September 1990
Vol 13 No 11
HOW DO YOU DEAL WITH FINANCIAL MELANOMA?
A few years ago I went to see a Dermatologist about removing a mole. In his routine examination, he discovered a malignant melanoma located in a glace out of my line of vision. Fortunately, it was removed before it had had a chance to spread to other more critical organs. The key was early detection and immediate REMEDIAL action. Over and over, I think of Cancer when I'm told of the financial calamities that have befallen many investors over the past couple of years. They share a lot of similarities. At the start, there are only a few minor symptoms, if any. The disease grows slowly and silently even though the victim feels that all is well. By the time it is detected, only heroic effort and radical procedures, at great expense to the sufferer, will prevent a disaster.
If one takes the metaphor a little further, as with a disease, financial ruin can often be traced back to a single incident of misplaced judgement or carelessness. In my own case, at the age of 17 I fell asleep for several hours on the beach and suffered intensive exposure to ultra violet radiation. From that time onward, I've stayed out of the sun as much as possible (notice the healthy green pallor that I boast despite living in the sunshine state). That was my only serious exposure. And 40 years later I found my first symptom. What might be analogous to the financial health of the small investor?
Climbing success mountain involves a period at the start where there are many upside rewards for little downside risk. When you start with nothing, it seems a marvel that you can incur hundreds of thousands of dollars of personal or business debt without the income to support it. Maybe not with banks, but certainly with sellers who willingly provide the financing in return for your purchasing their property. On the one hand, this is very beneficial, just as a good looking suntan in beneficial when you're young. But, on the other hand, it can cause you to have a distorted perception of the dangers inherent in excessive leverage and easy credit. In the final analysis, this can lead to the loss of years of effort if the economy turns against you.
Just as frequent medical and dental check-ups can save the expense of serious treatment later on, it pays to give yourself a financial check-up periodically. Here are some of the causes you should be looking for BEFORE THE SYMPTOMS APPEAR.
a. You continue to re-leverage your portfolio with new acquisitions and re-financing.
b. You 'harvest' your equity via financing and spend the loan proceeds on personal items.
c. After several years of investing, the ratio of debt to assets is more than 70%.
d. Although you have a fortune in real estate equities, you have low cash flow and reserves.
e. You've got full personal liability on loans – secured and/or unsecured – and low equity.
f. You're holding property (or 'paper' secured by property) with non-assumable financing.
g. You're accruing deferred maintenance on rentals in order to make loan payments.
h. You routinely sign 'interest only' Notes with short or medium term 'BALLOON' payments.
i. You're using 'credit cards' and short term credit lines/demand notes to buy real estate.
j. You've failed to make FICA and FUTA deposits for employees in order to maintain cash.
k. You're not current on Landlord/Tenant/Health & Safety rules on properties you rent. 1. The AUCTION LIQUIDATION value of your real estate is less than the amount that you owe.
m. You're writing down your properties over 15 years, but have them financed for 30 years.
n. You haven't taken the time to DOCUMENT that those who work for you are CONTRACTORS.
o. You've been co-mingling your corporate funds and activities with your personal funds.
p. You're using your corporate pension plan assets to make deals with related parties.
q. You aren't maintaining files to document basis, capital improvements, expenses, income.
r. You're not involved in cooperating with qualified tax professionals to make tax decisions.
ONCE YOU'VE DEFINED THE PROBLEM, EARLY CURES ARE THE CHEAPEST . . .
Let's do some quick grouping and analysis of the problems on page 1.
LEVERAGE: (a., b., c., e., h., i., 1.) All the causes cited occur when people are in a hurry to build assets. Because real estate is typically a 'big ticket item', it takes credit to get into the business, and credit to stay in the business. The trouble comes when borrowers start mistaking 'CREDIT' for 'INCOME'. Time after time I've heard the TV Gurus talk about pulling 'lazy equity out tax-fee' without once mentioning exactly how it was to be repaid, or the effect it had on future cash-flows, safety margins, tax liabilities and ultimately your life style.
