I’ve been pondering the enigma of why bright, energetic, ambitious people don’t become financially successful despite all their efforts. I think I’ve come up with one answer, although with such a provocative question, there are bound to be others. For simplicity’s sake, I’ve divided people up into different groups.
The first group include those who haven’t cultivated good work habits. Somewhere along the line they were conditioned by their parents, peers, or their government to regard work as something bad, and play as something good. As a result, they play their lives away living on dreams and credit. Their conversation is centered on all the things they want, but rarely on what they intend to do to achieve their goals.
By far the second, and largest, category consists of those who are held down by their fear of failure. I know this group well. I was a full fledged, dues paying member for over half of my life. They’re best known as “employees”. Here, in the most fertile economic environment on earth, they sacrifice all hope of rising to the top in order to avoid sinking to the bottom of the financial heap. Few of them realize that all of their security is based upon the next group.
Group Three are those eager souls who focus more on the pinnacle of achievement than on the risks associated with trying to climb higher up the economic ladder. The French have a word for them which derives from entreprendre. It’s “entrepreneur”. It means “to take the risk” of loss. These are the people who start up, finance, operate, and nurture financial enterprise, and who provide the opportunities and security for those in group two above. The majority of entrepreneurs in real estate include brokers, developers, builders, fixers, dealers, sales-people, and agents. They work “without a net” for most of their lives, relying upon their talents and skills to provide above average rewards to support a comfortable life style. But, they miss an important insight. Whether they perceive, or react to, risk or not, it’s still present; and they’re vulnerable to it.
The income of this group is totally dependent upon their being able to ply their respective trades on a regular basis. Without access to low cost credit relative to the rate of inflation, and readily available mortgage loan money, most of those in group three could lose everything. This, in turn, depends upon government policy and the Federal Reserve; it’s also influenced by local demographics.
People in this group routinely are in a feast or famine cycle. When times are good, thousands of competitors flock into the fray, driving down profit margins. When times are bad, they must limp along, using up profits from good years to sustain them over the slack times. If they should become crippled in mind or body as a result of stress, accident, or illness, even in good times, they’re effectively out of business. Few tears are shed for sales-people who can’t sell, and there aren’t many government safety nets for entrepreneurs.
Those who make money while they sleep are investors who let their money work for them. In real estate they’re the landlords. While they complain loudly about their plight, even in arduous situations, it’s almost impossible to find one of them putting in a 20 hour work week. Most feel abused if they have to work one week out of the month. Moreover, they can miss weeks of work because of illness or incapacity and their income is hardly affected. In a slowing economy, rental housing demand, rents, and landlord income, tend to rise proportionately.
“PEOPLE SKILLS” ARE THE KEY TO BEING A LANDLORD . . .
Where group two may be scared off by fear of failure, many of those in group three are afraid of dealing with people on a regular basis. They don’t mind closing a quick deal and moving on, but the prospect of having to attract and select people who would make good long term tenants is daunting for them. Why? Because they think of themselves more as “workers” than as “capitalists”. It’s all a matter of attitude.
When I rent a house to someone, I hark back to my days as General Foreman of a manufacturing plant. Although I was hemmed in by regulations and Union contracts, I could still develop job descriptions and set performance standards that my subordinates had to meet. When I interviewed job applicants, my primary selection criteria was the degree to which people would meet these standards. I didn’t hire prospective trouble-makers, slackers, or unqualified people whom I felt wouldn’t work out. It cost too much time and expense to hire and then fire people. I was better served waiting until the right person came along, even though it cost more initially. On the other hand, by doing everything possible to improve the workplace and job satisfaction of those whom I hired, I was able to attract and retain better people, making my job easier all around.
When you think of it, this is analogous to landlording. You start by offering a work environment (the rental) that is as attractive as possible. Surveys have shown that families rate the quality of area schools as the single most important criteria for choosing a home, followed closely by neighborhood safety and amenities, proximity to work, recreation, and shopping facilities. So, by buying rentals in areas designed to attract more and better tenant-applicants, the landlord is able to pick the best, and to hold them for years. This really works well. I’ve now got several tenants who have been with me over 10 years, and three who’ve been there over 15 years. I recently lost one who’d rented the same house for 22 years.
Where those who would be passive real estate investors go wrong is in focusing upon “bargain” houses that they can buy with low down payments. Or they aim directly at HUD Section 8 subsidized rent programs that produce above-market rents at the cost of more intensive management effort. This often attracts the most troublesome and transient tenants from among those with the least job stability. This guarantees that the landlord will spend too much time actively “managing” his rentals, performing maintenance, and pursuing missing rents. Ultimately this approach is the primary reason why those in real estate fail. They’re driven away from long-term financial success by landlord burn-out.
