Vol. 24 No. 3
ENTREPRENEURS AREN’T NECESSARILY INVESTORS . . .
Real estate investment clubs have been around for more than twenty years. They do a uniformly good job providing a forum in which members can network and exchange information. They invite speakers who present materials on a broad array investment and market subject matter for the benefit of their members. Yet, for the most part, investment club members more resemble entrepreneurs engaged in real business rather than investors. Investors are a different breed entirely.
To me, the epitome of investors is Warren Buffet. Repeatedly in his reports he maintains that he makes most of his money while sleeping. He will not buy anything unless it’s managed by owners who want to continue to run the business. Buffet’s wealth comes from the earning power of the assets he owns, not of the amount of work that he does to earn a profit. He operates his multi-billion dollar empire with 16 employees and no computers. How does the way he makes money contrast with “investors” who are members of a real estate investment group?
It seems to me that investor group membership consists of three kinds of people. Most members are dealers in property. They buy, sell, fix up, and finance real estate. A second group are vendors who sell building materials, insurance, appraisal and accounting services, furnishings, etc. to other members. The third group are mortgage brokers who finance the acquisition of property, or private financiers who offer to buy mortgage notes at discount that are created by other members to complete their transactions.
It seems clear to me that these clubs are misnamed. The should be called Entrepreneurial Associations. Members make money through their own efforts, rather than from income-producing assets. Unlike Warren Buffet, they make their money only by staying alert and ready to seize opportunities that come their way, not while they are asleep. There’s nothing at all wrong with being an entrepreneur; but this shouldn’t be confused with being an investor for several reasons:
An entrepreneur’s income stops when he stops working. Real estate salespeople, contractors, financiers, materials suppliers, fixer-upper specialists, dealers (newsletter writers and seminar givers) all fall into this category. Income stops anytime they are ill, injured, on vacation, out of town, on jury duty, or when their vehicle is in the shop, or when they can’t find new opportunities or financing, etc. For this reason, maintaining income needs to command a high priority in their planning. This would include owning a health and accident insurance policy to cover expenses if they must miss work.
They might also want to arrange a special line of credit with a bank or private lender to draw upon during spells when their income dries up for any reason.
When I first opened my real estate brokerage, I arranged for a line of credit with my bank. This was little more than an arrangement that would permit me to continue to write checks that the bank would honor after my personal account was empty. It filled in a lot of empty pay days between real estate commissions. Without this, I would have had to find a salaried job and abandon my entrepreneurial aspirations.
There’s another problem waiting to sabotage entrepreneurs. It’s called time. Every day everyone gets a little older. At some point, whether because of age, infirmity, competition, changing markets, or new regulations, the day will come when the entrepreneur will have to quit working. That’s when the differences between being an entrepreneur and an investor become most apparent. The entrepreneur without investments is broke. The investor remains solvent because whether he works or not, his assets are at work twenty four hours a day producing the income needed to support his lifestyle. Investment boils down to setting aside a portion of current earnings so they can compound to support one in the future. That’s what this month’s letter is all about.
INVESTORS ARE TURTLES, ENTREPRENEURS ARE RABBITS . . .
Both entrepreneurs and investors can agree that “time is money” The principal difference between an entrepreneur who speculates in real estate and an investor is their time horizon. Lapse of time between buying and selling represents a cost to speculators and entrepreneurs. They focus their energies on moving quickly to buy and sell in order to “turn their money” in the least possible time. In doing this, they make a lot of money, but what they earn is taxed at ordinary income tax rates that can go as high as 40% plus State taxes. They also pay a large percentage out of potential profits because of their need for cash upon sale.
Buy-Sell-Fixer dealers usually must use credit to buy, and credit to sell. Where investors can take the time to negotiate long term seller financing that generates profits, creative financing doesn’t add much to a dealer’s bottom line because the property is usually refinanced within a few short months. So, even though dealers might negotiate financing terms that can be “wrapped” when they sell, their most effective negotiating tool is cash, or a short term note that will be paid off upon sale. Then, they offer seller financing to induce buyers to pay premium prices. Because dealers are taxed on their full profits at point of sale, even when selling on installments, they can wind up being taxed on payments they haven’t actually received. This adds to dealers’ operating costs.
