April 1983
Vol 5 No 7
There's a built in bias in the investment newsletter field toward sensational headlines. Oh, it's great for circulation and renewals. Each month another chapter of the “Perils of Pauline“ unfolds. The intrepid entrepreneur again and again seems to be trapped by changes in the tax laws, interest rates, due-on-sale clauses, rent controls, the EPA. Only by buying the succeeding issue can one keep abreast of solutions to old challenges and precautions to avoid new ones. Beware! The newsletter industry is littered with the remains of toothsayers who mistook luck in forecasting for almost mystical ability to see into the future. Unfortunately, they took a lot of faithful readers along with them on the road to oblivion.
Never forget, YOU are the best forecaster of all when it comes to YOUR MONEY! Win, lose or draw; regardless of whose advice your heeding, you'll reap your reward all by yourself. YOUR informed judgement is the ultimate weapon for defending your assets and for optimizing your financial future. The way you deploy your dollars ultimately should be consistent with your goals, temperament, comfort zones, ability, knowledge and opportunities. There's no practical way for you to get advice from a newsletter, or from any other mass media, which will take into consideration all of your unique requirements.
Some of us are just starting to pyramid. We're willing to take chances to move ahead swiftly. And we're willing to lose it all and to start over if need be. Others don't like risk – debt. We're satisfied to move more slowly and surely to achieve more modest goals. Each of us has peculiar personal situations – a supportive/non-supportive family, low or high levels of surplus assets to invest, a local environment which might have greater or lesser long or short term investment potential. Hence, we need to temper our judgement with those individual situations within which we must build our security. Let me illustrate by using recent news regarding the OPEC price collapse as it might affect some of us in contrast to others.
First of all, let's recognize several facts concerning the SFH investor. (a) There is no “NATIONAL“ statistic which is valid, nor any source of information pertaining to SFH which isn't based upon averages. Remember, you don't fail or succeed as an average, and you can make serious mistakes when you make financial decisions based upon manipulated data. (b) Except in a few isolated places such as Orange County, CA – 1977 – investment houses aren't commodities. Therefore, the SFH market doesn't respond and can't be either manipulated or predicted by using historical commodity market analysis approaches. The overwhelming factor affecting SFH investment performance is LOCAL demographic trends as they affect supply of existing and build-able housing. Houses need USERS to remain viable investments. If the population is shrinking, or incomes dropping, or labor needs being changed radically, your SFH investment could be in trouble. Those are the basics.
How might the spectre of a return to 70 cent gasoline at the pump affect you as either an INVESTOR in single family houses, or as a SPECULATOR. For purposes of this illustration, let me define a speculator as one who makes his money more as a result of his being able to make a profit from events outside his direct control in contrast to an investor, who depends upon the investment itself to produce a profit under his management. The investor usually depends upon a smaller but more consistent gain from income and from long term capital gains. The speculator usually incurs more risk for larger profits which traditionally stem from buying and selling adroitly rather than from rental income. Both of these different types of entrepreneurs can interchange their roles, and usually do to some extent. And they'll each be affected differently by events – even in OPEC.
Here's the scenario. With $.80 gasoline, oil stocks will be down. Energy belt areas will experience slow growth as exploration for oil and gas, coal, shale, tar sands development, syn-fuels jobs disappear. Workers will move on to other areas. Rents will turn soft. In energy intensive industries, costs will fall off (Airlines), they'll be able to increase profits. Initially, they'll retire high interest rate debt. Then we can expect to see expansion as unused production capacity is reactivated. More jobs. More employees. More consumption. More sales of houses. But there's a dark side too. OPEC countries owe billions of dollars to U.S. Banks which they intended to repay out of oil revenues. They'll default unless Americans intervene. The FED will restructure their loans to save major banking interests and to avert an international credit panic. We'll see a return to high inflation. Investors will rush to acquire tangible inflation hedges. Gold, Silver, Gems, SFH will enjoy a lot of nice appreciation. Interest rates will rise to avoid being left behind. Eventually a new level of activity will distill out which will look a lot like 1980. Developers will find loans tied to prime will become ruinous. So will variable rate, renegotiable rate, and short term mortgage loans. Bonds will crash again. Taxes and tax rates will be higher.
