This month’s letter is aimed at those with appreciated equities. A few months ago, a front page story in the Wall Street Journal extolled the vision of an entrepreneur who was raising money with which to buy up thousands of low income and older single family houses in the New York and New Jersey area. The writer seemed impressed that our hero had devised a business plan based on the areas demographics. With the help of a crew of MIT graduates, he’d estimated costs associated with holding and managing these rentals. I’m not aware that MIT — nor for that matter, the Wall Street Journal — has any particular expertise with single family houses.
The article goes on to say that Fortune 500 companies are too large to be interested in a portfolio of single family houses. They can’t acquire enough to make a significant impact on their earnings. I think that’s a major reason why the little guys have the opportunity we do with single family rentals. Another is that they get their education on the job instead of in a class room presided over by a teacher who has absolutely no experience in business or as a landlord. Being able to invest in houses requires skill with people in negotiation, finance, management, maintenance, and valuation that can only be acquired through hands-on experience.
About 25 years ago a company called Epic embarked on a similar program of buying up houses to hold for long term appreciation. They wound up filing one of the largest bankruptcy suits in real estate history once they matched up income with expenses. The WSJ article seemed to miss an obvious ominous parallel with Epic when it went on to report the entrepreneur’s early experience with the properties he had bought thus far. It seems he to had discovered that the MIT crew’s ivory tower estimates of management and maintenance costs were below actual expenses. Hello!
It’s almost an axiom in real estate circles that when the Wall Street Journal — or anybody in academia — starts becoming enthusiastic about single family house rentals, that the end of the housing boom is drawing nigh. What Wall Street Journal writers don’t know about the single family house business would fill a good sized warehouse. Nonetheless, thousands of naive investors are heedlessly rushing in where seasoned pros fear to tread; grossly underestimating the degree of expertise and talent required to make money with low income single family houses.
There’s both good and bad news in this phenomenon:
The bad news is that the innocents will devastated when (not if) the truth slowly dawns on them that they have invested in pipe dreams founded on little more than the hopes of the promoters rather than on anybody’s practical experience. I‘m not singling out the WSJ’s entrepreneur any more than I single out many Real Estate Investment Trusts that raise money from those who know nothing about real estate, and turn it over to others who may know even less.
The good news is that these idealistic real estate newcomers aren’t alone buying in near the top of the current boom. Many otherwise prudent savers are jumping into houses in search of higher yields without knowing what they’re doing. Sooner or later, a lot of these houses will be sold at public sale as investors and lenders scramble to recover borrowed their money. When that happens, cash buyers will be able to take their pick of good properties at mere fractions of what they cost ill-prepared investors. Many houses being bought and/or re-financed today will wind up as a source of inventory for those who know what to do with them.
Before visions of sugar plums start dancing in your head, a national distress market will offer a lot more opportunity to cash buyers than to those who need to borrow money in order to buy. Institutional lenders who have made millions of Home Equity Loans in excess of fair market value are going to be burned too. They aren’t going to lend money that will be used to pick their bones. Many private investors will also choose to sit on the sidelines waiting to see what happens.
WHEN TROUBLE STRIKES, CASH TALKS LOUDEST!
I’ve had the good fortune to have survived 5 different housing deflations. In the 1950s, 60s, and 70s, I didn’t have enough money to take advantage of all the opportunities that the depressed house market presented, but I was there in full force during the 80s. At that time, in Texas, houses were selling for the price of a new car. Confronted with daily foreclosure sales where nobody bid, lenders published lists of houses that they offered for 25 cents on the dollar, and sometimes less. Those with cash reaped millions of dollars buying from over-leveraged lenders and borrowers, and from the Government’s Resolution Trust Corporation (RTC). The key to their success was ready cash that allowed them to buy “low“, hold for a few years, then sell “high” into the resurging market.
The past few years have afforded landlords an outstanding opportunity to convert appreciated equity in their houses to cash by selling them at retail prices to owner-occupants. When I suggest selling to capture equity is that all future appreciation will be lost forever, and that taxes will eat up some of the profit. Commencing with lost appreciation, then moving on to tax issues, here‘s my argument:
Single family price appreciation depends upon several factors owners can‘t control. These are: (1) Consumers must be willing and able to allocate increasing proportions of disposable income to pay for more increasingly expensive housing. (2) Interest rates will remain low relative to inflation, and that borrowers will be able to get the loans they need to help drive prices upward. (3) That government will continue to subsidize lenders who make loans to marginally qualified buyers. If any of these factors are missing, housing demand will evaporate; and appreciation will be an early casualty along with liquidity. I know! Due to shortages of credit and qualified buyers, I once reduced my prices by 25% to sell unwanted houses.
