February 1981
Vol 3 No 5
In the euphoria that accompanies Single Family House Investment yields, it is easy to forget there can be massive equity losses when property is lost through defaulted loans. Over the long term, we can make a persuasive case for highly leveraged houses as a hedge against inflation. For the beginning investor with limited means, there is no swifter or more certain route to wealth than a leveraged single family house portfolio. Nevertheless, with leverage comes risk of loss. It behooves us to consider the downside possibilities that a Reagan economic stability policy could bring about as it affects US.
Charles Ray Considine, real estate philosopher from San Diego, has suggested we consider the following set of premises and try to work out viable courses of actions:
(a) As long as our economy continues to expand and inflation drives the value of money down we can prosper with leveraged investment houses. If our rents will cover our operating costs and monthly payments, we can’t lose. Or can we?
(b) But suppose, for the good of the Nation, a depression is allowed to occur without any government intervention. After all, this is about the only way we’ll ever get control over inflation? While this could have drastic effects on business and the employment rates, houses would probably not lose much value. In fact, they could continue to increase in value in the event we continued to have some inflation for a time.
(c) But what about those negative cash-flow houses? If we leverage them with today’s interest rates and depend upon outside income to make up the difference between rents and operating costs at the same time as we are experiencing a business slump, might we not have a difficult time coming up with the necessary cash?
(d) At this same time, our institutional lines of credit will be drying up. We cannot be certain of their continued availability, nor of funds for long term refinancing.
(e) Not only could we lose our houses, but also our initial investment of time and cash plus our accumulated equity profit. Furthermore, on the houses we might be able to keep, our Tenants would also be under financial duress. Even assuming the courts to be sympathetic, which they might not be, empty houses from which we had evicted our tenants would pose additional financial burdens and hazards to our personal solvency.
(f) Any houses that we might lose through foreclosure or abandonment could give rise to taxable dispositions even in the midst of a depression as the Treasury Department tries to fund social welfare programs with diminished tax revenues, hence is more aggressive.
(g) Finally, we join the ranks of the economic victims. Wiped out financially, hounded by revenue agents, beleaguered by creditors and former tenants we must start over again.
NOW MIGHT BE A GOOD TIME TO TAKE A FISCAL INVENTORY!
With a reasonably leveraged portfolio balanced against recession-hedged liquid assets, cash, or income streams we should be able to weather the storm. However, if we’ve fallen prey to becoming dependent upon banks to bail us out with high cost loans, or if we’ve invested in high priced houses full of vulnerable tenants, or if our properties are in single industry areas that could be seriously hurt in a depression we could be in danger. In the uncertain years ahead, prudence suggests that we trim our sails or seek safe harbors.
Assuming that there were to be wholesale foreclosures and bankruptcies during a general depression; our cash flows backed by the assets of our “co-investor” would provide the wherewithal to buy distressed properties at bargain prices. We might indeed find that our total holdings of SFH would actually increase at a faster rate than those of our more adventurous peers who where treading on the brink of disaster because of DEBT leveraging.
FREE AND CLEAR SINGLE FAMILY HOUSES MIGHT OFFER THE ULTIMATE DOUBLE-EDGED HEDGE!
The wealth we keep is all that matters, not the wealth we’ve held! When we run inordinate risks to control property only to lose it later, we accomplish nothing. Why do we seek to take chances? In order to obtain leverage. And what does that accomplish? It enables us to acquire greater net worth in a shorter time. So that’s what we’re concerned with: YIELD! That makes a lot of sense for someone just starting out, or for a person who has only a limited amount of cash and/or time to reach a desired financial goal. We can say that leverage yields a higher return per dollar invested. Or the same return in a shorter time per dollar invested. Or both. If we don’t NEED that higher yield or shorter time frame, there is a strong case for holding property free and clear for the time being.
Why not turn our creative juices toward getting some of our properties free and clear? Here are some methods which you might consider in remedying over financed or high risk properties in the current tight money market.
