September 1985
Vol 7 No 12
Isn't it amazing how quickly we lose sight of our goals in investing? I've been watching a passing parade of pitch men on television who goad the gullible into attending various real estate seminars. These range from 1 hour high pressure sales presentations to 2 day high pressure sales meetings at which various educational aids are made available for purchase. It seems that the object of most of these sessions is to convince attendees that they should spend their money to buy an investment which doesn't return any income to the buyer.
I guess I'm old fashioned. I like capital gains as much as the next guy, but I need income while I'm waiting for my gain. Oh, there's nothing wrong with investing for the long term and deferring income to a period when it's needed. That's the essence of investing – sacrificing some of today's pleasures in order to enjoy security and ease in a period of life when active earning capacity is diminished. But the concept of actively seeking out negative cash flow properties with poor financing and calling these investments just doesn't seem rational to me.
The proof is in the pudding! How many people do you know personally who've been successful doing this? I'm not talking about people with high paying jobs or income from other sources who can afford continuing drain of their assets. The people I've been looking for are wage earners who hope to gain wealth through real estate investment – you know who they are – they attend all the pitch sessions and join the investment clubs, buy everyone's tapes and books, go to seminars. How many of them have been able to retire on their investment income?
The summer of 1985 has been replete with news articles debunking many of these same pitchmen. Some are being investigated. Some are lying low. Some have filed for protection under the bankruptcy laws. Some are out of business. Why? Because what they preach just doesn't stand up in a logical investment climate. And under the proposed new tax legislation, especially in combination with indexed mortgage loans, the concepts of super leverage and resultant negative cash flow investment could prove ruinous.
NO VIRGINIA, THERE IS NO SANTA CLAUSE – IN REAL ESTATE INVESTMENT . . .
Some people were lucky enough to have invested in real estate prior to 1980 with spectacular success. The combination of low fixed interest rates, assumable loans and high inflation coupled with a general lack of understanding of the value of real estate and particularly single family houses by the general public created a vintage investment period. Not so today. Aside from people who either lead investment clubs or conduct the investment seminars, few people are making much money today buying negative cash flow.
How does one hope to gain financial independence in today's world? The old fashioned way. Thrift. Hard work. Patience. Skill. Creativity. Comprehension. Desire. Sure it's possible to make a lot of money even with a very small amount of cash, but you'll have to do it a little differently – and you'll have to avoid negative cash flow financing on indexed loans. And you'll have to take time out to really learn the fundamentals that make the single family house still one of the paramount opportunities for the little guy.
This month we'll take a look at what makes a good investment property and ways to increase that cash flow once we get it. And perhaps, for the truly motivated reader, we'll be able to show one way to become independent before your financial investments and income properties begin to generate enough income for you to quit your job if you want.
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The hallmark of income property is INCOME! Let's start with that as the only legitimate objective of any pure investment that you don't intend to actually USE for business purposes or personally. Next we have to consider the TIMING of the receipt of that income, the COSTS associated with its production, the TAXES levied against income at both state and federal levels, and the CERTAINTY that said income will actually be available to us for our use where and when we want it – and in the currency of our choice. Lastly, we have to look at its bottom line PURCHASING POWER at the time it's received.
We can characterize income as that received from rents and that received from sales. Fortunately, for single family house investors, both of these sources of income are more or less indexed to inflation while acting as a hedge during deflationary periods. Here's what I mean. Let's look at the 'Carter years' when inflation was running rampant. Single family houses outperformed every other investment in or out of real estate when leveraged at 97% on readily assumable fixed rate mortgages below 9%. It didn't take much imagination to realize that while Gold and Silver, investment grade gem stones, etc. made a fantastic run up, they were rarely leveraged and few investors could afford more than a few thousand dollars in investment. Conversely, the single family house investor could snap up 10 or so houses easily for as little as $1000 per house plus some seller financing. In many markets in the late 70's that gave him or her control over between $500,000 and $1,000,000 in assets which appreciated at an average of almost 15% per year nationally. Nothing else performed as well in the up market years. Those few who sold out and paid their taxes reaped fortunes. Those who held on experienced a different phenomenon.
The inflation pyramid began to crumble in the 80s. Gold and Silver tumbled, bringing millions of investors down with the markets. Real estate in many areas became stagnant. Values stopped their rapid rise and settled down to moderate levels along with inflation. But rents started to rise! As investors abandoned real estate for the stock market, stock prices exploded in 1982 and again in 1985. SO DID RENTS! Real interest rates rose to their highest levels in history when compared to inflation locking millions of home buyers out of the market. They began to compete for decent rentals by offering higher and higher prices for shelter. We landlords call that rent. And rent increases in such a market go directly to the bottom line in terms of profits and cash flow.
Thus, it can be seen that the single family house continues to have the power to generate GAINS in inflationary periods and RENTS during stagnant periods. But there's a fly in the ointment. With the wrong kind of financing, the mortgage loans can rise in inflationary periods under the new adjustable rate loans, wiping out any gains to the investor. And indexed payment schedules can wipe out cash flow during slow growth periods. Thus, the prudent investor has to negotiate FIXED RATE, SELF AMORTIZING, ASSUMABLE LOANS if he is to have any certainty of cash flow or gain from his single family houses. Why? Because the financing he is able to extract from a seller may be the single most attractive feature about the property should he elect to sell in the future. One must assume that a future buyer will be rational too. He'll want as many benefits as possible for his dollar.