Regardless of how little liability you might have at the time you originally put acquisition financing on a property, the next loan will probably require that you personally endorse and guarantee payment. The 'equity loans' you make can ruin you in several ways. They can reduce net cash flow to a point at which you can't meet the payments. They remove both equity and market appeal/liquidity in your property – especially when they're non-assumable and/or carry high interest rates coupled to short loan repayment periods. When loan proceeds are squandered on creature comforts rather than on higher yielding cash flow investments such as discounted mortgages or cash flow leases, all the loans do is to consume investment capital. It's like eating green apples because you can't wait for them to ripen. All you get is a stomach ache. If you want to raise cash, it's better to SELL.
Short term financing can take many forms. The obvious ones are when the loan term is for only a few years or when there's a demand feature or a callable loan. In some instances, loans can be called anytime the RTC takes over a lender, or when there's a default (which can occur sometimes event though payments are current – read the language in the notes you've already signed and your blood will run cold). Of course, a due-on-sale clause (item f.) makes any senior loan callable. Some junior loans have a provision to make them also callable anytime there's a default in ANY PAYMENTS OF ANY OTHER OBLIGATION. Bill Zeckendorf lost a multi-BILLION dollar empire because of this type of wording in one of his lines of credit loans.
It's one thing to borrow money against reasonably liquid assets that can be turned into cash quickly (i.e. Stock, Bonds, Gold). But when you use short term money to buy real estate, then get a loan called, you're going to have to liquidate in a distress market at discounts which will yield only fractions of the property value. The higher your leverage, the more properties you'll have to give up to raise cash to pay off overdue loans. Just as in Cancer surgery, when the disease is acute, they always remove a lot of excess tissue to assure the treatment is effective. So you'll find yourself giving up vastly more property than a single debt might reflect. You haven't really lived until you see a $100,000 property with a $80,000 debt sell at auction for $70,000 – which you'll have to pay or add to your other debt load.
MANAGEMENT: (d.,g.,k.,n.) Equity won't pay the bills until you sell. Only by installing competent management can you expect your properties to generate any net cash flow. It's bad enough when you NEED every dime you can get to make mortgage payments, but it can get worse. What do you do when something breaks – like a boiler or an air conditioner, roof? Or when county codes change, requiring special safety devices to be installed to keep your property from being red tagged? Or, as did happen to me, you're forced to VACATE AN ENTIRE APARTMENT BUILDING to shut down dope dealers who've infiltrated the complex? Think how that affects cash flow. We won't bring up various fines for non-compliance, special assessments and taxes. The Supreme Court recently upheld a decision (April 18th) which could wipe out the protection offered by Proposition 13 and others like it without regard to voter mandates or actions of State Legislatures. Add some extra taxes to your cash flow and project the reduced cash flow on the value of your property. Or consider the effect of a person, ostensibly a contractor, who is injured on the premises – or who injures SOMEONE ELSE on your premises. It's fairly easy for the court to conclude (in the absence of a written contract) that your 'contractor' was really your EMPLOYEE, thereby making you PERSONALLY LIABLE for any jury awards. But the more ominous threat is from the tax angle. Keep on reading.
TAXES: (j., m.,o.,p.,q.,r.) When the IRS determines that your hired help are employees, they start looking for your deposits of employment taxes and withholding statements. This is the area of tax collection where IRS employees really show their teeth. It can easily escalate into criminal charges, levies, seizures. In the past 60 days, a prosperous management company was completely taken over and sold, with the President made personally liable for all back taxes, penalties and fees. The same thing happened to a multi-million dollar service company just on the threshold of being bought out by another corporation. Instead, the founders of both the above companies were wiped out, lost their homes and businesses, and STILL OWE THE IRS.
There's an automatic trap built into the 1981 ERTA accelerated cost recovery that is allowed. In just a few years, you'll owe more than your property is worth on your books. So when you sell, much of the sale proceeds will be taxed. That's why its so important that you assemble a complete documentation file on each one of your properties to show your original cost basis, any improvements or additions, any partial sales, and all PASSIVE LOSS CARRY FORWARDS. These records are your only defense in the event of an audit to determine whether or not you've paid enough.
Once you've got an information system in place to tell you exactly what each one of your properties is doing from both a cash flow and tax standpoint, you can then make adjustments in your planning to maximize performance after taxes. You may decide to liquidate some properties to raise cash, or to exchange them tax-free and replace them with properties that are easier to manage, or that make more money. In either instance, knowing the tax effects of your decisions will be crucial.
