March 1988
Vol 11 No 5
Did you ever get the feeling that you've been left out of the family picnic? For some reason or other, Entrepreneurs seem to be completely disenfranchised in this country. Everyone agrees that they're the back bone of our economic system, that they create about 85% of all the jobs, that the small business rather than the Fortune 500 is responsible for our prosperous middle class, that creative entrepreneurs are the source of much of our progress as a leader among industrial nations. But, we don't seem to have any champions to defend our cause at any level of government or politics.
Take a look at the farm lobby. Millions of dollars are being spent trying to influence Iowa farmers to select a front runner for the coming presidential elections. Iowa has been particularly hard-hit by falling exports and land prices. Farm programs currently cost tax payers $Billions which eventually find their way into the banking system. When a farm family is foreclosed, somehow we attach inordinate importance to it as if that family were somehow being victimized more than a city family or small business that was being foreclosed. But look at this paradox:
Each year THOUSANDS of new businesses are started and thousands fail because they can't meet the competition or are under financed. They represent the dreams and the future of their owners just as much as the family farm does to that Iowa farmer, but NO BODY CARES! Despite the fact that each year business failures exceed farm failures by a wide margin, politicians and news media studiously ignore it. We don't see the pathetic faces of the family and friends gathered around when a gas station, welding shop or small grocery store is foreclosed. There isn't any breast-beating or sack cloth and ashes for the landlord who's forced to liquidate because of a balloon mortgage or rent controls or 1000% increase in property taxes (that happened to me once). What are we doing wrong?
We spend our time quietly trying to secure our nitch – building and improving our products or services, establishing a customer base, marketing, competing. We typically don't have an advocate at any level of government, so don't hire people to lobby for us. SBA loans are for small businesses that are usually quite a bit larger than ours. In order to find credit, we usually have to mortgage our real estate and/or sign with full recourse. And when we're successful, we're taxed heavily at every level. Maybe we should make it a part of our business plan to become more political in this election year. Maybe not.
Look at the hurdles we have to overcome just to be able to operate a business. Zoning laws restrict the supply of business space, so we have to either pay more for rent or pay more for any property we might want to use. (Conversely, except for unimproved acreage, agriculturally zoned land is usually among the lowest priced property.) Next, we have to ask permission to be able to produce. We must qualify for professional licenses and buy business licenses, buy occupancy permits and subject our premises to the tender mercies of bureaucratic inspectors from Minimum Housing, Zoning enforcement, OSHA, and the Health Department. In some areas, in addition to rapacious real estate taxes, they add on tangible personal property taxes, impact fees, special assessments, city, county, state and federal income taxes, sales taxes, utility taxes, FUTA, FICA, workman's comp, etc. The miracle is that the small business survives at all, let alone makes a profit.
How do we prosper in the face of all the built-in adversity? By working smarter rather than harder. And recognizing that landlords are small business owners. By learning how to use all the available tools and techniques at our disposal to maximize our profits.
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YOU'VE GOT TO KNOW THE TERRITORY
In Meredith Wilson's 'Music Man', Professor Howard Hill makes a point. If you expect to succeed in business, you've got to learn everything you can about it. First, you learn to operate it, then to improve it, then to market it, then to retain customers. All the while, you've got to remain competitive so the value of what you offer is worth the price you charge. The first thing to realize is that the tax laws favor investors even less than small businesses. So start thinking of your real estate BUSINESS versus your real estate INVESTMENT. What's the most important part of your business? The BOTTOM LINE! That's the only reason to be in business – PROFIT. After-tax profit!
Let's begin with the fundamentals. If you expect real estate to be profitable, it's going to have to attract buyers or renters willing to pay that profit. You've got to buy or lease property at a price which will enable you to sell or rent for more than you've paid. This brings several other issues into focus. First, you've got to acquire a rental that will appeal to tenants who will be willing to pay to use it, and who have the CAPACITY TO PAY YOUR RENTS. That's where many people go wrong. They're so eager to own 'property' that they've bought 'creatively' that they buy the wrong rentals. These might be 'pride of ownership' homes or units. They might be 'combat zone' people-packers. On the one hand, the rents won't cover the financing. On the other hand, no manager will be able to generate consistent cash flows from tenants who can't afford to pay rents.
We can find both of these symptoms in Berkeley. Properties were relatively expensive. The activist student population influenced local politics to the extent that rent controls were placed on both residential and commercial properties. Landlords were effectively subsidizing the mellow life-styles of merchants who couldn't compete and their customers who didn't want to support their own living costs. Only on January 1, 1988 did the courts finally strike down commercial rent control laws in Berkely. But they are still in effect for residential rentals both in Berkeley and in some 300 communities elsewhere. Obviously, people in the rental business should avoid locations that espouse rent controls.