The “spread” between what a dealer pays and what he nets from a deal is whittled down by his costs. To get cash to buy with, he must first borrow it at fairly high interest rates. Then upon sale, he must discount the Note and Mortgage, or installment contract, to convert it to cash with which to pay expenses, taxes, and to buy houses. If bank loans are used, he has to expend time to find qualified buyers and to process loans. The final decision as to how to finance both inventory and sales ultimately will depend upon available credit and turn-around time.
Dealer profits can be illusory. Here’s an example: A dealer has to have money to work with. Once a house has been located, he usually borrows to buy it. Let’s say he borrows $35,000 at 15% interest with the balance due in full in six months; paying about $2000 for title work, closing and financing costs; and uses the cash to buy a derelict house from an estate. He pays a $1000 finders fee to a “bird dog” who finds it for him. He spends another $10,000 putting it into condition for a sale. Within four months from start to finish, he has sold the property for $73,950, with $2500 down payment, carrying back a promissory note secured by a first mortgage. He immediately discounts the note to an investor at 75% of face value, receiving $55,462.50.
How much net taxable profit does this transaction produce? $55,462.50 less $2000 in up-front costs, $1000 finders fee, $10,000 to fix it up for sale, $1,750 in interest, $1,000 in miscellaneous pro-rated insurance and property taxes leaves $5,712.50 net pre-tax profit. In the 28% tax bracket, and without regard to State income taxes, he will have netted $4,113 from this little venture.
If he can repeat this process 25 times in one year, an active dealer can earn over $100,000, after taxes but he’ll have to stay pretty busy keeping on top of multiple projects. Some people who wheel and deal with single family houses make a lot more money, but most make a lot less once net profits for the entire year have been tallied up. The dealer must remain active in the business on a day in and day out basis if he expects to maintain the pace of processing over two houses each month in good times and bad, in sickness and in health, until death does him part.
Suppose a dealer financed 25% of his houses with 30 year loans and rented them out as long term income-producing investments? He’d sell only 19 houses and make only about $77,000, but he’d also add net income from rents. Each year, if he repeated this procedure, he’d find that he’d eliminate twenty five percent of the costs in time and expense of selling houses he’d fixed up, he’d have lowered his overall tax bill, and he would have been building his net worth. That’s why turtles always win the race.
RENTAL INCOME CREATES FINANCIAL STABILITY . . .
In most investor groups, a critical fourth category of people seem to be missing entirely, or if present, represent only a tiny minority within the membership. These are Managers. If a person is going to be a real estate investor who lives off income produced by his properties, someone is going to have to learn how to manage tenants or be willing to pay someone else to do it. It would seem that joining an investment group would be a pretty good idea for property managers who want to expand their customer and property base. There’s little competition and a lot of prospective clients; but it will require a little change in focus.
Most wheeler-dealer types don’t want to manage for good and sufficient reasons. They know that their buy/sell activities will generate a lot more spendable cash flow on a day to day, year to year basis than dealing with a lot of tenants. They’re absolutely correct in the short term, but in the long term, there’s no comparison between investment income earned from rentals and income earned from buying and selling houses.
Harking back to our earlier illustration, the dealer netted about $100,000 per year by scurrying around finding, fixing, and selling houses. He had about $50,000 invested in houses with a market value of a little over $70,000. Let’s say that he was able to “mortgage out” on these houses, recovering all his invested cash by placing permanent 8% thirty-year $50,000 loans on them with monthly payments of $375 including taxes and insurance. They should rent for about $675 per month. To simplify things, let’s say that loan payments and expenses would soak up all but $140 per month cash flow per house. If he kept only 6 of these houses each year as rentals, he’d earn $10,000 in rents, or about $87,000 per year.
Although he’d be earning less taxable income each year, he’d be increasing his net worth by leaps and bounds. If he averaged $20,000 per house in equity over the loans, that would add $120,000 per year to his net worth, without regard to loan amortization or additional appreciation. Let’s extend his time frame out to 10 years. At the end of that time, he’d have sixty houses with an original value of $70,000, or $4,200,000. From his original $20,000 in equity per house, with 60 houses, his net worth would be $1,200,000 plus amortization and appreciation. The $10,000 in original annual income would have grown to $100,000; approximately the same income he’d previously earned buying and selling 25 houses each year.
