May 1996
Vol 19 No 9
In many parts of the country, vacancies are down and rents are rising. When business is good and asset values are being driven up by the low-interest rates, few people take the time to get their financial houses in order. Good solid cash flow, though possibly temporary, has a way of making the recipient real estate owner or manager feel confident in his/her ability to expand and to increase his/her holdings. It also makes it easier to refinance and to pull equity out of properties for use as down payments on more properties. Little thought is given to raising cash through equity sharing with investors in order to pay down risky debt.
It seems clear that an investor has to manage both the equity and the liability sides of the balance sheet in order to keep risk and reward in their proper ratios. Equity-leveraged entrepreneurs who own property jointly with others can spread risk of loss as well as profit among co-venturers. Income shortages can be made up by their jointly adding needed cash to see things through. On the other hand, leveraging property through the use of debt alone creates specific risk which stands apart from the ordinary economic, physical, or operating uncertainties associated with property ownership. Here’s why:
Despite all the carefully calculated forecasts and financial projections made to estimate the margin of operating cash flow, net income can still end up wide of the mark. A random occurrence such as an earthquake or hurricane – or recession – could disrupt cash flow with which to make payments. Unlike those who share equity, the debt-leveraged entrepreneur has nobody to turn to for help in paying bills until business cash flow resumes. There’s an old saying, ‘nobody knows you when you’re down and out’ – especially the lenders who financed your mortgage.
Debt and failure go hand in hand. Inability to pay debt as it falls due is by far the most frequent cause of loss of property. The evidence of defaulted debt is all around us. How many of those who apply to rent your properties have flawed credit reports? How many checks bounce because of insufficient funds? How many mortgages wind up being foreclosed? One bad year can completely wipe out earnings from preceding years. Worse yet, when the borrower has to guarantee debt with full personal recourse, family assets representing a lifetime of hard work can go down the drain because of a single unexpected event that no one could foresee.
AS GO INTEREST RATES, SO GO CAP RATES, VALUES, AND NET WORTH!
A small increase in interest rates by the Federal Reserve could spell disaster. The Fed controls the supply of money, interest rates, and credit of member banks. As a result, its policies are directly linked to borrowers’ profitability as well as the appraised market value of assets and net worth. This can be seen more readily if you look at your real estate rental properties as if they were long term bonds or mortgages , and at the market in which they must be sold or pledged for financing as if it were comprised of savvy, knowledgeable investors who make rational decisions regarding market values and yields they’ll accept.
The market calculates long term financial asset values according to the yield which investors use to capitalize the present value of their net, after-tax, future income streams during the holding period. Let’s look at an illustration of this. Assume you had $100,000 in cash to invest. You could invest that in a U.S. Treasury Bond which would pay a yield of 7% for the next 30 years. Because this is guaranteed by the full faith and credit of the government, it is probably the bench mark for safety against which all other risk/reward ratios would be compared.
Suppose that a single family rental house might be expected to earn a net pre-tax yield of 1% more than a U.S. Bond to reflect its additional risk. That amounts to a free and clear $100,000 house netting $8,000 inflation-adjusted each year after all expenses have been deducted from income. To keep things simple, we’ll assume that this represents fair rental market return where you live, and that you also intent to finance and to hold the house as an investment for 30 years.
The 30 year fixed rate mortgage interest charged by lenders is based upon a combination of availability of money, inflation rate, perceived risk of loan default, cost of borrowed funds, and the Federal Reserve’s 30 year bond rate. When all these factors are combined, interest rates vacillate downward and upward. To compensate for higher inflation, risk and cost factors, lenders raise mortgage interest rates. On variable loans, higher interest rates increase monthly payments.
With fixed rate financing, the differential between market interest rates and assumable rates on existing loans adds or subtracts value to properties. Every 1% change in interest on a $100,000 loan changes the mortgage payment by $83.33 per month. Interest changes drastically alter the value of lenders and financial institutions’ net worth. Their billion dollar loan portfolios are bundled into large blocks and sold in the securities markets to raise funds to re-lend on new mortgages. Just a little change in the rates of long term bonds has a profound effect on the cost of their mortgage money and thus on housing market values.
