“In Times Of Change, The Learners Are The Winners!”


February 2007
Vol 30 No. 5


I don’t know where the above quote came from, but I have been through enough changes to know it is true.  For half a century I’ve had to learn how to adapt to change to make a living.  I built my first house when everybody was crying doom and gloom over mortgage interest rates being hiked from 5.25% to 5.5%.  Housing slumped, but I adapted and began lending money on risky 2nd mortgages. I was able to get 8% on my money mainly because I was willing to take chances on marginal borrowers.  Then, the market turned down during the Cuban missile crisis and my loans’ underlying first mortgages were defaulted.  I took over the defaulted loans in return for the owners deeding me their properties; then had to learn the gentle art of remote management.  In retrospect, I would have been far better off to just lose my investment and walk away, but I stayed the course and managed the properties with high negative cash flow until, one by one, I lost them all.  Needless to say, what I got out of this little lesson was to be wary of lending money on, or buying, long term rental properties situated a long way from home.

My next foray into uncharted waters of a changing market came about in the early 1970s when the housing market became overbuilt. To make matters worse, FHA and VA loan programs expired for three months because Nixon was pre-occupied over some missing tapes.  At about the same time the FHA 235 low income subsidized housing program was scuttled.  By this time I was a Broker earning my living from selling houses.  As business dried up, I had to change my strategy and start representing buyers instead of sellers.  In the stagnant housing market of the time, buying at deep discount to value was the order of the day, and I was able to find quite a few attractive properties at very low prices.

Alas, being a buyers’ Broker wasn’t all that easy.  Sure, I saved a bundle by not having to run ads or service listings, but I had little control over my buyers.  After some of them went behind my back and bought houses without paying me, I learned to Option good deals before showing them; then to allow my buyers to buy my contracts prior to their buying the house.  Often, what they didn’t buy, I bought myself.  Eventually, Optioning houses enabled me to quit brokerage and to make enough money to retire after only 5 years in real estate at age 45.

In the late 70s, the highest inflation rate in memory drove house prices through the roof, and interest rates rose along with them.  Thirty year Treasury Bonds were being sold to yield 16.5% and FHA loans cost 17.5%.  With house prices rising by 3% per month in the hottest areas, it made sense to leverage houses with 20% interest.  When inflation was subtracted from interest, the result was a negative cost of borrowing for those who could keep up the payments long enough to harvest the appreciation.  Those who could take over older lower interest rate loans made fortunes off those who had made long term fixed-rate loans.

The banks were swift to slam this opportunity window shut by getting the infamous “Due-On-Sale” clause inserted into FNMA mortgage instruments.  That took the bloom off the rose for a lot of people.  At about the same time, California passed laws that more or less froze property taxes for a lot of people and restricted development along its coasts.  This had the effect of drastically increasing prices of existing houses while slowing down the market. All through the decade of the 80s, the markets were more affected by changes in the tax laws changes than by changes in economics.  Taxes were first lowered then raised to the point that capital gains rates were increased to ordinary income tax rate levels.

Following closely on the heels of the recessionary 80s, commencing in the early 90s and extending into the 21st century, we experienced a period when just about the only people who didn’t make money in real estate were those who didn’t buy any.  This was due to a combination of factors, which happily came to confluence a dozen or so years ago.  First, in an effort to revive the market that had been decimated by the Tax Reform Act of 1986, taxes on real estate transactions were gradually eased along with income and capital gains taxes rates.  Delayed Tax Free Exchanges and elimination of taxes on gain of up to $500,000 on residential sales made buying and selling houses almost tax free.  Mortgage interest rates gradually declined to levels not seen in half a century.  Rising demand pulled prices upward even though there was virtually no measurable inflation.

Homeowners were the first to realize that by buying a highly leveraged home, living in it for two years, and selling it tax-free; only to repeat the process every two years, they could salt away far more than they could have ever saved from their jobs.  People at every level in the housing market started selling and moving up into more expensive homes.  Builders rushed in to fill the growing demand along with fixer-uppers who remodeled homes for the retail market.  This fueled a hoard of entrepreneurs in every nook and cranny of the market from people who flipped houses and contracts in both the retail and wholesale sectors of the market, to people who financed them, to those who provided labor and materials.

About all it took to make money in real estate in most areas of the country was to show up.  That was the upside of the market.  The downside was that inexperienced and naïve neophytes rushed into the market expecting to make millions.  They were met by charlatans masquerading as investment gurus, seminar speakers, investment clubs, financiers, promoters, etc.  Con artists appeared on late night cable TV, in full page newspaper ads, on the internet, and in almost hourly Faxed announcements promising instant wealth to those who would mortgage their futures for a chance to get into real estate.

The odd thing about this was that, despite this, many people did make a lot of money, even though they didn’t know why or how.  They truly believed that real estate profits were “automatic” and that prices would continue to rise indefinitely.  When they couldn’t find an existing house to buy, they competed to put borrowed money down on property on which construction hadn’t even been started.

One day, speculators noticed that they were paying twice as much per square foot for pre-construction condos as they could build a house for.  They decided to walk away from their down payment rather than to complete their purchase.  Investors left the market in droves and headed for the stock market, driving it to new highs.  About the only buyers left in the housing market were those looking for a home.  Just as normal traffic flow turns into a monster traffic jam when the freeway slows down, so the housing market became jammed with unsold inventory.  As the supply of unsold houses grew, in areas with the most speculation and appreciation, builders began dumping their inventory at deeply discounted prices.  This drove the prices of all houses down; or extended the time required to sell them.  Squeezed speculators slashed prices.  Loan defaults soared.

The sowing market has affected developer and builder profits, brokerage, and speculator income.  As all those billions of dollars that flowed into real estate in 2002 left real estate to return to the stock market, those who have been buying and selling to create quick cash profits are going to have to change what they’ve been doing.  They’ll have to learn new ways to create income to replace that which they’ve lost.

I got into the landlord business many years ago for the same reason that many people are going to have to go into it in the coming months.  One reason was that I had bought 2nd mortgage Notes from a mortgage lender who had loaned money to people to make big money on highly leveraged houses.  When houses stopped going up, my debtors stopped paying.  In the stagnant market with no bidders, foreclosing them would have netted me nothing; so I wound up with four houses spread all over the country on which there remained first mortgages that I couldn’t afford to pay.

The second reason I became a reluctant landlord was because, like so many people today, I too had bought more houses than I could pay for.  It didn’t make any sense to try to borrow more money when I couldn’t see how to make the existing payments.  My only recourse was to try to rent my houses out and use my rents to make my payments.

It’s pretty common in the world of wheeler-dealers to consider management to be one of the least desirable aspects of real estate.  They seem to always describe management in the worst possible light.  Somehow cleaning toilets always seem to surface along with tenant horror stories.  For those who haven’t made an effort to learn how to manage, this isn’t far off the mark.  On the other hand, ask any skilled manager how he feels about management versus buying and selling, and you’ll hear a completely different story.  Managing a portfolio of houses can be one of the easiest jobs in real estate if done in a business like way.

I’ve been on both sides of this issue.  Until very recently, I was much more a manager holding rental property than a buy/sell entrepreneur.  Conversely, during the current boom, I’ve made a fair amount of money buying, Optioning, rehabbing, selling, and lending short term money to others who were doing the same thing.  When times are good, there’s no better way to make money.  But, when there are no buyers, this amounts to a ruinous spiral where the costs of acquiring and holding unsold properties can eat up years of saved profits.  Many a poor lad has been driven out of real estate into regular employment trying to stay financially alive as a developer, builder, or dealer when nobody was buying.  Let’s look at how management offers a completely different scenario:

If a dealer is the proverbial hare who spurts ahead in good times and lags behind in bad times, managers are akin to tortoises; they plod steadily forward year after year with hardly any financial reverses.  They capture inflation-indexed cash flows from rents, amortization from loan pay-downs, appreciation when demand is up, and depreciation from day one.  So long as they hold property out for rent, it is deemed to be Section 1231 property used in trade or business.  That means that they can expense just about everything they buy for the property so long as they wind up with net positive cash flows; which is often.  When, at long last, they finally sell, they are taxed at low capital gain rates.   They can choose to stretch out taxes on their payments via the use of installment sales.  Or they can pyramid their equity via tax-free Exchanges.  Dealers can do none of these things.

The most significant advantage managers have over non-managers is the ability to use leases and Options to create wealth over the long term.  As dealers make more money, about $100,000 of it can be subject to 15.3% self-employment taxes; plus, it is taxed at ordinary income tax rates in addition to State taxes.  This can siphon almost 50% of profits over time.  Managers who create income via leases pay no self-employment taxes, and depreciation can shelter much of their positive income from taxation at State and federal levels.  Full time managers can also use real estate losses to shelter income from any source.  This could be a benefit for the high-bracket investor who rent out negative cash flow properties.


Suppose you learned to manage your own houses, and had the capacity to manage many more; look at all the ways there are to create streams of income:

A.  Lease property from owners who refuse to become managers at a fixed rent of $100 per house under the current market. Sub-lease it to occupants at retail rates.  Ideally, your lease should be for several years.  Each month this would add $100 minimum to your cash flow with no investment or risk on your part.

B   Increase cash flow from various over-rides for maintenance and repair.  This might include lawn and pool maintenance, pest control, emergency assistance with plumbing, electrical, heating, and cooling; inspections and corrective actions.

C.  Small loans to cover the costs of major repairs, appliances, vacancies and even negative cash occasioned by unforeseen expenses.

D.  Tenant credit checks

There are many more possibilities which might include cleaning, painting, keys and locks, pet leases and pet boarding, RV storage, etc., all of which are very low risk enterprises that managers can become involved in; but the biggest profit center of all is created when an Option is coupled to a lease.  The lease gives the manager access to and the use and possession of a house; and when the house is subleased to an occupant, cash flow.  The Option can be written to capture all the loan amortization, a portion of the rents that have been paid in, and all the appreciation.

Let’s look at a fictitious situation.  Smith is an investor who owns a house he can’t sell.  Because of the huge appreciation of recent years he has a large equity, but his payments are $1500 a month.  His house would rent for about that if he were willing to manage it; but he isn’t.  You offer to manage the premises on a “performance lease” under the terms of which you’ll turn over all rents remaining after you deduct $100 plus out-of-pocket costs for maintenance.  Note that your income comes off the top before anybody else gets paid.  Any month you can’t rent the property, you owe nothing.  Out of the money you send him, Mr. Smith still has to dig down deep to add cash each month.

Let’s say at some point in the future, you’ve picked up several leases and have built up your cash flow.  You can offer to lease the property for no fee if Mr. Smith will let you pay him $50 per month for an Option on the house at this year’s depressed price.  In addition, in return for your foregoing the $100 fee you were receiving, and adding $50 per month to the pot, he agrees to give you 50% of all rents collected to be credited against the down payment and price of the house.  That means that your management plus $50 would be buying you about $750 per month in credits against the purchase price every month the house was rented.

The foregoing illustration was fictitious, but when an investor with a large paper profit doesn’t want to manage, and can’t afford to continue to hold a house, it’s amazing how compliant he can become when you offer to relieve his financial duress in return for a future interest in his property.  Incidentally, virtually the same approach can be used with homeowners whose income has been negatively affected by the housing slowdown.  They can save their equity by moving out and letting you lease their house and still sell tax free within 3 years.

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