It makes more sense to buy better houses in better neighborhoods to get better tenants. A good tenant is like gold. He always pays on time and never calls. He’s able to fix things, or to have them fixed at his own expense if he breaks them. He responds to incentives and understands that landlords have to raise rents to match rising costs. He doesn’t like to move, and will stay in a house for years if treated fairly. Why don’t more people buy better rentals? Because they can’t make the financing work. Let’s see if we can’t quantify this.
Suppose the best rental in your area would cost $100,000 and it would rent for $850 per month. In contrast, a rental that costs $60,000 would rent for $650 per month. Anyone with a pocket calculator can easily see that paying an extra $40,000 would only yield an extra $200 per month rent. That boils down to 6% gross yield per annum. Let’s take these figures apart. The cheaper house produces 13%. You could buy 5 of these for the same price as 3 of the $100,000 houses, and these would yield $39,000 per year in gross rents versus $18,000. That boils down to $21,000 per year in additional income for the same amount invested. This reasoning is why people buy the wrong houses.
What doesn’t show is the cost to the landlord of trying to manage the lower cost houses. Lower cost housing attracts those who can’t pay more because of lower earning power. They typically are the last hired and first fired. They create far more collection and eviction problems, excessive repairs, turn-over and rent-up expenses, vacancies, and legal problems than tenants a little higher up the economic ladder. In all probability, the apparent $21,000 difference the landlord receives in managing five difficult rentals compared to managing 3 easier rentals is reduced to around $10,000 per year when the smoke clears. There are easier ways to make $10,000. One way is by “flipping” houses by using short term purchase contracts and/or Options.
SELLER CARRY-BACK FINANCING IS THE KEY TO BETTER HOUSES . . .
The reason given by so many who buy the wrong houses for rentals is that the better houses don’t make financial sense at current mortgage loan rates. For example, the $60,000 house bought with 5% down payment and a 95% conventional 30-year mortgage loan would require payment of $418.25. Add $100/month for taxes and insurance, and there would be about $100 per month to pay for vacancy, management, and maintenance. The $100,000 house with the same loan would require $5000 down payment and $800 per month in payments once taxes and insurance had been added in. That would leave only $50 for operating expenses each month. One might make the case that, with better tenants, there would be fewer operating expenses, but that begs the point. By negotiating unconventional financing, all the numbers can be brought into perspective. Read on.
Given the above $100,000 house scenario, from a practical standpoint, the house you buy won’t be free and clear of debt; it will already have a mortgage loan on it. If you buy a fairly new house, with rare exception, it will have a fairly low equity and a high loan balance. That might seem attractive, but it denies you a chance to negotiate a lower price and a lower interest rate. If you were to prospect in mature middle-class neighborhoods for houses that are from 15 to 25 years old, you might be surprised to see what you can buy. In the first place, the house won’t seem “old”. Twenty five years ago houses were wired and plumbed for most of the amenities that are offered today. Most of the special assessments for curbs, gutters, schools, etc.would have been paid off, so property taxes would be lower too. Best of all, many of the owners who haven’t taken out equity loans would have large equities and existing mortgages with attractive interest rates. With large equities, you’d have the leeway to negotiate the financing you’d need.
The key to being able to find the right house in the right neighborhood with the right terms is to comb the market thoroughly. You can’t wait for the people who have already decided to sell. They’ll have already contacted real estate brokers and will be thinking in terms of all cash terms and retail prices. You’ve got to take the initiative to be “firstest with the leastest” by converting owners who were pondering whether to sell or not into motivated sellers willing to make a quick deal. This is a real art, but one you can master with a little practice. Start by thinking in terms of the thousands of people who live in your target areas. Neighborhoods are like shopping mall parking lots. They stay full, but people are always coming and going; for a number of reasons. Kids grow up and leave home, or return home. Families are forming and breaking up. Zoning laws, highways, and communities are constantly changing. Jobs opportunities open up and employers shut down. People get old, sick, widowed, or retired. All of these situations often result in a move from one house to another that suits a person better. Understanding this and contacting these people is the first step in buying the right house “right”.