Consequently, if the real yield of a U.S. Bond, discounted for inflation and changes in the tax code, should increase while net income remained flat, fewer investors would elect to buy, or qualify for new loans at the higher rates. Buyers would be forced out of the housing market. House sales would go flat, prices would slump, and owner’s equity would be worth less. Conversely, when long term bond rates drop; mortgage rates also decrease, buyers return, sales increase, owners’ equities rise with house prices, all other factors being equal.
Avoiding interest rate increases can add thousands of dollars to property value. Loans with variable interest rates adjust to market rates at preset intervals. They attempt to achieve a certain parity between lenders and borrowers while accommodating market interest rate changes. When a property is producing only enough cash flow to make payments on a loan with an 8% interest rate, a jump to 10% can create severe problems for the borrower. So can non-recourse balloon loans which must be refinanced from a low interest rate loan to a full recourse loan with a higher rate. The same thing can happen when a lender forces a new buyer to pay a higher interest rate after he takes title to a property on which a due-on-sale mortgage exists. If the buyer resists and the loan is called, he can still be trapped in the higher interest rate market even if he refinances with a new lender.
One can see that, (a) guaranteeing a loan personally, (b) with a balloon payment, or short term ‘call’ date, (c) or a variable interest rate, and (d) a due-on-sale clause in the note increases the risk of ownership. Higher risk translates into less appeal and lower market price. Put yourself into a buyer’s shoes. Would you pay as much for a house with risky financing as you would with one you could buy subject to in-place, long term, 30 year fixed, low interest rate financing?
ANTICIPATING CASH FLOW NEEDS IS THE FIRST LINE OF DEFENSE
How do we avoid being trapped by interest rate fluctuations? First of all, we’ve got to be able to anticipate our own credit needs. There’s a device that forecasts credit needs that’s been in use for as long as there have been businesses. It’s called a Capital Budget. To construct one of these, set up a matrix on a pad or on a computer spread sheet. Divide the page into 4 vertical columns representing the next 4 quarters. Divide the page horizontally as follows: down the left side, list all your sources of income which will be received in each quarter.
Leave out nothing. You landlords might list rents, late fees, telephone, laundry, appliance rentals, key and lock charges, lost deposits, etc. Certainly, you’ll want to include loan payments, especially balloon notes falling due, and any property sales. If you’ve set up an operating line of credit, include this too. Total these on a separate line in the applicable column for each quarter. If you can’t forecast these items accurately, make a worst-case estimate.
Next, list all expenses that you’ll have to cover during the same quarterly periods. Repairs, replacements, capital expenditures, vacancies, advertising, management, evictions, exterior and interior maintenance, etc. Be sure to include balloon notes you’ll have to pay, acquisitions you intend to make, and any unusual expenses. Next, total this line. For each quarter, net out the outgo and income and enter this on the next line. Finally, create a cumulative record in each quarter to reflect the positive and net cash flows from quarter to quarter.
For instance, if you’ve got a $10,000 surplus in the first quarter, and a $15,000 deficiency in the second quarter, but a $12,000 surplus in the third quarter followed by a $20,000 deficiency in the fourth quarter; your cumulative line will reflect +$10,000, -$5000, +7,000 and -13,000 for successive quarters. Each month, you should update the figures to reflect actual receipts and disbursements, and each quarter drop off the earliest quarter and add the quarter which will commence 9 months in the future. This way, you’ll be able to anticipate requirements for additional cash well ahead of need, and be able to make adjustments to meet them. What might these adjustments consist of?
First of all, go back and see if you can induce one of your quarter #3 debtors to make a payment in advance to beef up quarter #2. Or try to negotiate with Quarter #2 creditors to pay them additional interest in return for being able to make their payments in Quarter #3. Now, take a look at Quarter #4.
Quarter #4 has the largest deficiency. If the following quarter (#5) has a large surplus, repeat the above process. Otherwise, you’re going to have to raise more money. Remember, your capital budget gives you a 9 month head start on the problem so there’s no need to panic. First of all, you can negotiate with you banker for a line of credit to solve smaller quarter-to-quarter imbalances. For major imbalances like that scheduled to occur in quarter #4, you might simply sell a property, or bring in investors as joint venturers to provide needed cash.
