August 2001
Vol 24 No 12
One of the popular myths surrounding the single family house business is that those who buy and hold property somehow never sell, and that those who buy and sell property don't hold it for investment. As a practical matter, success in real estate requires that the entrepreneur take the course of action most likely to produce the greatest progress toward his or her financial objectives, long or short term, as the case may be. While buy and hold strategies provide most wealth over the long term, buy/sell techniques can best fund current expenses. What you ultimately decide to do with a house that you buy has a lot to do with how you finance it, and vice versa.
When you intend to hold a house as a long term rental property, initial leverage is less important than after-tax and after-inflation net cash flow. With each increment of net income received, part of your investment is returned to you, and your leverage is thereby increased a little. Eventually, once all your down payment has been recovered, you'll have a negative investment and an infinite return. The key to generating this cash flow lies in the financing you obtain and the way in which you manage the property to produce the net income.
With that in mind, mortgage terms should be negotiated to provide net positive income after operating expenses and debt service; and seller financing offers the best opportunity for obtaining payment terms that a property can support. Ideally, financing terms will provide a high rate of amortization as well as net operating cash flow, but the seller will want something in return. It isn't a bad idea to try to trade off a higher price to get the financing terms you need. In the final analysis, trading off price for cash flow can make a lot of sense. It increases both the income yield as well as the margin of safety at very low cost.
To illustrate, let's say that to buy a house that had a fair market value of $100,000 you offered $10,000 cash down payment. The seller agrees to carry back a fully amortizing $100,000 secured note, with fixed monthly payments of $800 including 7% interest. Let's presume that these terms will yield $100 net positive cash flow to you per month. In return for paying a price of $10,000 over its value, in 100 months. Even without any net rent increases, you will have recovered all of your down payment without regard to the price you paid, the rate of interest, or the loan amortization. Moreover, this property could continue to produce $100 for the next five years, after which time, the mortgage would have been completely paid off.
What about rents? Because rents are considered to be “leading economic indicators”, they are usually increased ahead of inflation. When a purchase is leveraged with fixed payments, rising rents can generate significant cash flow yield over mortgage payments. And when combined with rising prices, house investments can yield astronomical returns on invested capital. As a practical matter, over the past 15 years my rents have more than doubled. Based upon an average $3000 down payment, free and clear, my rentals are yielding over 100% per year cash flow.
What happens when the economy turns down, as it threatens to do today? Families cut back on vacations, retail purchases, new cars, computers, and other luxuries, but they cling to their lifestyle. They sacrifice to pay rents in order to maintain as much stability as possible amidst job changes and fluctuations in their earnings. So, in good times and bad, properly financed single family houses can maintain positive income. If this is so obvious, why doesn't everybody invest in houses? Most do, but they just don't realize it. Personal residences are often a family's best investment, especially after they've lost a fortune in .com stocks.
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PRICE IS MORE CRITICAL THAN TERMS WHEN FIXING OR FLIPPING.
Sometimes we tend to forget that houses appreciate at compound rates. The appreciation of one year becomes the basis for appreciation the following years. I studiously avoided applying an inflation rate to the above $100,000 house example, but if it had appreciated at an average rate of 6% of the 15 year holding period, it would have been sold for almost $240,000. This might seem fanciful, but it happened in many parts of the country; and created fortunes for thousands of home owners.
Without regard to inflation or depreciation, suppose at the end of 15 years you sold the then free and clear property for $100,000. Let's see how paying too much in order to get better loan terms would have affected your total investment yield over your holding period. If for 15 years the $100 of rental income in excess of expenses were to have been invested at 7%, at the end of 180 months, this would compound to $31,696; multiplying your $10,000 investment over 13 times.
So far, we've been talking about the importance of financing terms when a house is being held as a long term investment. If you expected to re-sell the property for cash, getting terms that provide for rental cash flow aren't as valuable as being able to buy a house at a low enough price to be able to create a larger after-tax profit upon sale. This is where single family houses can shine. Since 1997 most sales of single family residences in America have been tax-free. So, a personal primary residence can provide a tax-free source of funds when retirement needs exceed pension income. What about rental houses?
