Indexing Hedges Against Inflation

Topics: Landlording


     Just as Note terms can be indexed, so can Lease terms. With a Note, the interest rate can be pegged to the prime rate or to one of several major bank interest rates. I often index loan rates on my installment contracts to the HUD rate for FHA loans. Hence, when inflation drives up interest rates, it also drives up my cash flow, enabling me to keep pace with the rising cost of living. The indexing terms can be built into the language of the debt instrument, or the term can be shortened so that the Note has to be either paid off or refinanced at the prevailing interest rates every few years.

     It's also possible to index the principal owed by making the Note callable upon demand. Should this happen, the borrower/buyer of a property can either give the property back, or the entire transaction can be recreated with the price adjusted to compensate for inflation, and the interest rate set at fair market rates for that period. Leases can be handled in much the same way.

     Although we are fortunate in that we have many tenants who have been with us for over a decade, we still give both parties the legal right to terminate our rental contracts by giving the other party 15 days written notice. You can see that this is similar to a Demand Note. Upon such an occasion, a Tenant might be given the opportunity to sign a new rental agreement which included rents set to fair market value. This way, our rents keep pace with the market. Of course, the tenant has the equal right to terminate and to seek quarters elsewhere in the event that he felt he could make a better deal. We must be doing something right to keep our tenants as long as we have with rents that are regularly adjusted to the market.

     This might seem risky if a landlord were contemplating going to court to enforce payment on the unexpired portion of a residential Lease. We don't contemplate doing this. On the other hand, we also don't contemplate being left behind by a runaway rental or sale market. We always want to be in position to either raise our rents or to sell in the event this is the best course of action at any given time.

     Thus far, we've been looking at things through the eyes of a landlord. How might we use Leases to make money as Tenants. Suppose we called on 'For Rent' ads and tried to negotiate discounts for signing 1-year leases with five 1-year extensions at the same terms. Bear in mind that, as tenants, we don't want the leases we enter into to be indexed. We hope to profit by being able to hold them level, then to create a steadily increasing 'rental-spread' by sub-leasing the property at increasingly rising market rents. Our target market would be 'burned-out' landlords; especially those in the midst of evictions; or with properties needing repair; or with financial problems; or those who simply were sick of management, willing to give up cash flow in order to retain their sanity.

     Let's say that we're dealing with $1000 per month fair market rents. We both know that a landlord would have to pay about 10% for a garden variety manager who did little other than collect rents. So we'd start by offering $900 per month net rent. Then we'd try to get another 5% knocked off if we agreed to take care of all emergency repairs that didn't exceed $100 per month, including parts. He'd pay for all repairs in excess of that. Then we'd see if he'd give us another 10% off if we paid all rents one year in advance. By doing this, we'd have taken on the economic risks of vacancy and non-paying tenants, and we'd certainly point this out to him. Finally, once we'd established our credentials by offering advance payment, we'd offer a long term Lease in return for another 10% discount. I've found it to be more successful to offer discounts in terms of percentages than dollars. Somehow, people seem more reluctant to give up dollars than percentage points.

     At this point, after all discounts had been extracted, we'd be able to rent the house for $650 per month, and sub-Lease it for $1000. We'd certainly have some costs for repairs and vacancy, but it might be reasonable to expect that this little venture would leave us with $2000 spread per year, per house over time. We'd record our Lease and rights-to-extend to secure our position and the property. Because a Lease is an interest in real estate, it would precede any junior liens.

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