(a) Concentrate financing into a single property by giving the lender a higher yield. If you have a high equity/property with an older low interest rate loan, offer the lender a higher interest rate if he will agree to refinance the property. He will be more agreeable to this if you stipulate that you will use all the loan proceeds to free and clear several other low yield loans he is holding on other houses you own. In one case a lender we knew was “loaned out”. He agreed to the above arrangement because he was thus able to increase his bank’s portfolio yield by eliminating several old loans and replacing them with one larger loan WITHOUT ANY MONEY LEAVING HIS BANK!
(b) In lieu of having an institution refinance an older house, one might use EQUITY financing. A private investor could be offered an interest in enough houses to enable the current owner to free and clear them as discussed previously.
(c) Under Section 1031 of the IRS regulations, one might offer to exchange several houses having uncomfortable loan payments to someone with a free and clear more expensive house. The balance of the loans could be handled to minimize tax liability and they would be paid by the party accepting the smaller houses. If you did this, you would give up depreciation in return for cash flow and safety.
(d) Offer the former owner who is carrying back the financing other “paper” you have acquired. In these times of expensive mortgage money those paltry 9% Trust Deeds won’t be very attractive to the market. They might be purchased at deep discounts, then rediscounted to yield something more attractive. Finally they could be offered to your lender in payment of your debt. If you were currently paying him 10% and you offered him 13% if he would accept your “replacement” notes that you bought with a yield of 20% you would in effect be getting a discount for paying your house off. You could use your private EQUITY investor to provide the funding to purchase the discounted “paper”.
(e) To insulate yourself from being taxed on the above transaction, you could “contribute” discounted “paper” or securities such as deep discount bonds to a corporation. Then you could offer corporate notes with appropriate yields to “buy” your house loans back.
(f) In the current markets, lower priced houses seem to be selling readily. With the expected new capital gains tax rates, now might be a good time to SELL your houses and use the proceeds of the sale to buy replacement houses in the more distressed price ranges at foreclosure sales. The discounts available would permit you to use your cash to buy them free and clear of all loans. Builder’s models might be included among the more distressed merchandise which would have extraordinary growth later.
(g) Place a “substitution of collateral” clause in your loan instruments at point of purchase. Later, move the loan off onto something else, and free and clear the house.
Perhaps we should review some risk-limiting leveraging strategies which make sense in the current economic climate. While these won’t guarantee safety in an economic collapse, at least they will offer a greater margin of financial security to SFH investors.
(1) Buy SFH in areas with long term above average economic potential. The Kiplinger Washington Letter for December 26th provides an excellent demographic overview. It is too lengthy to print here except to say that the West, South, and high technology and energy areas will continue to attract money and people over the coming decade.
(2) Buy in traditionally conservative regions that favor entrepreneurship. Avoid liberal strongholds and areas with impacted organized labor movements that threaten ownership.
(3) Buy FHA and VA financed tract houses in price ranges falling just below the median. Seek them in smaller and medium sized cities with a broad array of commercial activity capable of producing jobs in a variety of basic industries. Orient your program toward the stable “hard hat” skilled labor market. They will be the last fired and first hired. Government backed loans are exempt from Due-On-Sale problems. They offer lower interest. And politicians scurry to the aid of all those distressed voters to assist with payments.
(4) Avoid incurring any liability for institutional financing! Government controlled bank loan policies are inflexibly regulated almost to the point of self destruction. Private financing carried back by Sellers and NON-RECOURSE Notes, Land Contracts, Options, etc. used in combination with “subject to” loan assumptions offer ways to avoid personal liability and deficiency judgments filed against your other assets when using leverage.
(5) When originating new loans, insist on built in “escape clauses” to limit risk. Negotiate to improve cash flow on current loans. Trade off higher interest rates in return for stretching out balloon notes and lowering monthly payments on conventional loans.
Does this sound as if we shut the barn door after the horse ran away? What about the people who did everything wrong up until now? They bought the WRONG house, in the WRONG area, at the WRONG price, for the WRONG terms. They have the WRONG renters who pay the WRONG rents. They have the WRONG cash flow. There is still a lot they can yet do!
WHY NOT CONSIDER DE-LEVERAGING YOUR POSITION FOR A WHILE UNTIL THINGS SETTLE DOWN?
Why do we use leverage anyhow? Of course it permits the beginning investor to gain control over a lot of assets with limited capital. And inflation drives the value of these assets higher each day. Investor’s net worth increases many times faster than inflation. But when the economy turns down we learn that leverage also brings risks. It giveth and it taketh away. Even so, there is a way to leverage purchases with very little risk.