Let’s start with ways to contact potential sellers. This is a numbers game. You’ve got to contact literally hundreds of people to find people who will do business with you the way you want. If you learn to fish with a net instead of a rod and reel, you’ll catch more. Your net will consist of running newspaper ads, mailing offers to purchase to specific addresses obtained from the tax records and/or the “criss cross” telephone books that list names and addresses in order. You can deliver flyers door to door, or pay kids to do it for you. Don’t forget signs in prominent locations on poles and trees where permitted. Some people hire telephone solicitors and computerized automatic dialing systems. What ever you use, you should get the message across that you’re a wholesaler, not a retailer, and that you can close a purchase quickly. What you don’t want to convey is that you’re willing to pay all cash retail prices. You’ve got to get sellers to carry creative financing.
Once you’ve made contact, the next step is to learn all you can about the seller’s personal situation, valid financial needs, and time frames. This is the key to being able to negotiate the terms you want. If you take the time to fully acquaint yourself with these factors, you can then begin to structure an offer based upon your assessment to whether you’ll be able to acquire the house at a price and with terms that will make sense to both of you. When I can see that there is little possibility of making a house work as a rental, it might be suitable for a quick buy/sell profit. In such case, my thrust turns toward negotiating price discounts to the market so I can offer it as a retail bargain and still make a profit. A short term Option contract with minimum Option consideration is an ideal tool in this situation. You can sell before you buy this way.
POSITIVE CASH FLOW STARTS WITH TERMS, NOT PRICES . . .
While buy/sell specialists need a price spread between fair market value and price to make a profit, landlords rely upon a cash flow spread between payments and rents to generate positive cash flow, and fast amortization to build back the equity they may have given up by paying a higher price. The lower the interest rate and the longer payments can be stretched out, the greater the cash flow and amortization benefits. But you often have to trade off a higher price to get these terms. That’s the bad news. The good news is that it’s a lot easier to buy from a seller by paying more than he’s asking in return for zero interest and lower payments. Here’s an illustration of how that might work.
In an ideal situation, the seller might have bought his $100,000 house for $50,000 ten years ago and might have a loan balance of $30,000 with monthly payments of $485 including principal, interest, taxes and insurance. As a speculator, I can make a quick profit if I can buy the house at 80% of fair retail market value and offer it for a quick sale at 90%. That would generate $10,000 profit and the whole thing should be wrapped up within 90 days. Often faster. I’ve been able to get short term Options for up to 6 months with less than $1000 tied up. If I want to take more time, I might be able to save on commissions and wait for a retail buyer, but that would require me to spend more money. I’ve found a quick turn-around at a bargain price is my best route to cash profits.
On the other hand, when negotiating for the same house as a landlord, I might set the tone by starting off with a wholesale price based upon 80% of the value, but gradually be persuaded by the seller to pay more. I’d make price concessions in return for the seller carrying back financing over a longer period with zero interest rate financing and with payments that would enable the house to provide cash flow starting immediately.
My objective would ideally be to pay a little higher down payment, say $10,000; and to take over the seller’s payments ($485) paying him an additional $250 per month for 240 months until the remaining loan balance had been paid in full. $10,000 and a quick settlement date, or, a $105,000 price might motivate the seller. Or, I might allow him to remain in the house, commencing my payments only after he’d vacated and I’d found a tenant. I’d be paying out a total of $735 and receiving $850 per month rent. That would give me $115 monthly gross cash flow until market rents increased.
Let’s calculate the yield. Let’s say that, even with a house in good condition, I’d use up all the rents the first year to support the property. My amortization on the loan would amount to $3000. That’s a 30% return on my $10,000 down payment. But that’s only half the story. Eventually, after the first mortgage loan has been paid off, even without any increases in rents, my cash flow will jump by $300 per month, assuming I’d still be paying about $185 for taxes and insurance. My yield would increase to 66% per year on my original $10,000. But, as covered in last month’s letter, my rents would be increased, driving my investment yield ever upward. This cash flow would increase by another $3000 per year once my second mortgage was paid off.
I started this letter asking you how much money you could earn while you sleep. In the above example, I’ve only dealt with one house. Multiply this by only 10 houses and you’ll find yourself with $100,000 per year in current dollars while you sleep. Of course, if you get greedy and buy more houses, you’ll make more money. When your invested dollars are earning this kind of return, it’s pretty easy to siphon off the earnings of a single house to pay for all your management. You can still sleep pretty soundly with the income from only 9 houses with no work at all. I must confess that I can’t understand why everyone isn’t a landlord.
There are a few points I should make. First of all, where do you get the $10,000 to buy the house? From profits on the houses that you buy and sell quickly using short term Options. What about the dreaded “due-on-sale” clause? Ignore it. That’s one of the fear factors that keep people from succeeding. Only a minuscule number of loans have been called nationwide in almost two decades since this law was passed. It’s all bark and no bite.
SEE THESE RELATED ARTICLES:
