December 1987
Vol 11 No 2
For the past 5 years I’ve been feeling foolish for not getting in on the stock market boom. After the whipsawing that the Dow took in October, I’m beginning to feel a lot smarter for having been invested in real estate. I entered this world just after the crash of 1929 in time to experience a decade of depression which was only ended by WWII. Now I can lay claim to having experienced a market crash which was almost twice as great in terms of percentages and perhaps 100 times as great in terms of monetary losses. In the interim between late August and mid October about $1,000,000,000,000. in the value of stocks was lost to investors. That’s almost enough to run the country for a year!
In the 35 years that have elapsed since I built my first house as a volunteer laborer for a friend I’ve never seen a year in which house prices fell 22.6% – let alone a day in which they fell that fast. But I have seen years in which houses ROSE in price by as much as 30% in hot real estate markets. There’s a message here somewhere. What’s the essential difference between houses and stocks which make stocks so much more volatile? Maybe if we can comprehend the factors which contribute to these differences, we’ll be more able to chart a safe course through the pitfalls and profits of the next few years.
First of ail, let’s recognize that there are investors who buy and hold for the long term in all markets as contrasted to speculators who gamble on the future rises and falls of prices. There are those who use leverage and buy on margin and those who pay cash or exchange for free and clear properties. Regardless of which market you’re in, if you use leverage you’re speculating to a certain degree on the financial markets and on the economy. When you own equities free and clear NO ONE CAN FORCE YOU TO LIQUIDATE REGARDLESS OF THE RISE AND FALL IN PRICES! If you’re in for the short haul by virtue of the use of short term financing or of short term Options or futures contracts, your future will be held ransom by market forces as they are influenced by government, the news media, actions of other speculators, financial panics, politics and credit. All of these came into play in October, wiping out millions of speculators in the process.
Investors who didn’t panic will be able to weather the storm. Sure, paper values have fallen, but dividends will probably remain as before. Sooner or later stock values will return based upon corporate performance and profitability. Quality stocks will still be a good investment /vs/ a good speculative venture. The same holds true for real estate and houses! Who can deny that even in Houston or Denver a well managed free and clear property can still be a good investment that will appreciate over the years? This is especially true with houses – whether as rentals or as your primary residence. It’s the use of poor financing, high interest rates, variable/negotiable mortgage loans, personal recourse, balloon notes, etc. that create most of the problems with real estate just as leverage and buying on margin created most of the damage in the recent stock market crash.
There’s another fundamental reason why stocks are so much more volatile than real estate. Financial News Network carried 14 hours of programming which detailed every move in the market to millions of viewers. This was multiplied hundreds of times by the radio, TV, ‘hot lines’, brokerage houses and banks as they kept the public informed. And with an orderly market, it was possible for computers involved in ‘program trading’ to dump over 600 MILLION shares in a single trading day on the NYSE alone. A dozen other stock markets were also seeing record numbers of transactions. Real estate comprises a fractured, disorganized market in which information is disseminated slowly throughout the
Copyright Sunjon Trust All Rights Reserved
Quotation not permitted. Material may not be reproduced in whole or in part in any form whatsoever.
1-888-282-1882 www.CashFlowDepot.com
market. And because real estate properties are inherently dissimilar, values vary between properties both locally and over wider regions. Hence, most house sales are transacted between parties who have inspected the physical premises and compared a host of personal criteria to the amenities rather than making a decision based on purely market and financial considerations. Thus, no computer can be programmed to buy or sell in a market in which individual preferences so affect market liquidity. Things move much more slowly with houses.
NO MARGIN CALLS IN REAL ESTATE . . .
Let’s look at two situations which reflect the way credit is used in the stock and real estate markets. Suppose you’d filed a financial statement and signed the required forms at your local Stock Brokerage. Depending upon the stock exchange and Federal Reserve Board margin requirements, you’d be able to buy stocks for about 50% of market value. In so many words, the brokerage house would hold stocks you’d purchased as collateral and let you buy twice as many stocks as a person who didn’t use ‘margin’. So long as your stocks continued to climb, the collateral value of the stocks the broker held would also climb. You could use this excess collateral to borrow cash or to buy more stocks on margin. But when stocks started down in October, computers which monitor the value of collateralized stocks generated ‘margin calls‘. This meant that speculators had to gather up more cash and bring it into the brokerage in order to further collateralize their borrowed funds.
