May 1991
Vol 14 No 7
Have you ever noticed that certain people always seem to be able to get a better deal when they buy or sell? Oh, there are always the fish stories about the one that got away. And there are those once-in-a-lifetime transactions that happen from time to time that are more a matter of luck than anything else. But the people I'm talking about are those who seem to be able to consistently wind up with the bigger slice of pie regardless of the circumstances. What's their secret?
Early on, they've learned that commercial enterprise is a lot like a poker game. While the cards one holds certainly have a lot to do with the game, winnings are accrued more by knowing how to play your cards than by relying on the luck of to draw. In like fashion, getting a good real estate deal surely depends on being able to find a solid investment property that will afford a desired array of benefits. However, ultimately, the economic return – whether it be in the form of personal or business USE, after tax NET RENTAL INCOME, Capital GAIN, HARVEST of minerals, crops or live stock, or DEVELOPMENT – will depend upon net present value of both what you paid for it and what you received.
Re-read that last sentence! There's a lot of meat there. Notice that the range of economic possibilities is quite broad. You have to know WHY you're buying anything – what your intended purpose is for it – BEFORE YOU BUY. That will have a lot to do with HOW and WHERE you complete your transaction. Furthermore, calculating NET PRESENT VALUE of an acquisition and disposition means that you need an overall PLAN which incorporates TIMING of initial payment, cost during the holding period, and reasonable estimate of the income including gain over the entire holding period.
Boy, this is getting tough. Most people never do it. But, if you expect to find yourself among those who always seem to DO better, you have to BE better. And, you're not through yet. During your planning you'll have to isolate the economic benefits of ownership and try to express them in terms of discrete income streams. These should be computed in relation to the time periods in which you expect to receive them NET after all tangible and intangible costs. Following this, you must establish a discount factor which will enable you to estimate and compare the present value of your investment to the present value of your returns to see whether this is a good enough deal for you. You're probably doing a lot of this now. Here's an illustration:
When I first went into the Real Estate Brokerage business, my objective was to buy a well located house to use as a small office during the first 5 years until I could afford the overhead of more expensive accommodations. The overall cost had to be less than the rental expense of comparable offices. I wanted something with additional space in it that I could rent out to others to offset my own costs. I set out to locate a suitable property. One that specifically met my needs as to UTILITY as an office, LOCATION which would enhance my business prospects, APPEARANCE that would support the IMAGE I expected to present to the public. Bear in mind that I was competing with Brokers who were able to present a professional image by renting commercial office space. I wanted to be able to attract commercial tenants who would complement my own activities – building business for both of us. That was my plan.
I located a house. I planned to open for business just as soon as I could negotiate a purchase and convert the building to offices. I estimated my rents would cover all my office operating costs. Next, I projected my net cash flow from sales which would be available for salary and debt payments. From these figures I set the maximum amount I could pay down and the maximum amount I could pay on a mortgage.
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With the time frame, cost, use, profitability parameters, all I had to do was to calculate the present values of all my estimated positive and negative income flows. The key word was CALCULATE. This is a mathematical exercise best done with a calculator. It's virtually impossible to compare economic yields without being able to calculate their relationship in terms of the present. To do this, you have to determine a discount rate which anticipates market yields over the holding period. I think using the 30 year mortgage rate works well. This gave me the present value of both my expenses and my profits for the next 5 years. It also was the basis for all subsequent negotiations for mortgage interest, repairs, furnishings, and business expenses.
HE WHO PREPARES BEST WINS . . .
If you want to motivate yourself to approach a project with a modicum of professionalism, first consider that everything you save belongs to you. Next, bear in mind that you'll be negotiating with someone else who's also prepared. To the extent that one of you is better prepared, that will be reflected in your ultimate yield. Setting your own negotiating objectives based on a range of cost/profit margin that represents your GO/NO-GO decision point simplifies things from your end. When you negotiate merely for the lowest cost and/or highest sale price, you risk losing the transaction because of greed. But, by objectively establishing your negotiating parameters ahead of time, you can be a much more effective buyer and/or seller.