IN MANY INSTANCES, BAD FINANCING IS A SYMPTOM OF POOR NEGOTIATING SKILLS . . .
Where does the financial cancer start? Probably when you first buy a property. Let's face it, it's an extremely emotional time. Big decision. Lots of factors to look at and weigh. Ego. Seller and Buyer needs. Investment projections. It's no wonder that so many people give little thought or time to purely financial strategy and tactics. How often have you heard of someone at the closing table who suddenly saw the interest rate jump or the lender require personal endorsement. The price for failing to accede to lender's demands meant losing the deal. So they signed. They never even perceived that the lender was using tried and true negotiating tactics on them.
Buyer and Seller are guilty of the same negotiating techniques, so you're at the mercy of both at one time or the other, depending upon whether you're buying or selling. It seems only prudent that you'd want to hone your own negotiating skills if you expect to be able to compete in the marketplace. Fortunately, we're offering a class to accomplish some of this at the end of September. Check the last page of this letter. For now, let's take a quick look at the underlying foundations of all negotiation.
DON'T FALL IN LOVE WITH PROPERTY UNTIL YOU'VE BOUGHT IT . .
Easy to say, hard to do. Everyone makes concessions when he/she wants something. Just think back to your courtship – to all the ways you changed your behavior, dress, image in order to attract your spouse. Remember those words love, honor, OBEY. With all my worldly goods I thee endow . . . I wonder how many divorcees have cause to ponder all those vows and realize that another negotiation was taking place. Ever wonder who wrote the marriage ceremony in the first place? If you become EMOTIONALLY INVOLVED in the outcome of any negotiation, you're at a disadvantage. To the extent that you're willing to walk away, even at the last moment, you'll be in a much better position to control the outcome.
If you expect to become a good negotiator, you've got to recognize techniques when someone is applying them to you. That takes both training and practice in the actual arena. But, it's fun to apply negotiating skills in every aspect of your family, financial and career life. When you read a price tag, a contract, a Note and Mortgage, a Lease, a Permit or License, sometimes even a Deed; you are being handed a proposal represented to be the final word. You've got to learn to CHALLENGE ALL ASSUMPTIONS. I've cultivated a healthy disrespect for the pre-written document. I've successfully changed the language of Notes, Deeds, Mortgages (including re-writing the fabled Clause 17 in FNMA instruments) and Leases. I've gotten away with it because the other party wanted the deal more than I did. I even took on SEARS just to see what might happen. I got them to stay open ½ hour after closing time (challenged) to sell me a suit (sale price was challenged), then got them to throw in a belt. Quite often, the more powerful your adversary, the fewer skills he'll be able to use.
In our first Negotiation Workshop, people got hotel rooms cut in half, got meals and drinks, show tickets thrown in, got rental car rates reduced. Ditto airline up-grades into First Class. A couple of girls got a T-Bird for a week for $39. Don't wait until you have a hundred thousand dollar deal to start practicing. Start small and see how fast you can learn. Be prepared to be patient, to use TIME to your advantage, especially when the other side is in a hurry. Don't over look negotiating with Tenants over OCCUPANCY, DEPOSITS, REPAIRS, RENEWALS, INCREASES, APPLIANCES, PETS.
Don't take yourself or any potential deal seriously. Learn to LAUGH – especially when you're presented a price or terms you want to improve on. Stay loose. I psych myself into feeling good when I walk away from a deal, rather than feeling bad. Let's face it, there are lots of deals out there. Discipline yourself to just take the ones you can make into good deals. That way you'll avoid accepting bad financing, bad pricing, bad management. And you'll be able to avoid many of the fundamental causes of financial malignancy listed on page 1. Right pricing includes right financing. Negotiating seller financing enables you to negotiate cash-flow terms AFTER TAXES, VACANCY, MAINTENANCE. Hence, you won't have to depend on chiseling property up-keep, tenants or the IRS to stay alive – and you'll be able to avoid having to put a 2nd Mortgage on a healthy property just to keep it operating.
Remember, houses are a lot like race horses. It's the number of winners that you have that counts, not the number of properties. Both landlords and horse owners can go broke if they have to feed too many for too long between paydays. These two seminars will help:
