can be crippling. You can obtain the same profits as with the SAMs using a joint ownership plan where the owner of the house will sell you partial interest in the house for your note, with which he can make part of the payment. I will elaborate more when I have more space, in the meantime proceed with caution and a good lawyer.
A couple of short subjects: A recent study at Harvard University has concluded that “good luck” is directly related to your state of mind. Two groups were given identical tasks to perform. One group was convinced that the odds were against them and they all failed. The other group with the same tasks and talents were told that the odds were strongly in their favor, and you guessed it, they were successful. A negative attitude slows your reflexes, dulls your perception, and makes you less attractive. Keep smiling and looking up and you will have more reasons to with each passing day.
B. Ray Anderson, Howard Ruff’s attorney, has just published the best book I have seen on estate planning for investors, titled “How You Can Use Inflation to Beat the I.R.S.” (Harper and Rowe $14.95) It is comprehensively, timely, and easy to understand.
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