February 1982
Vol 4 No 5
Mortgage lenders and real estate sales will never be the same again. The giants are moving in. Insurance & Securities companies, Retailers are rushing to get aboard the gravy train. Prudential is buying Bache, American Express now owns Shearson Loeb Rhoades. Sears has bought Coldwell-Banker and Dean Witter Reynolds. Merrill-Lynch is the biggest buyer of real estate brokerage firms. FNMA has opened the doors by offering investors 100% guaranteed mortgage-backed securities on single family houses. TRILLIONS of dollars are at stake in this decade and competition will be brisk.
Traditional financial institutions and real estate brokerage firms will be the losers over the next few years. They aren’t prepared to compete and are already feeling the pinch. De-regulation, mergers, interstate and branch banking, entry of foreign interests which uncontrolled funds are forcing lenders into more risky ventures in which they have little expertise. We can look for many more forced mergers and closings of banks and S&Ls in 1982. Closing of real estate offices across the country is already of epidemic proportions.
When a company like Merrill-Lynch can offer super mortgage backed bonds to attract Trust funds at moderate interest rates, they are in position to package the entire transaction from land acquisition to resale at below-market interest rates. In like manner, Sears can take trade-in homes fully furnished in one part of the country and permit the owner to select the home of his/her choice in another area, fully equipped and insured. With access to billions of dollars from retail financing and the sales of securities, these two firms are going to dominate real estate for years to come.
The entrepreneurs will still find a way to survive through creative financing, exchanging, Options, managing –areas too small or technical to attract competition. Property Managers will be able to capitalize on the emerging market in several ways. It’s one thing to acquire hundreds of properties through financial power. It’s another thing to maintain control over them. Managers will be needed as never before, and they’ll be well rewarded. A 50 house portfolio with average rents of $400 per month would generate about $24000 per year to the manager in fees. But that’s not all. . .
Property managers are the first to know when a house will be offered for sale. They also know its true performance as an investment. A manager friend reports that he recently bought 3 houses from a nervous owner who anticipated a real estate crash. Terms nothing down, no payments for 7 years, and the balance due. The first lien was at 8%!
Of course, when a property manager accepts a future interest in the property in lieu of any payment, it generated additional cash flow to the owner. It also generates incredible benefits to the manager. For years we’ve been teaching ways to do this, and we number several people among our subscribers who have equities worth hundreds of thousands of dollars as a result of their use of management services to garner property interests in the form of Options. Spin-off maintenance companies just add to the icing.
DEALING WITH DISTRESSED LENDERS – a new world?
Greg Adams, Editor of House Traders, P.O. Box 1631, Bowie, MD 20716 recently offered $64,000 for a partially completed house worth $68,000. But there were conditions. The bank had to lend 100% at 12% for 30 years on a fully assumable mortgage. The loan was approved in 10 minutes, he reports. As soon as lenders realize that a foreclosed property is a double liability, they are easier to deal with. When they take a house in lieu of mortgage, they’ve LOST all interest on the loan. They’ve also accepted risk that the property may go down in value due to neglect. They now have management chores to do to keep the property presentable. It’s only a matter of pointing these facts out and offering an acceptable solution which will make the lender more comfortable.
In Southern California, Roger Krogen has reported that one referee in bankruptcy has over 400 houses for sale. He’s accepting non-qualifying, non-recourse 2nd Trust Deeds which require payments on interest of about 9% and the buyer must take over 8% 1st T.D.s. Investors are welcome. I understand that the rental market is quite strong too. Often it is far better to deal with distressed lenders than with distressed owners.
BEWARE OF THE 1986 MONEY-MARKET BOMB!
Creative financing has bred a multitude of financial instruments, both from private lenders and institutions. Many of these require some sort of payment or roll over after 5 years. Because the bulk of these came into being in 1981, their 5 year due date will fall in 1986. I foresee a capital crunch far worse than the present one as everyone rushes to refinance their positions. One study predicts the need for OVER A $ TRILLION by 1986 between Government refinancing of deficit spending and the nation’s credit needs.