In a typical case, the person who’d been riding a 5 year stock market boom had already spent all his cash either to buy more stock or to support a life style commensurate with the ‘paper wealth’ represented by the value of his/her stock portfolio. Hence, the calls for more cash could not be met. The brokerage house then sold the stocks it held to pay back the loans and the speculator was out in The cold. That’s had enough, but for many of these highly leveraged victims, the picture became much more bleak. Part of the paper work that sets up a margin account includes a personal promissory NOTE to repay any loans not covered by the sale of collateralized stock. In one instance, a Doctor not only lost his total nest egg. He’s still in hock for $500,000. He’ll have to completely change his life style, wipe out any hope for his children’s education, sell his practice and start all over even though the value of his stocks recovered later on. Too late!
Contrast this with the person who used high leverage to buy real estate. In the first place, it‘s possible to have bought real estate using 80% – 100% leverage depending upon the buying technique used. Like the stock speculator, the real estate speculator is counting upon the value of houses to rise in order to repay the loan and the interest. But he’s also got a secret weapon: TENANTS! While he’s holding his houses, they‘re typically returning about 6% – 8% in rental income to help service the debt. This enables him to hold on longer than the stock investor who’s getting a miniscule return of around 1% when the market passes 2600 on the Dow. We’ve only got a few instances in which values dropped below loan balances in recent history, because mortgage interest rates have historically been lower than margin account interest rates while rents have been on the rise. But in the mid-50’s, 60’s, 70s and 80s real estate flattened out and suffered declines of around 10% to 15% in a few markets. More recently farm land experienced a traumatic drop as did some of the real estate in California and New England after being run up to stratospheric levels by action of speculators who had access to easy credit. But when values did drop, there were no margin calls by lenders! Why? Because the disorderly market prevented rapid sales!
On the one hand, the stock brokerage house was able to sell the stock in a matter of moments on the floor of the Exchange. On the other hand, the mortgage lender must go through months of legal processing in order to reclaim a house, then he has to insure, pay taxes on, maintain, manage and re-sell the house in order to get his money back. Meanwhile, the value of the property may continue to fall. This is why foreclosed properties typically have in excess of a year of back interest accrued when they’re sold. And in many areas, no deficiency judgement will attach to the former owner by virtue of state law. So what does the prudent lender do? He does nothing so long as the payments are being received on time. When the market value of the real estate falls below the loan balance, he does everything he can to encourage the borrower to continue to make payments rather than to call the loan.
WHERE DO WE GO FROM HERE?
In 1883 in Malaysia, the explosion of Krakatoa lifted 4 square miles of dirt into a giant dust ball that obscured the sun for thousands of square miles. People living thousands of miles away were affected by tidal waves, crop failures, radical temperature changes. As many as 40,000 lives were lost as a result of these secondary effects of this event. The record crash of the stock market must also be viewed from the perspective of the event itself as well as the secondary effects caused by its ripples through our society and economy. This is particularly important in this politically sensitive season. Just as the 1929 crash by itself didn’t cause the depression, but rather motivated government to make many bad decisions in restricting credit and passing anti-trade legislation, so are we now vulnerable to that same sort of political interference in our markets by legislators.
Consider that Alan Greenspan immediately reversed policy and opened the credit window at the FED to shore up overextended banks who’d made loans against stock portfolios. Thus, he loosed billions of dollars into our economy. He helped coach President Reagan in his preparation for the national news conference – a revealing portrayal of the close links between the supposedly independent FED and the Administration. And look at the 180 degree turn in Reagan’s attitude toward increased taxation. Notice how Bork’s nomination moved from being a close call to a runaway for the liberal side of the political spectrum after the market crash. The Democrats, sensing political capital in the market crash are already reconsidering their options. Don‘t he surprised if Cuomo, Bradley and even Nunn re-emerge in response to a ‘draft‘ as Presidential candidates. And look for INCREASED GOVERNMENT CONTROLS over margin accounts and credit in general. All brought on by stock‘s Krakatoa.
What happened to all the money released by the market to all those investors who were able to get out? Gold waffled a little. It didn’t go there. It went into the Bond market – from equity positions into debt positions. As a result, interest rates started to drop a little. Prime went down. Mortgage interest rates dropped several basis points. In the short run, this is good for business and real estate. It was good for government too because all of those stock sales triggered additional taxes at the same time as the interest paid on T-Bills, T-Bonds and T-Notes fell off a little because of the flight into ‘quality‘. Now, Reagan has convened a panel to try and find ways to raise the money to pay the interest on all that borrowed money. Thereby hangs the clue to the future.
