February 1996
Vol 19 No 6
At about this time each year I like to take stock of my situation. Where am I in relation to the goals I set this time last year? Where do I want to be a year from today? What obstacles – especially financial – must I overcome? What will be my cash flow and capital resources? What claims will there be on the income that comes in? How will income and outgo match up? Am I going to have to raise additional money in order to overcome any imbalance? How/where can I do this? How much tax will I have to pay if I sell something to increase my income rather than to borrow what I need? If I borrow what I need, how much will it cost me? How will I pay it back? When? From what sources of cash? How could political or economic changes harm my plan?
This isn’t a bad exercise for every investor to engage in. If you have difficulty in predicting things a year in advance, you can chop the year into months, quarters, estimated tax payment dates or selling seasons to match either your calendar or fiscal accounting year. You’ll want to pay close attention to balloon notes that are due to be paid. Don’t overlook large capital expenditures that may be required on your rentals. These might include carpeting, air conditioning/heating systems, roofs and appliances, etc. These expenditures can distort the best laid financial plans if they aren’t anticipated and if provisions aren’t made well in advance to fund them.
When it comes to raising extra cash to meet anticipated costs when my normal investment income won’t provide it, I’ll admit I’m biased. I’d rather pay income taxes than interest. I’d rather sell a house than to mortgage it to raise needed cash. Here’s why: Let’s suppose that I anticipated that I’d need $25,000 to cover a balloon Note that would fall due next July. We’ll say that it’s secured by a $100,000 property which is encumbered with an existing first mortgage of $40,000 at 9% in addition to the above $25,000 balloon note.
Suppose that I could refinance this property with an investor loan of $80,000 for 30 years at an interest rate of around 8.5% fixed with 2 interest rate points. We’ll add another percentage point for loan processing and payoff of all the old mortgages. All these costs can be included in the loan. By filling out a few forms at the bank, I’ve not only covered my balloon note, but also have about $12,600 in tax-free cash left to plug into my overall budget. All this will cost me $643.70 in total mortgage payments each month.
Conversely, let’s say that I sold my property instead of mortgaging it, and paid off all loans (including my $25,000 balloon note). Admittedly, this would be more troublesome and time consuming. I’d have to start selling in February in order to give myself every opportunity to get the sale closed by July. In the event it didn’t sell in time, in a pinch, I could always run down and mortgage the property as in the preceding paragraph. But, let’s assume that the sale closing takes place in time to pay off the balloon note.
From the $100,000 sale price, I’ll pay about 6% in commissions and another 2% or so for my share of the closing costs. I’ll also pay off all the loans. This will leave me with about $27,000 ($100,000 minus $65,000 in loans minus $8,000 in selling costs). If my adjusted cost basis in the property were $75,000, it would trigger $25,000 in taxable gain. If I paid $7,000 (28%) in capital gains taxes I’d wind up with $20,000 in cash compared to $12,600 above. This is just the tip of the iceberg, there’s more to this than meets the eye.
ALL IN NOT GOLD THAT GLITTERS WHEN YOU BORROW TAX-FREE . . .
If I borrowed the money I needed, although I’d have less actual cash in my hands, I’d be able to keep my house. It should be producing just about enough net cash flow to service the new loan. That’s the good news. The bad news is that I’d probably have to sign personally on the new loan with full liability for payment. My personal risk would have increased without a corresponding increase in my reward. Furthermore, unless property values and/or rents were rising rapidly, I’d more or less be an unpaid manager of this property for years until cash flow began to exceed the new loan payments.
The concept of borrowing ‘tax-free’ ignores the fact that, whether derived from earnings, rents or future sale of the property, all loan payments to repay this loan will be out of tax-paid funds. Moreover, personal debt liability above will increase by $80,000 while increasing total debt on the property by $15,000. By the time monthly payments on the new loan amortize the debt on the property back down to the original $65,000 in mortgage debt, I will have paid almost as much in interest each year as I would have paid in capital gains taxes. Meanwhile, I’d wind up with less cash and spendable cash flow.