For borrowers, now is the time to defuse this situation by re-negotiating your balloon notes so they fall due either ahead or behind this critical year. I prefer 7 – 9 year due dates. I’m willing to pay a little extra in the form of higher price or interest provided I can gain the safety of several years distance from a potential credit crash. Even then, I build in a contingency penalty. In the event I might not be able to raise cash when the note falls due, I get the lender to agree to specific extension provided I pay a penalty. This stood me in good stead in 1981 when I extended a 9% note by payment of an 8% penalty. The total of 17% cost was far cheaper than current lending rates.
Lenders may already be in jeopardy. This year I had one or two mortgages go in default. Rather than take back the property, I renegotiated terms to extend the loan. I didn’t really WANT to, but it seemed the wiser course of action. Now I won’t buy notes or mortgages with due dates in 1986. Those that I hold are being re-negotiated now so that I’ll be safely out of them. If I can’t move the payment date up sooner, then I’ll try to use them to buy property with. Of course, I offer discounts for early payment so the borrower will have the incentive to pay them off.
One technique might be to offer a “buy-down” if your borrower would refinance the property and pay you off today. Essentially, you’d agree to pay all new loan costs and to subsidize the interest payment for the remaining term of your old loan. If you had a $15,000 2nd Trust Deed with 60 more payments of $150 per month and balance due, you might offer to give $3000 of the proceeds to a borrower who would pay you off via refinancing. This would be left in the lender’s care and used to subsidize payments for the borrower. Suppose we discounted the original income stream and the lump sum $12,000 you’d receive from refinancing at 20% to compare the benefits. The present value of total monthly and balloon payments on the original loan is $11,784.21 compared to $12,000 net for a pay off. Plus, you’ll avoid the risk of default in the future and the collection problems today.
CONVERT EQUITY TO INCOME USING GROUND LEASES
When interest rates are high, ground leases can solve problems. Suppose you wanted to sell a property for $75,000. Payments on the $60,000 loan would be close to $900 per month today. To qualify, a buyer would need an income of $35,000 or more, after the down payment of $15,000 on an 80% loan. Suppose you accepted a 55 year ground lease and retained title to the underlying land as part down payment. The buyer could reduce his loan to $45,000 by paying the $15,000 in cash to you. His new payments would be some $200 per month less. He’d only need an income of $25,000 to qualify for the loan. You could set ground lease payments at 2% of the appraised value of the total property per year. The first couple of years, you could let lease payments accrue to the value.
Assume that after one year, the property had appreciated from $75,000 to $82,000. 2% of this amount would be $1640 so monthly payments on the ground lease would be $136.67. Each year lease payments would be compounding along with the property value, INDEXING the income to inflation. Contrast this with merely carrying “paper”. Eventually it pays off. Even during the term of a loan, “paper” is reduced in value by inflation. Leased land increases in value. It is one of the most secure income streams available anywhere.
Anytime you might want to convert your land lease to cash, there are any number of buyers in the market. Pension Plans, Retirement Funds, Insurance companies, investors who want a passive, safe, indexed income stream will compete for solid land leases. It would seem that adroit investors with corporate pension plans would buy the ground from other investors’ property, and sell the ground from beneath their own. This way, they’d be able to expense lease payments on their property while their pension plans accepted the tax-free cash flow from leases they owned on other properties.
UPDATED RENTAL CONTRACT LANGUAGE FOR 1982:
In our management course we introduced using First Right of Refusal Options which the tenant purchased instead of paying any deposits. At the same time, tenants were advised that they would earn a Bonus at the termination of their contract period provided that they met all the terms of the agreement. Recent court decisions have indicated that giving a tenant an option to purchase as a condition of the rental contract or lease is hazardous. In some instances eviction has been refused and owners have had to resort to suits for partition – a time consuming and costly procedure.
We now offer a First Right of Refusal Option TO RENEW THE RENTAL CONTRACT at an increase not to exceed 10% of the base rental amount. Thus, we have alleviated a possible title problem and at the same time programmed the tenant for a 10% increase next year. We increased our rents in December on this new contract with no resistance whatsoever.