Once the property has been acquired with price, terms and a good location where the rental business is FEASIBLE, then it's up to the owner to MANAGE it to produce income. There's a real incentive here. Rental activity losses are being phased out. The phase-out losses allowed are being taxed at 21% under Alternative Minimum Tax. The solution is not to have losses. Like any business owner, you've got to raise NET income while reducing GROSS expenses. First, let's look at INCOME.
OCCUPANCY IS THE KEY TO INCOME! Divide your monthly costs for principal, interest, taxes and insurance, management (the market value of YOUR time or those you hire), repairs, etc. by 364 for each house. Write this down. It's what each day of vacancy costs you. On the other hand, it's also what you're being paid for each day you receive rents to the extent that a tenant covers this cost. Everything over this amount represents profit. To the extent that you can avoid paying taxes on it, it becomes net profit. Anything you can do to improve occupancy rates at market rents will generate bottom-line profits. On the other hand, occupancy must be measured in terms of rents received, not whether or not your rental has people living in it. Beware of offering free rent, color TVs and VCR's, etc. to get people to fill up your vacancies. They could cost more than they're worth.
BECOME THE EXPERT IN RENTAL RATES! Survey your market. Find out what others are charging for comparable rentals. By averaging 20 or so rents, you'll smooth out variables that might occur between similar properties. I like to use number of bedrooms/baths to compare houses, but square feet and amenities to compare apartment/condo rentals so that
I don't wind up comparing apples to oranges. If you're out of the market, make adjustments. I once lost all my old time tenants – with average occupancies over 7 years – because I raised rents without surveying my market. Rents had gone down, but I didn't realize it. Rather than lower rents, it pays to make special improvements like carpeting, appliances or air conditioning, sod, fences, paint while keeping rents the same to adjust to lower rents. Any rent raises following these improvements can be justified by them and used to pay for those cosmetics that you'd have to do any way to attract replacements if they don't renew.
DOES YOUR BUCKET HAVE A HOLE IN IT?
There are two ways to get rich. Either make more than you spend, or spend less than you make! Think of a football team. Offense puts the points on the board. Defense makes 'em count. Income is the offense. No business can exist without it outside of those run by the government. Expense control is the defense. Without it you can't survive. If you expect to prosper, you've got to continuously find ways to plug up cash flow leaks.
Vacancy is the biggest expense as we've mentioned before, but it's linked to TURN-OVER and that to MAINTENANCE. Suppose four-year tenants, the Smiths, move out of a house with a $20-a-day payment habit ($600/mo PITI). With all the furnishings removed, the blemishes are glaringly apparent. You need a new carpet ($700), paint ($400), minor spruce up and cleaning ($50). You'll have to have the water and electricity turned on ($25) to do the work. You'll need to run advertising ($50) and deal with applicants ($100 -your time). The property rents up in 10 days including repair time to desirable long term tenants. Your cost of this turn-over is $200 lost rents, $525 in deductible expenses, $700 in capitalized expenses to be depreciated and $100 in non-deductible loss of your productive time. Total costs of turn-over under the best of circumstances can easily run the above $1525. Let's say your rental has $75 per month NET cash flow, it will take you over 20 months to recover these expenses BEFORE YOU REAP ANY MORE PROFIT. That means, you'll be working as a manager for nothing until that time. Turnover is a critical parameter in rental management. Watch it!
The best way to deal with this expense it by prevention. Create inducements by which the tenant has an incentive NOT TO LEAVE A VACANCY. That doesn't mean not to leave, but to have a replacement who will agree to accept the property as is, or who will perform the needed refurbishment in consideration of credit against DEPOSITS or rents. The danger is that you'll accept a marginal tenant who CAN'T AFFORD to pay the rent/deposits rather than one who PREFERS to save money by doing the work. Always maintain your vigilance by credit-screening each tenant applicant with the local credit bureau and with prior landlords to assure you're not letting tenant quality control slip. And be sure that he/she has the qualifications/tools/materials to do the work that must be done. And stable employment.
Suppose you'd found someone who'd take the property under the above arrangements, what's the best way to proceed. First, WRITE IT DOWN! One property I owned needed extensive repairs that would require several months. I blocked out each month's work in a separate contract, specifying precisely what had to have been accomplished in order to complete the job. I CHARGED FULL RENT AND DEPOSITS, BUT 'PAID' ABOVE-MARKET PRICES. This way, my house appealed to the tenant by virtue of the high pay it offered for repair work. Each month's contract paid $200 for that month's work, thus, if it was completed to my satisfaction, I'd give the tenant a check for $200 which he'd turn back in for part of the rent. This way, I (a) controlled the quality/quantity/cost of each contracted segment of the overall job, (b) controlled the sequence of operations, (c) established a CONTRACTUAL relationship rather than that of EMPLOYER/EMPLOYEE to avoid liability, FICA, FUTA, WITHHOLDING, etc. (d) Held off payment until each job was completed, (e) eliminated vacant days lost to repairs, (f) got my house rented swiftly. Best of all, I didn't have to listen to tenant complaints about shoddy workmanship, sloppy painting, wrinkled carpets, dirty grout, etc. and the tenant paid for out-of-pocket costs AHEAD of the rent coming due rather than my having to pay for it.