Why not employ EQUITY financing instead of DEBT financing? That’s what giant corporations are doing when they sell their stock. It’s also what an Optionor does when an option is sold. Equity financing is being done anytime a partial interest is sold in a syndication. Creatively structured, it can involve transfers of intangibles such as “RIGHTS”. We know about Air, Timber, Mineral, Water, Rights. But how about Remainders, Leaseholds, Easements? These too offer financing possibilities. Regardless of the particular technique one might choose, Equity financing reduces risk by sharing future profits and losses. At the same time, it offers a way to expand one’s estate rapidly because leverage risk is reduced.
Let’s see how you might bring an over encumbered portfolio back to life in today’s market. First we’ll identify WHO would be a likely Equity Investor. When inflation is 20% the whole world is crying for help. Everyone needs higher yields, but not everyone has the skill to find them. Those with liquid assets – Cash, Bonds, Stocks, – are especially needy. Rich Trusts, Profit sharing and pension plans, holders of Notes and Trust Deeds, businessmen owners of cash flow enterprises are all experiencing the ravages of double-digit inflation and double-whammy taxation as their tax brackets climb higher and higher. They need help.
Suppose you offered ½ of your single family house portfolio to one of these folks in return for the use of his or her liquid assets. You would agree to use the cash to lower the encumbrances on your properties. You would both share in the benefits according to your specific needs. By using appropriate forms of ownership and leases, tax benefits could be allocated in one direction and cash flow in the other. Suppose you gained $5,000 per month in cash flow this way; couldn’t you use it to buy more property at distressed prices? If you were able to do this, then to refinance new properties using the Equity investor; wouldn’t you be able to re-establish your leveraged position after a time in a larger portfolio?
Admittedly, merely freeing a property from debt does not free yourself, but it does protect your estate and your more precious assets from economic hazards. It isn’t our purpose to cause alarm. There are compelling reasons why most of the country will enjoy bountiful years ahead however it isn’t very comforting to know that most people are safe and comfortable when you are individually under extreme duress.
WHAT DOES THE ECONOMY LOOK LIKE FOR 1981?
The Federal Reserve Bank of St. Louis reported a contraction of the monetary base of over a billion dollars the last week of December. If that were to continue we’d be looking at a full bore depression in the summer. I don’t think it will continue. The Carter budget will leave Reagan with a $55 billion deficit. His tax cut backs will take effect long before his spending starts to taper off, so he’ll have to print money. This means we’ll have more inflation. Whether government spending will be linked to jobs remains to be seen. We’ll keep close watch on this.
Demographically, we seem to be entering the decade of the small businessman. All the indicators point toward better times. We’re going to get needed tax breaks to spur us onward. Our savings will be exempted to some degree from taxation. We’ll get faster write down of equipment, buildings; and corporate taxes will be reduced. There will be more people entering their peak earning years than ever before in the history of this country. That translates into billions of dollars of consumer goods being produced and purchased over the next 9 years. Despite the current slump in the economy, we are going to enter a period of fantastic opportunity. The question above all is whether we’ll be ready for it.
The next few months will offer one of the truly great opportunities to us as SFH investors. We are going to see tight money holding market activity down while demand continues to soar. The singles market is exploding across the face of the housing market and awaits only the return of reasonable interest rates before it drives the price of SFH to unheard of heights. Nothing else in real estate will approach the magnitude of this movement into single family housing. But to participate in the profits, one must become the owner of the property or at least have the RIGHT to own it via an Option.
How does this square with the depression scenario we’ve been discussing? We’ll have our buying opportunities during the slack period which may or may not result in a depression. Once it is over the housing market will lead the recovery. Based upon past slow downs, including the great depression of the 30’s, a recurrent hope of the American people is ownership of a private residence. This dream takes a high priority when it comes to spending personal income, and as incomes rise, so will the prices people will be willing to pay for rent and for ownership. Right now Americans pay a smaller percentage of their gross incomes than any other civilized society for basic housing. There’s plenty of room for housing costs to continue to rise despite the laments of those who don’t own any.
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