What about the tax costs? Suppose you sold a $200,000 house with a loan balance and tax basis of $100,000. Ignoring selling costs, and State taxes, you’d wind up with $100,000. You could shelter the $15,000 tax with any passive losses you might have carried forward from prior years. In the worst case, you’d wind up with $85,000 and $100,000 less debt than before. This way, you would have replaced risk and management effort with cash to be used any way you wanted. To replace appreciation perceived to be lost by selling, you might use some of your cash to buy a highly leveraged house (ideally with non-recourse, seller financing).
Patience might reward you more. If you bide your time, in the foreclosure markets that we should see a little later on, you might use your after-tax cash sale proceeds to replace the houses you sold with better houses in better areas for less than your sale price. If your timing were right, you might even be able to complete tax free exchanges with deeply discounted lender-owned foreclosed houses. Failing in this, you could write-off up-grades on your remaining houses to offset the tax on profit. Finally, you will have improved your current portfolio; and you will have achieved a stable cash flow position to make you less vulnerable to future events.
How does selling contrast with simply refinancing the houses you have? In the permissive loan climate that prevails, investors can refinance existing houses with long term, level payment, fixed interest rate loans. Those who take the jump from equity to cash by increasing debt are betting that the same economy that creates widespread distress among borrowers and lenders won’t affect their rental income. Certainly, borrowing is easier than selling; but is it prudent to increase full recourse debt to hedge against potential future hard times? It’s not for me.
There are other disadvantages when equity is withdrawn from houses by refinancing. One problem with “borrowing” versus “selling” to convert equity to cash is that net rental cash flow can turn from positive to negative; making full recourse personal debt even more risky. Moreover, if forced to sell, you will incur “mortgage-over-basis” that can increase taxes later on in a variety of situations. Finally, it’s one thing to refinance just one house, but with each additional house you refinance, cautious lenders make borrowing more difficult and expensive.
TAKE THE MONEY AND RUN IT UP . . .
A basic tenet of investing is to only make moves that advance you toward your goals. Many resist the idea of cashing out their house equities because they don’t know how to keep their cash liquid while producing high yields. I too had trepidations about cashing out my long-term houses and trying to get a decent, safe return in today’s low interest rate market. To my amazement, even after paying taxes, the cash I’ve been able to invest has returned several times as much as the equities I cashed out. Here are some insights that might be an eye-opener:
A mega-trend that manifests itself today is the hundreds of thousands of older dwellings being transformed into decent affordable housing by those who specialize in buying, fixing, and selling houses as dealers. Although completely different skills are involved, making the transition from landlord to fixer is a lot easier than you might imagine. The secret is to ally yourself with someone who is already successful in this business, then to help him or her to expand by adding cash to the mix. The key to extraordinarily high yields lies in the speed with which a property can be acquired, fixed up, and sold. The more times each year that invested cash can be turned, the more everyone makes. Institutional loan processing delays are avoided by using private financing, so everyone makes a lot more money. Here are five examples of how people have been able to do this:
1. One experienced rehabber was hampered by availability of credit. With funds provided by a private investor for which he paid 20% per year. Using this, he was able to fix up three extra houses per year. Here’s how this adds up: A pro forma house cost $55,000 to buy, $15,000 to fix up, and sold for $100,000. Three additional houses generated about $75,000 more net profit after all marketing costs. He paid $14,000 to the investor for the year, leaving $61,000 more profit for him.
2. An investor buys a fixer-upper house for cash, It is held in a Trust, then leased it to a rehabber. The fixer provides all funds needed to fix it up. He also has an Option to buy or sell the house with 115% of the investor’s actual costs at the time the house is sold. This money is recycled between 3 and 4 times per year, and the investor reaps 15% profit on his invested cash with each recycling!
3. A fixer-upper has devised a system to find, buy, fix up and re-sell foreclosed houses and repossessed mobile homes from lenders at deep discount to market value. As the are acquired, each property is placed into a separate Trust. He is funded by a Private Line of Credit Loan set up by an unrelated IRA that is secured by his personal residence. Each loan is also secured by a first mortgage that is signed by the Trustee for the full fixed-up retail value of an acquired property. An Option gives the IRA Custodian the choice of a fixed 12% rate of return or half of the net retail sale proceeds of the fixed up property. When the house is sold, IRA’s funds are returned. Net profit is divided 50/50 between the fixer and the IRA.
4. On the instructions of the various beneficiaries, a group of Roth IRA Custodians form a Grantor Trust with an Independent Trustee and fund it with money from the IRAs. The Trustee then lends this money as in 3 above. All profits received by the Trust are automatically credited to the IRAs for the respective beneficiaries.
5. The procedure for assembling IRA funds are repeated, but from IRAs located in many portions of the country where there is less opportunity for investment. The assembled funds are used to create a Line of Credit for a non-related middleman. He makes short term loans to various rehabbers using all of the foregoing techniques. Net profits are divided with half of the profit going to the middleman and the other 50% divided among the IRA Custodians according to their percentage of investment.
While an annual return of 20% is a high yield for passive investors who allow their cash languish in mutual funds, banks, and money market funds, it is at the low end of the yields available through the foregoing profit-sharing loan approaches. Best of all, this money is rarely tied up more than 4 months, and in worst-case situations the investments can be liquidated quickly.
EVERY DOLLAR SAVED FROM TAXATION IS AN AFTER-TAX DOLLAR . . .
When you begin liquidating property and earning high un-sheltered cash income you’re going to be in for sticker-shock at tax time. Without some tax-planning, a lot of profit is going to melt away in taxes. It’s amazing how much people complain about the taxes they must pay, yet how little time and effort they are willing to invest in taking charge of their own tax strategies. Typically, single family house investors and entrepreneurs keep sloppy records; then they pay Accountants high fees to do what amounts to fairly simple bookkeeping. Why? Because they won’t go through the ordeal of learning Quicken or Quick Books.
One of the tax myths is that individuals are required to do “double-entry” bookkeeping. That may be more comfortable for accountants, but it isn’t a requirement of the Internal Revenue Code. All the IRS requires is that taxpayers be able to accurately report income and expenses. Here’s the simplest system: Pay all expenses by check or credit cards. Use a large three-check check-book. Put a piece of carbon paper under all checks and, in addition to completely filling out the stub or memo page as you write checks, make carbon copies showing the check number, date, amount, payee, and purpose of the check. Pay different expenses with separate checks. It’s easier to code each expense category with its own number in a “chart of accounts”. Make a carbon copy of deposit slips annotated to show who, where when, and why funds were received. This is all that‘s needed to set up your books.
One of the most successful landlords I know must deal with and/or render financial reports to tenants, investors, lenders, insurance companies, tax collectors, and maintenance companies on 80 houses. He keeps a timely, accurate bookkeeping system without the use of computers at all. He uses a system trade-named “SAFEGUARD” (800-338-0636). It uses special journals, ledgers, and checks to reduce the entire bookkeeping system to the simple process of writing checks and filling out deposit slips. From the records thus produced, anyone taxed as an individual filer can prepare tax returns using software such as Turbo-Tax. This will save a lot of money, time, and anxiety. So, where do Accountants fit in?
Accountants’ earn their keep helping you devise tax-reduction strategies BEFORE you make financial decisions, not AFTER. Some of the things that a competent Accountant who has had experience with real estate entrepreneurs can help you decide is whether or not to use single or multi-member LLCs, “C” or “S” Corporations, and/or Grantor and Non-Grantor Trusts; and what kind of assets to hold in each. Each has its own particular tax ramifications that an Accountant can help you sort out to your best advantage. The choices you make can have a major impact on Estate Taxes and the tax basis of assets in the hands of your heirs, so be sure to factor this into your strategies. You should also consider your retirement plan.
Retirement plans come in all shapes and sizes ranging from Roth IRAs to 401-Ks, qualified corporate profit sharing and defined benefit plans, SEPS, etc. Each of these offers the potential for huge tax savings, but these vary according to your age, the amount of money you make consistently, the number of your employees, whether or not you are married, with or without children, how your business is organized, etc. Making a decision as to the right plan for yourself and your family members is a complex process, and you’re going to need help. Your first stop might be to visit a Pension Actuary to see how a qualified corporate pension plan would help save taxes. You might also consult a certified Financial Planner. You’ll have to pay for this help, but it will be well worth it at tax time.
I started this letter with a foreboding view of the near term future that can be converted to a major opportunity if you sell for cash and put your cash to work aggressively. I finished it warning you to formulate a plan to hold taxes down to a minimum while you fund your future retirement income. We live in a dynamic world that changes almost daily. Staying informed and being prepared is the key to staying on top of the heap regardless of what an uncertain future might bring.