SPECULATORS WILL HAVE A FIELD DAY. . . IF THEY PLAN THEIR MOVES CORRECTLY.
In the early stages, the public won't perceive what's happening. Seller carry back financing without any personal recourse, Options, Fixed-rate self-amortizing long terms loans, gaining control over build-able sub-division lots close in, bidding on HUD projects or participating in any Federal Land Bank or Farm Home, FHA, VA refinancing or repo program in which long term, low interest rate loans are available will set the stage for down-stream profits once things tighten up. Make sure that the loans you get have no contingent liability, are fully assumable, or are made to entities such as Corporations, Partnerships, Trusts in which transferability can be achieved without jeopardizing the loans later on.
A glance backward to the fortune building techniques used in 1977 – 81 will show you the possibilities, although this next cycle promises to cover a shorter period. In 1977, the market enjoyed 8½% financing. Developers who controlled build-able lots were in the driver's seats. They could pre-sell their entire project in a matter of days. In many areas there were waiting lists. They signed construction loans indexed to prime with impunity. Real Estate residential sales were up everywhere. The rehab business enjoyed subsidized loans, easy refinancing, easy take-out sales. Almost every loan was assumable. Within 3 years everything had changed. 17.5% mortgage rates. Ruinous construction loans were taking back all those early profits from builders who couldn't get buyers.
Those who had planned carefully reaped a harvest in the distress markets. In 1979 we started advising readers to refinance out their profits while interest rates were low. In 1980, we illustrated the “Split-Wrap“ mortgage technique whereby the entrepreneur passed along his assumable loan at a gross profit to buyers in that market, and took back high “paper“ with yields which exceeded even historically high inflation rates. Those who had liquidated early enough used their cash to buy existing loan portfolios at discount to lock in long term yields which sometimes exceeded 50% per year. It can happen again.
Those of you who are Speculators should monitor long term interest rates in your areas closely. Negotiate loans which you can later sell to others at a profit once rates start to rise again. As long as rates are moving down, activity in the market will cause house prices to rise, especially in re-sale houses. You can make money with “slow closing contracts”, Options, Land Contracts which lock in prices. You can re-sell these properties before you have to close on them. This is a high; risk business and only true speculators should engage in it. You'll benefit from any explosive rise in inflation because of your leveraged position. Remember, avoid personal liability on those loans. Once rates start back up, go to cash. You'll be able to buy “pacer“ at high discounts once credit tightens.
THERE'S PLENTY OF ROOM FOR INVESTORS IN TODAY'S MARKET.
There are surfers who can learn to ride the highest wave. There are people who sell or rent surfboards. You may choose to leave the turbulent economic surf to those who speculate and stay high and dry on the beach, satisfied to merely collect rents. It requires a lot less daring do and skill. It isn't glamorous or nearly so lucrative – or as fraught with peril. In “The Unsinkable Molly Brown“ one of the songs had a refrain: “It ain't how you start, it's how you finish.“ It's a rare speculator who finishes rich! On the other hand, rich investors are legion. Probably because they don't take chances.
Under the same set of OPEC circumstances and attendant scenario (which may or may not come to pass), what might you investors do to enhance your financial positions? Stick to the fundamentals of selecting an attractive smaller house in the strata just below the median price range in your investment community. Choose a neighborhood in which most of the tenants you desire will WANT to live. Bet on the climate, not the weather. If the economic and political climate are liberal, or if demographically the population is aging or in obsolete industries, select an alternate area.
For example, I live in Florida. It's a good place to live and invest. We have a positive growth pattern, reasonable taxes, and in general a pro-business climate. At the same time, I invest in other areas too. I like to diversify. I like to spread my investments into other areas which promise consistently high returns with safety. One such area is Nevada which also enjoys the prospects of long range growth in a healthy environment. You can do the same. If your long range plans involve a change of locale, why not start now to invest in property in the area in which you'll eventually reside? It shouldn't be too difficult to envision you taking your next vacation in that area. Instead of working at playing, why not spend your time surveying the market and buying one house there? Your costs might be capitalized rather than wasted on the vacation. Next year, you'll have a place to stay at a lower cost while you locate and negotiate for another SFH. Eventually, you can gradually transition into that area with an income from your houses.