When a rental house is sold, tax on sale can be avoided when the funds are used to buy a qualifying replacement investment. By using seller financing to stretch out payments, tax on gain from the sale of a rental house can be spread out over many years while un-taxed profit continues to earn high interest rate yields. When gain is finally taxed, it enjoys rates that are being reduced with the passage of each new tax law. Let's return to the $100,000 property previously discussed to see how it might be bought by a person who fully intended to resell it for a short term profit:
Instead of over-paying $10,000 to get favorable terms, suppose we negotiated an all cash $80,000 purchase from a distressed seller who had an immediate need for cash. If we didn't have the cash, we'd borrow it from a private investor. Let's say the house could be sold at fair market value for $100,000 cash within three months. From the profit, we might deduct $10,000 to spruce up the property and to pay for marketing, fees, and three months use of an investor's cash. A clear profit of $10,000 would thus be realized on this relatively quick deal. If the same “spread” could be made four times each year, the buy/sell specialist would earn $40,000 in pre-tax dealer profits annually. Not bad, but not terrific.
Fully taxed, this isn't enough to support much of a family life style, so for those who buy and sell houses, income relates directly to being able to buy and sell more and more houses. This can consume prodigious amounts of cash and credit, so the speed with which a house can be “turned” is a critical factor. A successful dealer will sell about 20 houses a year and earn pre-tax profits of about $200,000. After taxes, this boils down to an income of about $150,000 or so. Being able to negotiate an additional $5,000 in profit per house by getting a buyer to pay more and the seller to accept less would make a $100,000 difference in gross income on 20 deals a year, and have a major impact on life style. This is where negotiating and marketing and negotiating skills really pay off big.
One of the first priorities of dealers should be to try to find a source of cash both for buying properties, and for selling them. One way to do this is for the investor to provide the cash to buy a house in need of cosmetic repair in return for a guaranteed return plus a portion of the profits. The target property is placed into a land trust which holds the title. The investor would be the beneficiary and have the power to replace the Trustee if things didn't work out. The investor might be guaranteed a 12% annual yield plus one half of the profits at point of sale. No payment on the debt would be required until the property is sold. The dealer would be freed from making payments, and use his own cash to fix up the property in order to command a high loan appraisal, and sale price.
To make this work, there has to be a large “spread” between what is paid for the property, repairs, and marketing, and what is received. That all boils down to being able to buy low and sell high on a regular basis. Oddly enough, this spread can be realized with extremely low priced houses, or high priced houses more readily than for median priced houses. Let's see why this is true:
COMPETITION DRIVES AWAY PROFITS . . .
It seems to me that when a lot of people all try buy and sell in the same way in the same market segment, that competition forces profits down. They pay more and receive less than those who find a market niche. Two largely overlooked niches are: 1. Mobile Homes, and 2. Upscale mid-level homes. Let's consider each of these:
At the lower end of the housing scale, one can find what amounts to slum properties in marginal neighborhoods that, at best, are risky propositions because area residents can't obtain financing with which to buy a house, and won't pay rent that isn't subsidized. Selling and “carrying paper” more often than not embroils the seller in frequent foreclosures. In contrast, used mobile homes cost less and, even in otherwise blighted areas, can be situated in attractive, low-crime, mobile home parks. This makes mobile home strategies a viable alternative for those who are just getting started. Where is the “hot spot” with mobile homes today?
In many areas, mobile home loan defaults and record numbers of repossessed homes have left manufacturers, dealers, and lenders glutted with homes they can't sell. That means that mobile home sellers must offer creative terms and lower prices in order to attract buyers. Recently, I had an opportunity to visit an area that was inundated with repossessed mobile homes, both in parks and in dealer's back lots. The retail price on a new 16' X 70' single-wide was $44,000. This could be financed at 9% with 5% down payment. The same home could be bought by a dealer from the factory for $22,000. A similar slightly used nice home at a repo-lot could be bought for $16,000. And from one distressed lender who was paying $185 per month space rent in a mobile home park, the cash price would have been $14,000.