Never fall in love with a deal until it's closed! Over the course of many years I've had the opportunity to come out on the short end of lots of transactions because of emotional involvement. Now, I'm willing to walk away from any proposition when it doesn't fit my prepared position. If a specific yield is my objective, then that's ultimately what I'm negotiating for. If I can't achieve that, why close at all? Enough about my side of a negotiation, what about the other side?
It's my job to discover who I'm dealing with, how well prepared his position is, what his time frames are, what his true needs are, whether or not there are any emotional or psychological hooks I can hang my negotiating techniques on. This means I've got to spend some time getting to know the other party on a personal basis. It is at this point that most people fail – especially professional Brokers. It's the most important factor separating mediocre and superior negotiating ability. It's the hallmark of successful businesses everywhere.
Notice how many deals are made on golf courses, at resorts, on cruise ships. Notice how conducive a relaxed mood is to putting people and properties together. You may not be able to whisk the parties away to Tahiti, but you can make the effort to take a genuine personal interest in them prior to initiating any economic discussions. Remember, you're an adversary until you become a friend. Once you've built up the other guy's confidence in your integrity you'll be able to explore his real motivation and needs. And he'll be much more receptive to unconventional/creative approaches to finding a way to do business. Some of the brightest people fail to succeed because they spend their energy creating technically brilliant solutions but forget to communicate a sincere interest in the other party's own objectives.
Once you've broken through the other party's facade of ambiguity, half truths and feigned ignorance; you'll be able to understand the nature of the obstacles that must be overcome in order to make a deal. You'll discover that his SECURITY NEEDS coupled with irrational attitudes concerning taxes, finance or realistic values can become the source of major uncertainties that you can only resolve after he trusts your motives. CASH FLOW, COMPARATIVE VALUES, YIELDS often are relegated to relatively easy bargaining once you've dealt with his personal needs, biases and fears of YOU, the opponent. Learning to deal with people on a face-to-face basis is one of the most critical talents the would-be negotiator needs to develop. Being able to create workable financial structures comes in a close second.
FINANCING CAN PROVIDE A COMMON FETING GROUND . . .
The trouble with institutional financing is that it isn't flexible enough to provide real break throughs when negotiations hog down. No one can be sure that the lender will provide the financing under the terms and conditions specified. If one party needs cash flow relief and is willing to pay a higher price to the lender to get it, the institutional lender will refuse it because of his own need to match his loan portfolio to the secondary market and/or to meet regulatory requirements.
On the other hand, when the individual parties can structure financial terms between themselves, many barriers to negotiating a satisfactory settlement can be overcome. Anytime that interest rates are low, yet loan approvals are still not being given by scared lenders, the time is ripe for individuals to negotiate financing as well as price in property transactions.
This isn't some great cosmic insight. Just watch TV and newspaper ads. You'll see 'No payments for 6 months.' Or, 'Zero Rate Financing'. 'Cash Back at Closing.' 'Decorating Allowance.' 'Drawing for a Free Car' (or Cruise, or Vacation, or Time Share). There's no reason why the same kind of innovation shouldn't also be brought to your own transactions. Here are a few of my own variations.
Many moons ago I built a house in Japan. I promised to pay one third down, one third when it was half completed and one third upon completion. When the final third came due, I hadn't received a check I'd been expecting, so found myself trying to explain this to a troubled Japanese Contractor without creating an international incident. The upshot of it was that I had to produce the cash in a week. Without any banks. I got a private party to lend me the money only because, in addition to 8% interest, he also got the free use of my car until I paid him back. You'll find that cars/boats/RVs often figure prominently in working out financial arrangements.
Taking the car approach a step further, a few years ago car sales were slow just as they are today. Cars from the previous year were piling up. The factory was offering incentives to a local dealer under which he'd make about $300 for every one of the inventoried cars he could move. We were able to buy brand new year-old cars for about 60% of the price of a new one. When we advertised them in the Auto Trader as down payments on houses we were deluged with calls.
