May 1980
Vol 2 No 8
The current high interest rates may stop builders from building and manufacturers from expanding, but they won’t stop inflation. In fact who do you think pays for these high interest rates? Right, the consumer. Manufacturers and retailers alike are passing along this one more cost of doing business.
The high interest rates are curtailing consumer spending, and small businessmen across the land are laying off workers. Those brave and ignorant who try to tough it through will either spend the next two years struggling to pay the utility bills, or go broke. Although it is tough to lay off employees who have been with you for several years, it is imperative to cut overhead during the next eighteen months. Cut back on all expenses that are not directly related to producing income in today’s marketplace. Isolate those activities in your business which produce the most immediate cash flow and concentrate your efforts on them, for in 1980, CASH WILL BE KING.
Last summer we advised readers to start getting liquid. In the event you heeded that advice you are in for a treat. Speculators across the country are being caught with short term notes which are now coming due and will be forced to liquidate good inventory at their cost or below. Although you will see a bonanza of opportunities, move slowly because the good times are yet to come.
The rapid rise in house prices tapered off in most areas late last summer or early in the fall. Speculators who bought them or builders who got in on the last of the cheap construction money will have one year from then to bail out. Therefore, this summer, the banks will exert a ton of pressure on these owners to bail out, even at a loss. Ask Bunky Hunt if speculators ever have to pay up.
Interest rates traditionally fall in the summer before an election year. Then again, these high rates are supposed to stop inflation. You may recall that in the last “recession” we still had inflation of five to seven percent. Inflation is basking in the current high rates and if it continues to run away they may not lower the rates. Even when they do, look for the prime to drop down to 12 or 13 with the long term rates begrudgingly tagging behind to a rate of 14+. The Savings and Loans are borrowing at over 14 percent now on six month C.D.s and will not loan at a rate lower than they are paying.
Many investment advisors are suggesting that now is a good time to buy long term bonds at a discount in order to take advantage of the long term capital gains that will be available when the rates drop. What they fail to see is that one year from today, the interest rates will likely be higher than they are presently. At a CommonWealth Trust Meeting in Las Vegas in March one of the trustees elaborated on the success he had had acquiring free and clear or high equity properties using bonds he had purchased at a discount.
Properties with large equities are especially hard to dispose of when new buyers cannot or will not qualify for loans at high interest rates and high constants. Many people who own free and clear property are going to take the proceeds and invest all or part in a secure cash flow investment such as bonds. By offering the sellers a note for the full purchase price and securing that note with a bond or bonds with a similar term and face value you can solve a problem for the seller and acquire a property on excellent terms.
For example in today’s Wall Street Journal, American Telephone and Telegraph, a respectable company that most people would recognize, has issued bonds due in ten years which are selling for fifty-six and one-half percent of face. Therefore you could purchase one hundred thousand dollars in ATT bonds for $56,500. In the event the owners of a $100,000 house were eager enough to sell to take a note secured by the bonds, you could acquire a $100,000 free and clear house with a note secured with the bonds. The house could in turn be refinanced by you to raise the cash to buy the bonds, or simply sold. In the event you sold the house for $100,000 in cash shortly after you acquired it, you could pocket the cash, tax free. You paid $100,000 for the house and sold it for a similar amount; the security for the note was not the house.
The sellers have sold a previously unsellable asset for full price with the full faith and credit of not only you, or some overpriced piece of real estate for security, but one of the largest corporations in the world. In addition, they may elect an installment sale to save taxes, and you may agree to pay them a higher than market interest rate which is what they were after in the first place. To go one step further, reserve the right to substitute still another bond of similar security as collateral for the note so that in the event that the bond market does come back you can sell the ones which are the security at a capital gain and replace them with a cheaper issue.
Howard Ruff held his annual Convention for his subscribers last month in San Diego. Howard now agrees that houses, no matter where they are located, are a good investment. The Convention was more optimistic than years past with most people more interested in making profits, than hedging against the big depression. Miller and Schaub with Don Tauscher and several members of the Academy of Real Estate conducted several workshops which drew large crowds of investors looking for investment alternatives to non-producing “hard money” investments.
Most people are acutely aware, after the fifteenth of last month, of the effect of inflation on their income taxes. Investments in T-bills and other interest bearing securities compound this problem. Investments in Gems and Metals may prove profitable in the long run, but cannot hold a candle to the typical SFH when it comes to overall benefits.
Many more hardworking Americans will make over one hundred thousand dollars in taxable income next year. The tax on $100,000, using schedule X from this year’s 1040 for an example, would be $49,376. In the event the same hardworking person had been astute enough to accumulate twenty houses with an average basis of $50,000 and could manage them so that they lost less than $1000 per year each (before Depreciation), his or her tax liability would be reduced to less than $18,000. That savings of over $31,000 would more than fund any present or future negative flows. It is said that only the poor pay taxes. Although paying taxes certainly makes you poorer, many potentially wealthy people who earn in six figures are basically poor not because they don’t work hard, but because they are lazy when it comes to managing their own money.