Taxes are going to loom large as a major expense under current legislation. Each of your rentals will require it's own account. You're going to have to document any active management, segregate loss properties from gain properties, be able to allocate any excess losses that you can't currently deduct to a particular property to use when that property is sold. You're going to have to sell some property, or re-leverage/acquire additional rentals in order to minimize your taxes. Financial management will become a major profit center activity because of the tax laws. By carefully structuring your real estate holdings to match Positive Income Generators (PIGS) to Passive Activity Loss properties (PALS) you'll be able to avoid much of the bookkeeping and tax accounting complexities a mismatch creates.
THE CORPORATION IS KING FOR SMALL BUSINESSES – and maybe Landlords too . . .
If you're single, your tax bracket reaches 28% after your Adjusted Gross Income reaches $17,850. Marrieds pay 28% after $29,750. Corporations pay 15% up to $50,000. If you don't use full recourse loans, the amount financed can't be used as a part of your deductible basis. If you do use full recourse loans, you're placing yourself in jeopardy. If a corporation buys property, a loan signed by a corporate officer, not personally, can be added to the depreciable basis of a property. As of January 1, 1987, losses generated by rental properties can only be used to shelter wages and profits on a decreasing schedule of 65% in 1987, 40% in 1988, 20% in 1990 with no shelter being allowed after that. But if those same properties were inside a 'C' corporation, that shelter could be used up to 100% to offset income in the corporation. Thus the 15% corporate bracket could be extended by the amount of the shelter, since it applies only to the AGI of the corporation.
The combination of corporate tax strategies and real estate activities generates benefits beyond mere tax bracket advantages. Suppose a person earned more than $150,000. The $25,000 of active management deductions would be wiped out. But if his/her corporation earned $50,000 while paying out a $100,000 salary; that would be shelter-able under current regulations by the $25,000. Meanwhile, the corporation would be taxed at 15% on its income.
'S' corporations are all the rage now. They aren't taxed per se' because all profits and losses flow through to the shareholders after operating expenses have been paid. Suppose you can't use all your losses from rentals but you have a profitable business that's incorporated as an 'S' corporation. If you don't materially participate on a frequent and regular basis in operating the business, all income is deemed to be passive. That means it can be used to offset passive rental losses – effectively making your shelter work well. So, while you've got business profits and passive losses, hire someone to run the business. You deserve a break today, take it. Spend your time getting profits up on your rentals.
Let's move forward a few years. Now both your business and your rentals are in good shape throwing off a positive cash flow. You can buy more real estate with the income and continue to shelter it all as before. Or you can sell some of the real estate to your corporation in an arm's length transaction and defer the gains by buying replacement properties. Thus, your corporation would be leveraged and sheltered while you personally might own attractive properties at distressed prices which continue to provide sheltered income.
One day you might decide to place all your property into a 'C' corporation so your family can begin to take over the management chores. You could create both voting and non-voting stock which would permit you to control how much a corporation retained for expansion or paid out in salaries or dividends. You could set up corporate pension plans which would enable you to fund one that suited your advanced age and pension requirements while enabling your spouse/offspring to embark on corporate careers with a variety of fringe benefits. These more or less permit a lot of what might be deemed personal expenses to be paid for by 'the company'. They include subsidized housing, legal services, tuition for courses relating to employment, favorable loans, medical reimbursement and more.
Privacy in both ownership and in operating real properties is a feature of many corporations. It's usually not difficult to identify the officers and directors of a corporation. It's another matter to determine who controls it through bearer stocks, or debentures that can be converted to stocks, or options or remainders. So a large portfolio can be held fairly discretely inside a corporation. And with privacy comes protection from liability so long as corporate formalities are strictly observed. At the same time, you can tailor your image to suit. You can represent a large powerful sounding corporation such as FEDERAL NATIONAL CORP. or an innocuous one like Equitec Inc. Either way you reap the benefit of all the legal advantages obtained by corporate lobbies everywhere, and possibly a bigger piece of the action both now and for the future. Find out more if you'd like to:
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Quotation not permitted. Material may not be reproduced in whole or in part in any form whatsoever.
1-888-282-1882 www.CashFlowDepot.com