Depression is on everybody’s mind. Yours, mine, the politicians’. Nobody wants another 30s style decade. Reagan‘s power is on the wane. Even his own party wants him to relent on taxation. The market has sent signals that capitalists won’t invest in stocks if the budget deficits aren’t reduced. Consumers are jittery – starting to save against a rainy day rather than to spend. The coming holiday season can spell success or failure for retailers across the country depending upon what the consumer does, so politicians are talking up ‘confidence’ and ‘spending’ just as they’ve always done when things slow down. New cars are finding few buyers. The tax act is also reducing credit card buying. There seems to be only one way out for the politician who hopes to save his job: INFLATION. The FED has already expanded credit to offset the psychological loss in purchasing power of the American family caused by the market crash. Even though it cost about $10,000 per family for the drop in stock prices, the loss wasn‘t spread evenly. Many who lost nothing are now fearful of their bank accounts being lost in a bank crash. Others who were conspicuous consumers will be forced to cut back. Only easy money will get things going again to generate a higher gross national product, higher wages and profits to tax, reduction in the trade balance, and the ability to repay foreign loans with cheaper dollars.
They’ve already figured this out overseas. They’re moving out of the dollar into stronger currencies. The dollar is dropping. About the only way they can spend it is to spend it in America. If they buy Bonds, interest rates will drop and real estate will rise. If they buy real estate, demand will push up prices. If the government inflates, cash will rush to tangibles, and real estate is the most tangible of anything – especially AMERICAN REAL ESTATE. Of course it doesn’t follow that what the government wants it gets, but I’m going to place my bet on inflation – and houses with safe leverage . . . or no leverage!
LOOK WHAT THEY’VE DONE TO MY SONG, MA . . .
The decade of the 70’s made many real estate investors wealthy. The decade of the 80’s spawned hours of TV time devoted to transient gurus who promised easy millions to those who could learn the secrets of wealth available at $395 in a handy-dandy tape set. These ‘secrets‘ were really more or less standard real estate techniques all dressed up in a new dress called ‘creative buying’ that were out of date almost before they were presented. The 80’s also saw fundamental changes in the way houses are financed, taxed, pyramided to build an estate and managed. This has been the decade of the manufactured home, equity sharing, time sharing, syndications. There’s more to learn than ever before if you expect to take advantage of what might well be a ground-floor opportunity in real estate investment. You’re going to have to forget much of what you already know if you’re to succeed. All year we’ve been presenting seminars to cope with 1987’s changes. We’ll do even more in 1988.
When dealing with the real estate market in the balance of the 80’s and into the 90’s, it will be necessary to devise structures which will permit you to avoid litigation, liability on loans, indexed financing, negative cash flows, recognized taxable gain, tenant disputes, rent controls, loss of tax shelter. More and more the use of Trusts, nominees, corporations, options, exchanging, leases and remainder estates will play a larger and more sensitive role in successful estate building techniques. Learning ways to negotiate the structures you must have will be more important than either price or terms in many instances. This means that the real estate markets will become the province of the best trained and the most experienced. It will be more and more difficult for amateurs to survive, thus learning how to do things will be the key for the future.
There are going to be some new types of real estate opportunities which will compare favorably with quality stocks for the investor who’s looking for growth more than for income. Consider buying random building lots in run-down areas of town which you feel will be ‘coming back’ in a few years. Controlling improved lots with all utilities nearby, close in to city centers and transportation have proven to be solid investments in the past. Often, these can be picked up at tax and estate sales for small amounts. They require no management and usually have low property taxes assessed. Later on, you’ll have the choice of either building a small house for rent or resale, or of selling/co-venturing with a builder who wants to build on it. Or you could exchange it readily in most markets.
For you readers who like bigger deals, I was recently offered an improved piece of land on the water already zoned for 25 condos with sewer, water, permits and fees intact by a lender who’d taken it back from the developer. He’d already built out 75% of the project and had completed selling it when he got caught in a cash-flow crunch and returned it to the lender. The lender didn’t want it, but agreed to accept ‘paper‘ on another completed project which had been sold by the developer who’d carried the financing himself. This was valued at about $10,000 per unit. There will be more and more of these types of deals in the future. Look for them.
Copyright Sunjon Trust All Rights Reserved
Quotation not permitted. Material may not be reproduced in whole or in part in any form whatsoever.
1-888-282-1882 www.CashFlowDepot.com