As a last resort, you can seek to refinance any of the properties. Pick one carrying a balloon note that is due soon. This is where the capital budget comes into its own. The key to being able to borrow money is to borrow it at a time when you don’t need it! If you’re going to need money in Quarter #4, borrow in Quarter #1 at a time when interest rates are low, or when you’ll be showing a large surplus on your P&L statement. By borrowing at the best time to obtain anticipated funding, you’ll be able to negotiate a better loan on your terms and won’t be forced into foreclosure or the need to borrow at a time when interest rates are too high.
CAPITAL STRATEGIES CAN PAY OFF FOR THOSE WHO THINK AHEAD . . .
Acquiring the habit of anticipating capital needs can have an even more profound result for those on an acquisition binge. Let’s say that you plan to buy one $100,000 house per quarter for the next 5 years. At the end of that time you’d be the proud owner of 20 houses. Your goal is to buy them only when you can pay 70% of fair market value from distressed borrowers (or lenders who have taken them back in lieu of foreclosure). You know you’ll need to finance 90% of the costs of acquisition. That boils down to financing a targeted $63,000 or so of the $100,000 retail market value. Your first approach should be to use your capital budget and business plan which will include both acquisition costs and management forecasts to attract investors. Here’s how you might describe the deal to them:
Title to each property would be placed into a Limited Liability Company. You’d retain management control but allocate income and deductible expenses, including depreciation, as agreed between you. The investor would provide the necessary funds required to buy a specific quantity of houses within specific time periods in return for 50% share of ownership and net profits of the LLC. You’d contribute an Option to buy the first house to the LLC, and additional Options over time as agreed between you. In return, you’d receive the remaining half of the company shares. You can repeat this process with a variety of investors, keeping them, the properties, and the arrangements segregated from other investors with whom you might buy properties. This is equity financing. How might debt financing work?
Wait patiently for periods when interest rates are low. In the meantime, line up lenders who will make loans for the purposes of buying investment houses. Begin to cultivate investors with strong financial statements who can sign on the loans. Also start to use Option contracts to tie up selected properties while sales are slow and interest rates are high. If you’d made these preparations last year, money could have been borrowed for 30 years at 7% with no points in February 1996. If interest rates fall again, use your investors to borrow as much money as they can and use the loan proceeds to close your Options. A drop in interest rates will generate an increase in the market value of the houses you’ve Optioned. Your investors will be able to swiftly realize the untaxed appreciation in their assets as well as an increase in their net worth and in their basis in the LLC.
While we’re on the subject of Options, they’re the lowest cost form of leverage of all. Thus far in this letter we’ve been trying to translate interest rates into values of properties. If lower interest rates increases values, doesn’t it stand to reason that zero interest rates would enhance the value of a property the most? Or negative interest rates? An Option is merely a legally enforceable agreement enabling the parties to it to complete a transaction under previously agreed upon terms at some point in the future. When you can learn how to negotiate Options, you’ve taken the first step on the road to equity financing and tax-free pyramiding. Think about it. In the above illustration, by being able to contribute a purchase Option representing a below-market purchase price to an LLC, you’d be able to acquire a 50/50 interest in it with no investment other than your expertise in locating the property and negotiating the purchase contract.
If you’re going to have to manage investment properties you acquire in order to attract equity investors, you might as well consider going it alone without the need to share profits. That’s what I did. This is by the technique of combining Options with leases. The people most susceptible to lease/Option offers are absentee owners and landlords who are in over their heads with maintenance and tenant problems, or simply burned out from too many years in the trenches.
By negotiating a lease and sub-letting the property for more than you’re paying, you’ll have create a ‘sandwich cash flow position’. You can realize relatively risk fee cash flow doing this until you can sell or buy the property. A lease/Option in which you get an increasing equity position by virtue of a rent credit against the eventual purchase price will transfer untaxed equity value to you with each rent payment. It’s only a hop-skip-and-jump to contributing this to an LLC (as above) in return for equity, using investors’ cash to close the deal.
Best of all, with proper structuring, neither lease nor Option need confer any risk on you in the event the economy turns down. Conversely, they would afford maximum leverage and yield in any scenario in which rents or prices rise, regardless of the cause. Used in combination with groups of investors, lease and Option techniques are dy-no-mite. They provide the highest return with lowest debt risk.
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