In selecting your area, bear in mind growth patterns, taxes, energy needs, life style, economic and political potential. Avoid single industry cities. I think having a let airport and a small college are minimum requirements for the long term growth of any small city. Just as the rivers and harbors, railroads, super highways foretold the future of yesteryear's towns, so will access to air freight mean the difference in tomorrow's high tech world. And high-tech means high, continuing educational needs. Organized labor, liberal politics, a high component of unskilled citizenry spell trouble! Rent Controls, high-cost social services, cyclical employment patterns, high tax loads are the Siamese twin of anti-business liberal politics. Witness New York, Boston, Miami – civic disasters.
Emphasize investment in properties with feasible income returns. That's the basis for your long term strategies. With income, you can adjust your rents to the market when others may become over-extended. In inflationary periods, your rents can be raised to keep pace provided you've selected decent housing which competes well. By avoiding bad financing through adroit negotiating, exchanging, and use of cash to retire debt; you'll be positioned to ride out any credit crunch by using operating income to pay bills. This will also give you cash reserves which you can invest in high yield paper during the tight money cycle. As an income investor, you'll get your chance at the brass ring when things tighten up. Your houses will have continued to appreciate during the inflationary cycle. Your rents will have generated more and more cash flow. And when the credit cycle turns down, you'll be ready to enter the distress markets to buy gross profits others give up.
A word is in order here concerning Syndicators. Syndication, the process of putting several investors into an investment, is going to come into a golden age for those who know what they're doing. It will be a golden fleecing for others. Beware the person who offers negative cash flow property together with his brains and ability unless he can demonstrate a track record as a manager and a property substantially BELOW wholesale price. SFH investment is beginning to attract a lot of people looking for a quick buck. Watch out!
Except for some rare exceptions, it's a wise policy NOT to invest in negative cash-flow properties or those with financing that could become hazardous in a credit crunch. Remember, we are the folks who are going to benefit from that crunch, not be penalized by it. On the other hand, there are syndicators who are lining up small investors and buying SFH in today's distress market for cash to the existing assumable mortgage. This involves the investors putting in a relatively large cash investment to obtain 8% – 9% financing over 20 – 25 years. In return there is positive income as well as security. For those who can find and market these properties to syndicates, the future will be bright indeed. When the syndicate offers only future appreciation, it is just another form of speculation.
CORPORATE STRATEGIES ARE GOING TO LOOM LARGER UNDER THREATENED TAX LAW CHANGES.
Suppose you were running $200 Billion in the hole even after cutting everything you could out of your budget. You're facing even higher deficits as oil prices drop. The baying of the opposition is getting louder as they line up to oppose you in elections still 18 months away. You're already creating money at record rates. You need to increase taxes. First you increase Social Security Taxes. Next you rescind a pending tax cut. Following this, you remove indexing so that each year everyone's tax bracket creeps up. Desperate, you start looking for ways to close loopholes – and real estate shines like a beacon. Just think, if you can tap that mother lode you just might make it. First, there's that $10,000 investment interest limitation. The code section is so constructed that almost everyone could lose some of their interest deductions, throwing them into a higher bracket. And if you could establish that any house investment that could only earn a profit through resale would be defined as “inventory“, you'd be able to recapture all that depreciation and tax all sales as ordinary income – wonderful.
No, that hasn't happened yet, but it casts a shadow over many negative cash-flow and tax-shelter schemes. Consider, on the other hand, that you can have a corporation. Your spouse can have a corporation. You both can have 50% of a commonly held corporation. Each corporation can earn $50,000 and remain in the 19% bracket. Corporate pension plans could shelter thousands of dollars more. Houses held inside corporations would almost always be deemed “business assets“ and hence, outside the purview of the ominous portents outlined above. Your corporation would be able to accumulate retained earnings up to $250,000 – and possibly up to the amount of any mortgage debt it would be liable for. As long term investors, you need to explore this area before your taxes become a burden.
There's a move afoot in Congress to make some changes in the estate laws. It's doubtful that estate planning is a preoccupation with everyone, but real estate investment has away of growing by leaps and bounds. Putting property into a corporation provides access to various estate freezing strategies not available to the individual. And having a corporate owner in a state with lower estate and income taxes might prove advantageous. All of this is byway of saying, corporation strategies are worth looking into – now.
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