We'd discovered an entire sub-group of customers among divorced women. At that time, in property settlements, it was typical that the woman kept the family home to provide stability for the kids and the man kept the car. This left the woman with high house mortgage and maintenance payments coupled with a need for good reliable transportation to and from work, schools and for emergencies. We'd exchange the car for the house, then create a 2nd mortgage on the house to raise money to pay for the car. Thus, we were able to transfer the discount on the wholesale car price into the house price while meeting the needs of the owner. Sometimes we were able to combine this with a trade-in of a larger house for a smaller one to match her budget.
One last illustration of ways to use cars in negotiation. American values have always placed ownership of automobiles very close to ownership of homes. In the decade of the 80's, it was common to find many Yuppies with BMW's parked in front of rented condos. The problem with financed cars is that the loan companies often place restrictions on their movement out of state. Add to this the fact that job hopping and upward mobility are what Yuppiedom is all about. Here's a typical transaction:
Yuppie has a job change. Finance company doesn't want the car to leave the state. Yuppie has a house with a reasonable equity that also must be disposed of. He goes to the Lender and offers to place a 2nd mortgage on his house to cover the amount owed on the car – at least to the extent it can leave the state. You buy the house with nothing down other than to agree to make the payments on the 1st and 2nd mortgages. This will give the Yuppie payment relief and allow him to continue his career move while retaining his Bimmer. (Alternatively, in the event of due-on-sale problems, you can Lease/Option the house.) Voila. You've bought another property.
PAPER CAN BE A UNIVERSAL SOLVENT . . .
Even the ugliest property can produce beautiful mortgage paper. You can use paper to overcome geographic problems where owners have to move their equities into other areas. You can use it to 'make change' when the buyer and seller can't get together on price. Notes can be used as private currency to provide down payments, Option consideration, to create a secondary market for Leases, to capitalize corporations and to increase basis in stock. Obviously, no one can afford to overlook it when trying to structure a difficult transaction. Let's see how.
Suppose I have a management intensive, low income apartment block in Washington, D.C. Basis and Equity are $100,000 which produce $1000/month NET cash flow. I'd like to transfer this into a $300,000 single family home in Costa Mesa, California. You live in Costa Mesa and are nervous about your investment exposure. You've got five $300,000 houses with about $100,000 equity in each that you rent with slightly negative cash flows. You're afraid the market sag will wipe out too much leveraged equity. There's no market to sell these into in your area today. You'd like to reduce your debt exposure and reposition your equity into other properties.
Here's my proposition. I'll offer you my D.C. apartments for one of your houses, and you can carry back the $200,000 balance on a wrap around mortgage. You don't like the idea of having management problems so far away, but offer to to accept a $100,000 2nd Mortgage on the apartments as down payment for 2 houses. You'll carry back two $250,000. wraps, conveying $50,000 equity in each property for the Note.
Finally, we negotiate a way to proceed. First, I'll place a master lease on my D.C. property into a wholly owned Nevada corporation. It will create a $100,000 corporate note secured by a pledge of the next $100,000 in net lease income to be paid directly to you by the management company. You'll be further secured by a collateral assignment of my stock. This insulates you from any liability associated with actual apartment operations. I'll buy one of your houses with 100% financing at 10% interest amortized over 30 years with a balloon due in 15. The corporation will buy one other using the above corporate note as a down payment with you carrying a wrap note on the remaining $200,000 at zero interest for 7 years, payable then. Let's see what we've accomplished.
1. We've each done what we set out to do I've got a house. You've moved out 40% of your leveraged position with improved geographic diversification and cash flow.
2. My corporation has a basis equal to the lease value, owns the D.C. apartments and a slightly negative cash flow rental in Costa Mesa. It can shelter all income from corporate activities by means of the real estate operating losses and interest.
3. My own high residential interest payments are deductible while adding to your income.
4. Rather than bicker over price, I've paid you for your full equity but received the benefit of low interest rate financing overall, thereby improving my net cash flow while bringing my passive losses into the deductible $25,000 range.
5. By securing a Note with LEASE INCOME I've transformed rents into a form of private currency which I've in turn converted into real estate equities. Not too shabby.