You can plug in your own figures insofar as price appreciation, loan amortization, and rental increases are concerned. The above figures are purely mathematical. If you can allocate a portion of your time to creating tax-free equity values, then hang on to them as long term rental income investments rather than selling them and paying taxes, you can build a tax free estate that will provide tax-advantaged income for decades. The part of the above scenario that is overlooked by many people is that rental properties will provide an income that is recession resistant and at the same time inflation hedged. When the economy is zooming along, it’s hard to remember the lean times when high interest rates and inflation effectively shut down real estate markets. But it has happened many times before and will happen again. That’s when rental houses come into their own.
When interest rates rise, fewer people can afford to buy a house, and so must rent living space. Just when it becomes almost impossible for dealers to buy and sell, landlords see vacancies virtually disappear, driving rents up. When interest rates come down, tenants all move out to buy homes of their own. Housing demand drives up the value of a rental house portfolio. The investor/entrepreneur can sell in a housing boom to raise operating capital, and go back into the buy/fix/sell business in time to meet the growing demand. Because he will be selling investment property rather than inventory, his gains will only be taxed at long term capital gains rates. He can further reduce taxes by entering into Section 1031 tax-free exchanges and/or carrying back the financing in all the ways we described in our October letter. Property management is what opens this cornucopia of financial opportunity. It’s a career track that shouldn’t be shunned.
LEASING CONVERTS ORDINARY INCOME TO CAPITAL GAIN.
Bob and Bill both buy houses. Bob “flips” properties, earning a profit on the price-spread between what he buys and what he sells for. Bill makes his profit by renting to tenants on three-year lease/Options. Tenants must remain in the premises and pay rent for three years after which they can exercise their Option and buy the property at the appraised fair market value. When they buy, they must pay all cash and all costs of financing. About half of the initial tenants either terminate their lease early, or elect not to exercise their Options. About half buy their homes for cash. What are the pros and cons of each approach?
Bob is clearly in the business of buying and selling houses. Unsold houses are treated as “inventory”. He gets to expense the costs of his houses against his profits, but any net gain is taxed at his ordinary income tax rates. Bill isn’t a dealer holding houses in inventory. He’s in the rental business. He earns his living renting houses to tenants. As an inducement to get tenants to sign three year leases, he offers to sell them an Option for an up-front non-refundable $3,000 cash payment that will be credited against their down payment. In return for their agreeing to perform all minor maintenance on the properties such as spraying for insects, replacing batteries in smoke detectors, replacing filters, painting, doing lawn maintenance, and furnishing their own appliances, he gives them a fixed-rental that is approximately $75 below comparable fair market rents.
At the end of the three year period the tenants can exercise their Option at the appraised fair market price. Bill will pay for a title insurance policy, and for recording the deed. They must pay all costs of financing and closing. If they elect to not to exercise their Option, Bill will extend their lease another year at the same rents and under the same conditions. Whenever they move out, Bill will give them $1000 if they get the premises cleaned and ready for immediate occupancy by the next tenant. If they would like to extend their lease and Option for an additional three years at the same rent, or to assign it to another qualified replacement tenant, they can do it by paying another $2000.
Let’s see what all this has accomplished. First of all, Bill’s management obligations have largely been passed along to his tenants for the next three years. By requiring a $3000 tax-free Option payment, he increases his after-tax cash flow by that amount to use to buy more houses that he can rent. He compensates for this by providing the tenants a fixed-rent at $75 below fair market rents. Over the three year period, the tenants will recover this at the rate of $900 per year in reduced rents if they decide not to exercise their Option, plus they will get $1000 of it back when they leave if the premises have been maintained and are ready for occupancy. This enables Bill to re-rent the premises with minimum lost rent days. It also gives the tenants an incentive NOT to exercise their Option.
By giving the tenants the right to extend their lease and Option for another 3 years at the same rents or to assign their lease/Option to another qualified tenant by paying $2000 additional, Bill has given his tenants an incentive to continue paying him rent for another three years, or to find someone who will. Either way, Bill figures that his management chores will be reduced. While one might argue that accepting $5000 over six years in return for not being able to raise rents might not be enough, Bill is willing to accept that risk in return for not having any cleaning, minor repair, collection, or rent-up expense for six years.
What happens when a tenant wants to exercise his Option? Bill will have sold a house for cash at current fair market value without any marketing expense, sales commission, or financing costs. Because he will be selling property used in his trade or business, he will only pay taxes at capital gains rates if he takes the cash and spends it. Or, as previously explained, he could sell the property for cash and enter into a delayed tax-free property exchange, using the money to buy a replacement property. As a dealer, Bob can’t do this, but as an investor, Bill can.
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