None of the used homes I saw needed much work other than exterior painting, cleaning, minor drywall repair, fresh appliances, and carpeting. A person who could complete these repairs and sell the homes to buyers on a “rent-to-own” program would have been able to get about $595 per month including lot rent. After paying lot rent and expenses, that would have left about $4000 per year in pre-tax income to service debt. In a little over four years, it would be possible to completely pay off one of these mobile homes out of rents, and from there on in, it would have been all profit. Ten of these could provide an income stream that would be greater than the incomes of most wage earners in America today. Not a bad way to retire with or without Social Security or a K-401 plan.
What about upscale homes? Quite often more expensive homes won't generate income as rentals, but can be very profitable for those who buy low and increase value by fixing them up. The opportunity for most entrepreneurs lies in taking over loans on neglected houses that cost between $150,000 and $250,000 that are situated in good neighborhoods and which have “the right things wrong with them”. Buying them from motivated owners at discounts, then adding value by 20% or so over the next couple of years through a combination of fix-up, appreciation, amortization, and leveraged inflation will generate impressive tax-free profits when they're sold.
IT'S JUST AS HARD TO SELL AN EXPENSIVE HOUSE AS A BAD HOUSE!
One of our Mentors recently pointed out what should be an obvious truth: If you intend to buy and sell houses, you've got to look at the “deal-after-the-deal“. To quote him, “You need to have a plan for disposal BEFORE you purchase.“ He goes on to say that the market for bad houses is about the same size as the market for expensive houses; limited with fewer buyers, and a lot of sellers. He divides the house market into four quadrants ranging from the cheapest to the most expensive, and avoids quadrants 1 and 4, focusing instead on quadrants 2 and 3 where most of the buyers live. To his observations, I might add that you've also got to have a financing plan to fund buyers' purchases in each quadrant. The price of the house, and how it can be financed, will have a lot to do with who buys it; and when.
For years, most of the houses I bought and sold were those that could be financed with FHA and VA loans. Buyers had little money for down payments, so, the sellers usually paid all costs of financing and sale. My principal criteria for buying a house was that it qualify for this kind of financing. I listed, Optioned, and sold literally hundreds of houses using these loans. My costs were high, but so was my cash flow. What I lost in selling costs, I more than made up with high sales volume. As I gained experience in selling FHA and VA houses, I gradually took on more challenging situations that required different financing solutions:
From time to time I found myself buying a house with an equity over the loan that was little more than the commission I was charging the seller. In such cases, I bought the home without recourse, and resold it on a land-sale installment contract. I found I could sell these properties and close the loans in days where FHA and VA loans took weeks to close. I also found that the people who bought from me on contracts were happy to pay top dollar for the house, and top interest on the loan so long as they didn't have to come up with a very big down payment. When it came to deciding whether to rent an acquisition, or to sell it on a contract, all things being equal, I sold it when the buyer could come up with a down payment equal to at least three times the amount of money required to rent it, including deposits.
To keep from running short of cash, I only sold on contracts when I had very little investment in the property. When I had invested a fairly large sum, I only sold to cash buyers. The way I could finance my ultimate sale pretty well set my criteria to determine whether (1) I would list a house as a broker and earn a cash commission (2) buy a house with an existing low interest rate loan and low equity that I could sell on a contract (3) use lots of cash to be able to buy a low, low wholesale bargain that I could flip quickly at a retail cash price (4) buy high equity with a moderate amount of cash to keep as a long term positive cash flow rental, taking title subject to a low interest rate non-recourse loan; with zero, or low interest rate seller financing for the balance of the equity (5) lease/Option the property and “wrap” my lease/Option to a long term occupant to provide cash flow, or (6)simply Option the house and try to sell either the house or my Option to a cash buyer who would finance the property with a new loan; conventional, FHA, or VA. Somewhere along the line, I discovered that I could use some of the contracts I was carrying as down payments to buy other houses. This catapulted my profits as I “spent” retail profits I'd captured with my contracts to buy equities at bargain prices from owners who needed to increase their personal cash flow.
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Quotation not permitted. Material may not be reproduced in whole or part in any form whatsoever.