If I sell the house, I’ll wind up with more money, while reducing my mortgage debt by $65,000 overall. Remember, the reason for selling is to eliminate the balloon note, not to reduce real estate assets. The balance of $27,000 in cash could be reinvested tax-free to buy a replacement property. Suppose that I were able to complete a tax-free exchange of these funds into another $100,000 house with an existing $65,000 loan on it (which someone else was personally liable for). In this fantasy, I might buy another property by giving the owner the $27,000 and taking title subject to the existing $65,000. My full price would be $92,000. That’s about what an owner would receive after paying the selling costs. Viola! I could wind up right back where I started, but without the balloon note and without any personal mortgage liability.
I know, I know; life just doesn’t work out this neatly, but the principle does. It has been my experience that successful people own property and lend money. Unsuccessful people rent the property they use and borrow money. The difference between the rich and the poor can be blamed to a large degree on the rent they pay on property, and the interest they pay for the money they use. Few people become poor paying capital gains taxes.
There’s another chapter to this story. A borrower in the above example would pay out about $110,000 in monthly cash flow over the 170+ monthly payments required to amortize his new $80,000 loan back down to $65,000. Borrowing can be costly, especially if rising rents or property values don’t generate profits to compensate for costs of the money and loss of cash flow.
That opens up an entirely new can of beans. Are property values and rents going to rise in your area in 1996? While guesswork can’t be avoided when trying to anticipate future events, you can hedge your bet by doing some basic research. Except for loan availability, interest rates, taxes and local regulations; national statistics on housing construction, sales, price and cost increases, personal incomes and debt, family composition may have little effect on your particular circumstances. You have to know your own rent/sale market.
There are many markets, even within cities, when it comes to rents and prices. For instance, rentals might spread out over an area which measures about 30 miles across in the Tampa Bay area alone. Within this market area, rental houses range in price from as low as $30,000 with $75 per week rents to $500,000 at rents of around $3000 per month. You can see that it’s pretty hard to make a meaningful general statement about price trends and rents even in as small a market as this when it contains so much variety. It’s dangerous to elect to personally guarantee loan payments without first knowing your market.
BETTING ON GOVERNMENT IN 1996 IS GOING TO BE RISKY . . .
When trying to gauge a market, you’ve got to focus as narrowly as possible on the segment that affects you the most. Let’s start with rents. It’s my opinion that relying upon HUD Section 8 and local subsidized housing programs isn’t going to be a very profitable policy over the long term. What a landlord can make in increased rent subsidies could be at the expense of declining property values, higher personal tort liability, and stress. With Congress looking for reductions in social welfare programs, I wouldn’t want to build my financial fortress on the shifting sands of political promises.
Just consider for a moment what you’d do with personally guaranteed loans supported by Section 8 rents if that program were to be scrapped. Which of your Section 8 tenants could afford to pay market rents? How long would it take you and the tens of thousands of other Section 8 landlords to evict all those non-paying tenants through the courts? How much of your property would you still own if you couldn’t collect rents or evict the tenants? The 1995 government shut down should motivate you to start converting from government subsidies into private rentals and solvent tenants as swiftly as you can.
When your properties are rented under normal market conditions to those who can afford them out of their personal earnings, you can make better predictions concerning your long term cash flow and property values. For years I’ve tried to buy rental houses that were just below the median point in the market. In other words, about half the people in my area live in houses priced just above the value of my rental houses. The others live in cheaper houses.
My tenants consist primarily of skilled blue collar workers such as constructions workers, salespeople, factory workers, small business owners, clerks, mechanics, etc. with a few truck drivers and accountants on either end of the spectrum. In attempting to estimate potential increases in my rents, I’m interested in local rates of employment vs. unemployment. These give me an idea of how stable my tenants’ incomes will be. The potential for wage increases is indicated by lots of ‘help wanted’ ads. Labor shortages hint at my tenants’ future wage bargaining power and the potential for rent increases.
I also keep an eye on competing rental space. When I first started renting houses, other rental houses provided my competition. No longer. Nobody is building houses in my price range. Competition for my smaller rental houses now consists of mobile homes and condominiums as well as apartments. These must compete against each other as well as against my house rentals.
The competition might offer newer living quarters, but I can still gross a little over 1.00% of fair market value per month in rents. I find that my tenants will pay more in order to have pets in their own fenced yards, and more personal freedom. They’ll pay more for closed garages, space to park boats and RVs, and personal privacy. I’ve been able to increase rents regularly for many years without suffering worrisome vacancy rates, staying 98% rented. I’ve already raised rents again for 1996, so can estimate rental revenues for this year and plug these figures into my cash flow projections.
There’s a potential profit to be gained by combining deferred tax-free exchanging and distress-buying (as was pointed out in the September 1995 newsletter). Thus, it’s not a bad idea for under-performing houses to be sold every year provided that you can use the sale proceeds to move you closer to your financial objectives. As was explained previously, this offers a way to pay off personally guaranteed financing. It also generates sale proceeds to use to upgrade your properties; making them more competitive, less troublesome, and more profitable. Potential sales for 1996 should be planned well ahead of time and any fix-up costs plugged into your annual budget forecasts.
When contemplating sales, you’ve got to cock a weather eye out for both interest rates and government budgets. When government shut down in 1995, HUD, FHA, VA, Farm Home loan processing shut down too. If, suddenly, there were to be no more government assisted or subsidized loan guarantee programs, would there be any sale market for your houses? You might want to explore other alternatives for financing your houses.
Currently, there is a real shortage of owner-occupied, first mortgage notes in the secondary credit markets. If financing were to dry up, I can envision a situation in which sellers could charge higher interest rates to buyers, then sell their mortgages at lower discounts. In a few cases, I’ve seen people convert mortgage notes by selling them at discount to face value into about as much cash as would have been realized net from an FHA sale. The advantage to their own sale market is thus broadened while all the costs and delays of government guaranteed financing are effectively bypassed.
IT’S GOING TO BE A VERY GOOD YEAR – FOR SOME . . .
Despite the rocky wind-up of 1995, for 1996 I’m optimistic about single family houses (including manufactured housing). I can see a silver lining behind every cloud. For instance, the full implementation of the lead paint inspection and abatement program will provide big profits to inspectors and abatement contractors. Mortgage lenders who finance abatement costs will profit along with those who buy contaminated properties low, fix them up and sell them high. As rentals are removed from the markets, rents must rise to meet demand. This will make more rental properties feasible, so construction activity will perk up, and along with this, land values and mortgage lending.
While government can always shoot itself (and us) in the foot because of political wrangling; real interest rates compared to the inflation rate should remain stable. Any lurch in the stock market would probably scare a lot of money back into the banks, improving credit availability for a time. Changes in the tax system along with cuts in federal programs will affect us all, but non-government employees and local economies that aren’t dependent upon government payrolls or subsidies will survive. Think small-town America.
Things they are achanging. The continuing onslaught of the information super-highway is going to bring prosperity to small-town America within reasonable reach of metropolitan area conveniences. We’re trying to negotiate options on building lots, with nearby city water and utilities, in a small town near us. We want to hedge our bet that people are going to flee city budgeting and tax problems if the welfare ball is bounced back to the States and local city government. We’re also looking into designing and developing a new manufactured housing community near jobs and recreation. That’s going to be the future of affordable single family housing for millions of Americans. We want to be in on it. You shouldn’t ignore it either.
It takes money to make money, but it takes talent and energy too. If you don’t want to borrow money, and have nothing you can sell, where will you raise the capital you need? Why not equity sharing? If you’ll divide profits, you can avoid borrowing. Here again, the future lies in joint-venturing with investors who haven’t the time, skills, or inclination to engage in hands-on real estate operations. I recently financed a small town building lot on a shared appreciation basis. I put up the money for its purchase, and will advance money from the sale of a pre-1978 house to build a small house on the site. Total cost should be about $60,000. It should sell for about $90,000. We estimate that we can build and sell two of these each year. We’ll divide the profits 50/50 and each receives about $30,000 annually. We each will make money that neither of us could realize alone – without using any debt.
Copyright Sunjon Trust All Rights Reserved
Quotation not permitted. Material may not be reproduced in whole or in part in any form whatsoever.
1-888-282-1882 www.CashFlowDepot.com