LEASES WITH OPTIONS ARE EMERGING AS THE OPTIMUM BUYING TOOL IN 1982
Buying for tax shelter alone can be extremely expensive under the new ERTA laws so Options may well become the only game in town. I just bought an attractive water front condominium in a slow rental market by agreeing to pay annual payments in advance to relieve the negative cash flow of the owner. He initially agreed to a 3 year option price of $87,500 after which time the rent would increase by 10% for 2 more years with the option price being increased to $90,000. He agreed to continue to pay condominium fees, taxes, insurance, and to leave all the furnishings as part of the option. Over the entire term of the option I’ll pay him a total of $36,630. This amounts to just over 8% even if the premises remained EMPTY. Because my rents are at market rates, it’s more likely that I’ll pay nothing for the option over the whole period. I arranged to pay a 10% penalty in the event I should elect to extend the option for 2 additional years.
Anytime there is an inversion between market value and market rents, it doesn’t pay to become the owner of income property. A soft rental market enables one to obtain the best lease/option terms from anxious owners. It’s critical that a long enough term be negotiated to enable the property to increase in value.
REVERSE ANNUITY MORTGAGES – The Ultimate Weapon
Mrs. Smith, a widow, owns her $85,000 home free and clear. She paid $14,000 for the property in 1955. She likes the neighborhood and doesn’t want to move but the property taxes and maintenance bills are depleting her small pension swiftly. If she borrows against her property, she runs the risk of missing a payment and losing her home. This looks like a job for super-loan: The Reverse Annuity Mortgage.
She applies for an 80% loan of $68,000 at 17% payable $938.49 per month for 20 years. She signs the Trust Deed and on the first of the next month she RECEIVES the payment rather than paying it. This payment will continue for the remainder of her life or 20 years if she survives. At that time she’ll sell, refinance, or sign a new note depending upon her needs. At 10% annual increase, her house will be worth $571,000 with a $68,000 loan to be paid off at the end of 20 years. If YOU had 5 houses you’d be able to have a $50,000 income for life while still leaving a multi-million dollar estate. And your income would be TAX-FREE because it is BORROWED!
ERTA CHANGES ESTATE PLANNING STRATEGIES
The Feds are getting tough on investments without any redeeming value other than TAX-SHELTER. For 1981 deductions they disallow, or on any other unpaid taxes, they charge 20% in interest, 5% negligence. If you over-value assets to get higher tax credits or depreciation you can be charged a 30% penalty plus 50% of the interest charged. Now’s a good time to start cleaning up your act if you’ve been a little loose on valuation.
B. Ray Anderson’s TAXFLATION FIGHTER (New Capital Publications, P.O. Box 3000, San Ramon, CA 94583) has a great December issue on estate taxes under ERTA. Surviving spouses can inherit ALL the estate regardless of size and pay no estate taxes. After 1987 other heirs will get the first $600,000 tax free. Gifts up to $10,000 can now be excluded. Before you turn off, consider how many people die as a result of accidents or illness at fairly early ages. And while your estate may not be large today, project what it could rise to in 5 years. You may want to do some planning. Consider:
Suppose you and your spouse hold title to your home as Joint Tenant with Right of Survivorship and one of you dies. You paid $20,000 fifteen years ago. It’s worth $85,000 today. The new basis to the survivor would be ½ of $20,000 plus ½ of $85,000 or $52,500. But if the descendant held title solely, the new basis would be $85,000 and the property could be sold for cash tax free. Multiply this single house by the number of various properties you hold, and you can see the need for some planning. Of course the use of the $10,000 gift exclusion, corporations, trusts, probate avoidance etc. are all part of the process of maximizing the benefits to your heirs.
This is an area in which expert counsel and guidance are crucial to the well being of your family. An ounce of prevention could save years of anguish and thousands of dollars of unnecessary tax losses.
There’s a new book out, FORTUNE BUILDERS, (Impact Publishing Company, 1601 Oak Park Blvd., Pleasant Hill, CA 94523). It’s a story about some of you who’ve succeeded in amassing portfolios of single family houses. Happily, Miller/Schaub was mentioned. If you want to find out what some of your peers are doing, get a copy. Try Waldens.
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