WHERE DOES IT SAY YOU HAVE TO PAY INTEREST?
There’s a lot of confusion about the 1984 tax law regarding seller carry back financing. Let me put it straight. Seller’s don’t Have to charge interest, but if they don’t the IRS can tax them as if they received it. That’s all there is to it. No law in the United States says interest is mandatory. Indeed, 30 years ago I was buying without interest and I'm doing the same today. Not from banks. From motivated sellers. So are a lot of other people. Why aren't you? Consider how a zero interest rate loan pays down in contrast to a 10% fully amortized loan. On a $70,000 mortgage with payments of $614.30 at 10% for 30 years you'd be paying about $33 on principal each month instead of having the entire payment count against principal. And over the life of the loan, you'd pay over $150,000 MORE FOR THE SAME PROPERTY. Figured another way, the house would be free and clear of debt after about 9½ years – more than two decades earlier than with interest.
So AMORTIZATION also holds a key to future income. Regardless of any increase in property value or rents – even assuming a completely flat real estate market – your cash flow after 9½ years would leap by the amount of the rent you were collecting. You wouldn't be dependent at all upon the vagaries of the hucksters or the fanciful projections of the market soothsayers for your ultimate security. You'd be able to predict your own cash flow based upon mathematical certainty as a result of the amortization of your loan. You'd be increasing your safety margin as well as the value of your investment portfolio.
It's easy to talk about zero interest. How do you get someone to go for it? You have to offer trade-offs which will motivate sellers to agree to this kind of financing This has been discussed in previous letters. Simply put, the swift pay back of his equity has its own attraction to the seller. So would more cash flow. So would a higher price for the property. So would some up-front cash for the down payment. And, as we stated in last month's letter, rather than offering a distressed owner a deeply discounted price, give him full market value (which will make your offer much more appealing in comparison to what other liquidators might offer) but with zero interest rate terms.
When there is an underlying loan you'll only be able to deal with that portion of the property representing seller's equity above that loan. Even so, zero interest rate financing of that portion serves to reduce the overall interest cost. To make a simple example, take the same $70,000 house and assume it has a fully assumable 10% loan on it. in the amount of $35,000. You'd paying 10% on one half the total loans and 0% on the remaining $35,000 the seller would carry back. Your effective interest rate would be 5%. Think of how readily such a financing package would sell in any market. Think of potential cash flow from rents if you were collecting the equivalent of .8% per month – 9.6% on an annual basis – and paying out an equivalent 5% on the loans. Of course the amount of the difference which would be net cash flow to you would depend upon your own management skills and the particulars of the monthly payments of taxes, insurance and principal you negotiate.
OPPORTUNITY LIES IN THE EYE OF THE BEHOLDER . . .
There has been a lot of talk lately about paying down mortgage loans in 15 years rather than in 30. A laudable concept, but one shouldn't lose sight of the fact that all the money this might save will yield only as much as the face amount of the interest on the loan that's being paid down. If a person could get a higher yield spending the money on something else, then that alternative should be explored. I think zero interest rate loans offer a better solution at lower cost to the entrepreneur. If you seek gain rather than cash flow, suppose you sold the above house with a low down payment for exactly the same price you paid, but with 10% financing and payments to match your principal only terms. At the end of 9½ years you'd still be owed $155,000+ dollars – a comfortable sum and one which you might multiply with each additional property you bought and sold this way.
The bottom line then is this: if you intend to continue to make money buying single family houses, you MUST put your profit in when you buy. This can be in the form of a lower-than-market price or lower-than-market payment terms which will generate cash flow from rents and eventual profit upon resale. Resale profits can be obtained from inflation or amortization of the loan. Amortization is swiftest when zero interest is being paid. When cash flow rents, amortization and inflation occur simultaneously, yield and profit can be awesome. But it all depends upon YOUR ability to negotiate, manage and sell. Notice that no mention is made about profits being dependent upon income tax policy or the changes in the proposed law. Buying real estate the way I've described it generates true profits regardless of income taxes while meeting most of the requirements for maximum deductibility
On page one I listed several attributes of the successful entrepreneur/investor in today's markets. Patience was one of them. If you're champing at the bit to quit your job and become a full-time entrepreneur, there's a way to speed up the process IF you're willing to bet on your own skills and abilities. Here's what you have to do: Establish a household budget sufficient to support the lifestyle you and your family can agree on. Be sure to allow for current obligations and retirement of debt. Be realistic. Don't cut back so far that you can't stick to your financial plan. This budget should be extended to cover a full 12 months. It now becomes your 'can't miss' financial objective.
Next, go to work. Get the entire family involved. Once you've been able to earn one year's budgeted income, you'll have enough money to support one full year of self employment as an entrepreneur. For instance. If it takes $30,000 to meet your needs each year, you'll be able to take a year off once that sum is in the bank in cash. It's O.K. to acquire paper, cash flow property, etc. But the cash in the bank is what really sets you free. Don't fudge. If it takes 2 years to earn the right amount that's an indication of how truly ready you are to test your skills in the market as an independent businessman.
It's also a test of your self-DISCIPLINE and COMMITMENT. Without these you won't be able to survive. You may be surprised to discover your ability to make money rises at a geometric rate once you've become a full-time entrepreneur. The next $30,000 will be a lot easier to earn. But beware! Don't BORROW your income, EARN IT! SAVE IT!
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