Now is the perfect time to solicit investors in the tax brackets described above. In the event you now own several houses, and do not need the tax shelter, or feel that you can acquire more quickly enough that it will not adversely affect your situation, sell out to an investor and retain a leasehold and option interest. Structure the sale at high prices, but with terms that will allow you to elect an installment sale. This will give the investor a high basis and more tax shelter. Obligate him to pay you the cash flow that he would normally give to Uncle in withholding or estimated tax payments. Contact local CPA’s for leads. They have hundreds of clients screaming at them about high taxes and would love some relief.
Anyone in the discount paper market is now getting yields of 35% on well secured firsts and seconds and forty and up on long term notes with “questionable security”. That’s a term the paper people use which is synonymous with the house buyers term “it needs a lot of work”. The prudent paper investor nearly always gets paid. Sometimes it is months, or even years after you expected to receive your cash, but those who can wait profit greatly.
The secret, like in houses, is to be an investor, not a speculator. The speculator buys short term paper at big discounts and bets that it will pay off when due. When the note becomes delinquent (notes which are sold at large discounts are often sold because the original holder was nervous about being paid), the speculator panics and is often bought out by an investor at even a greater discount. The investor is willing to wait until the courts take their course or may renegotiate the note for longer terms, but much to the investor’ advantage. Surely many notes will go into default in the next year and those with long range vision will be able to increase their fortunes. Be especially attuned to wraparound positions where the holder of the notes may have to face a negative cash flow situation in order to protect his equity in the note. In these cases, buy the interest in the wrap with a single payment note secured only with the position in the wrap.
For example, Jones had a wraparound note which had a balance due of fifty thousand dollars with payments to him of five hundred per month including interest of ten percent. The payments on an underlying first were four hundred per month at 9% and the balance due on that note was forty thousand. The wrap was due to balloon in three more years and was secured by a house worth in the sixty thousand range. The makers of the wrap had missed a payment and Jones was in no position to make the payments on the first without the income from the wrap.
Under normal circumstances, I would buy this relatively well secured note at a thirty five percent yield or for $6334. However, since we now have the potential for a long term negative cash flow, my offer would be for the same $6334, but payable in three years in a lump sum, or whenever the note secured by the wrap is paid off. Jones says O.K., not because he likes it, but because he cannot afford the alternative, indefinite negative cash flow of $400 per month.
I now approach the owner of the house and give them 2 alternatives. One, move out; or two, start making payments again. Often I will agree to add the payments that they are behind to the amount of the note in return for a shorter due date, maybe one year instead of three, or increasing the interest rate from the current rate to the market rate of eighteen. We leave the payments the same and let the interest accrue so that the balloon will be larger than before. Generally the house is increasing in value at a rate higher than eighteen percent and the owners will have a chance to cash out their equity or refinance prior to the balloon.
How does all this affect our yield? If we make up two back payments on the first (2 x $400 = $800) and reduce the payments on the wrap to four hundred per month in return for an increase in the interest rate to eighteen percent and a new due date one year from today, our profit after paying off the original holder will be $14,735 on an eight hundred dollar investment. I’m not sure of the yield, but it’s enough. The key is to be able to wait for your profits and to be able to afford even a little negative cash flow. Most people who will sell their houses, and carry back financing as described above, cannot afford even the slightest interruption in their cash flows.
The Wall Street Journal reported that new home sales are at the lowest level since 1975. Their figures show 387,000 new homes once the market at the end of February, which will take over nine months to sell at the current pace. Hardest hit will be areas which did not suffer much during the big depression of 1974. Most areas saw many builders go out of business and banks and S & Ls holding large inventories of unsold and often unfinished new houses. Those builders and bankers that survived are playing it a little smarter this time. But in cities like Houston, where they never stopped building in 1974-5, they are in for a big tumble. It is a good place to buy long term, but plan on being in competition with thousands of other owners trying to rent for whatever they can to help cover payments. The rental market will be soft in towns like Houston, and it may well be two or three years before you can cash in your chips at a substantial profit. You will probably have to buy at below construction loan balances in order to make sense out of today’s market. The banks will cooperate in time as they did in the Southeast last time, but it may be a while.
Especially when money is tight, there is safety in numbers. When ten people who all know each other join forces for a common cause, the results can be devastating. Banks are easy targets and can be persuaded to make loans to you, as one of their favorite customers, when you explain about all your friends that will withdraw their accounts in the event that they are not cooperative.
Management problems can also be reduced when ten owners of a number of houses all retain one manager for their properties or one handyman, plumber, etc., to do all of their repairs. We had one attorney and accountant for a number of us. It is amazing how much respect and attention you each receive when they know that when they make one of you mad, they make all of you mad.
Speaking of groups, Tom Hurst, 1640 South 600 East, Salt Lake City, Utah, 84105, is interested in getting together with any previous students in that area to work productively together. Obviously when you get such a group together, they will have diversified interests. Some will have high income and will be looking to acquire investments which will shelter income, and others will have the time to find and manage these investments for a share of the profits. There will be good buyers, and good managers and good bankers. With that combination somebody and everybody can make a lot of money.
If you are interested in getting together with other investors with similar objectives, please write (don’t call) Fortune Seminars, 1938 Ringling Bolvd., Sarasota, FL 33577. State which class you attended and which area you are interested in and we will mail you a list of active students.
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