September 1986
Vol 9 No 11
The Congress, suddenly confronted with accountability for its decisions over the past terms, has abandoned statesmanship in favor of full employment – for itself – after the coming election. In the process, they've managed to create a Tax Recession. Responsible business leaders, faced with massive uncertainties generated by the various tax proposals, have elected to play it safe. Hence we have under-used manufacturing capacity, under-employed skilled labor, under-invested cash reserves, under-developed high tech industry all of which have created our under-achieving economy. And they keep calling this a period of recovery.
Consumers are beginning to play it safe too. Despite massive expansion of the monetary base, on the whole, things are pretty flat in most areas. While lower interest rates have generated lots of residential sales, with the notable exceptions of the Southern California and Northeastern markets, prices have remained surprisingly stable. The resurgence of the automobile industry is directly traceable to special financing and rebate promotions. Without them, there would be real trouble for the Big-3. And what little increase in the gross national product our leaders have achieved in this banner recovery year can be laid at the feet of DEFENSE SPENDING. Without it, we'd be seeing negative GNP growth. We might say that our recovery, now setting longevity records, has been hooked up to artificial life-support systems in the form of government debt and tax collections which have been channeled into high-tech weapons systems and social programs.
What would happen if our economy had to make it on its own? Ask the farmers! First, government gave them artificially created low interest rates so they could operate. Their profits soared, so they borrowed to expand their acreage and to buy more equipment. This created inflated prices to match the demand. Land, equipment, labor and money went up in price. But they forgot that they'd have to sell to NON-SUBSIDIZED CONSUMERS, and that they couldn't survive without being competitive on the WORLD market. They didn't realize that government intervention in their markets simply created a monster COLLECTIVE FARM PROGRAM which was no longer competitive. Last year was bad. A world glut in farm commodities will make this year even worse. So we might say that the farm belt problems were first of all government subsidized and finally a REAL ESTATE FAILURE vs farm failure.
In a way, real estate in general has had a parallel experience. While interest rates weren't directly lowered for speculators and investors, they were INDIRECTLY SUBSIDIZED through the tax laws. 50% tax payers were having half their interest rates, operating losses and 'accounting' losses (depreciation) paid for out of saved taxes they would have had to pay anyhow. So they bought syndications in record numbers, driving up the prices and motivating developers to create an oversupply of shopping centers, office buildings, warehouses, apartments and condominiums all over the United States. The new tax act – if it ever gets defined and passed – will have the same effect on real estate investors as it had on the farmers. If $3000/acre farm land can drop to $600, is there any real reason why a $100/sq/ft building can't drop to $20/sq/ft? Especially if there's no income or at least not enough UNSUBSIDIZED INCOME TO PAY THE MORTGAGES?
Note, I didn't include single family houses in that scenario, because the vast majority of them are purchased by CONSUMERS without reference to any income they produce. But their future is far from being settled until the ripple-effects of the tax act have had a chance to work their way through the lenders, courts, and the economy. What should YOU do?
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WHEN IN DOUBT, SEEK THE HIGH GROUND . . . MANAGEMENT!
Please note, I spelled management with a small 'm'. That denotes the FUNCTION rather than the TITLE. Too often one is substituted for the other resulting in chaos such as we now see in the farm, steel, energy and international trade/debt areas. But we don't have to go overseas, we can find mismanagement throughout the real estate industry just by consulting the yellow pages. And just imagine how the demand for competent, responsible managers is going to escalate in the near future in the event negative cash flows in excess of rental incomes are disallowed under the revised tax code.
This is going to be a dual-level labor market from the consumer viewpoint. First will be those investors who will be paying top level taxes in the aftermath of their loss of tax shelters. And on top of this will be the cash operating losses of properties they neither understand nor are able to become involved in. They'll be in the same condition as any accident victim who has lost a lot of blood – but their losses will be caused by financial hemorrhaging. Their only salvation will be in stopping those losses and the only person who can do that will be a skilled manager. Without him/her, they'll be foreclosed.
This brings us to the second level in the management market. First LENDERS and subsequently RECEIVERS in bankruptcy will need to turn properties around to get them on a paying basis. It's one thing for the lender to sit idly by offering murmurs of hope and encouragement to the swiftly foundering leveraged owner. It's another matter entirely when the lender has become that owner. Now he's under the skeptical eye of the regulators who take a dim view of lenders going into the negative cash flow property business. Even free and clear property generates cash losses from security, taxes, utilities, maintenance. Yes, the ultimate owners of distressed properties are going to need management help just as much as the original owners. And the source of these managers will continue to be hard to find.
There are several ways to play this market – assuming you already have the skills you need.
(1) As a broker, just list property for sale or exchange. You'll only be able to earn a fee IF you can properly evaluate the ADJUSTED market value without the tax shelter component and convince the owner to sell at that price. And you'll need to know ways in which to structure transactions in the event the lenders are no longer interested in making loans as happened in the mid-70s real estate bust in Florida. So you'll need to know a lot about EXCHANGING. This is still untouched by the proposed tax revision. It's a goody.
(2) In the event a creative solution is called for, a greater profit will be made if you employ OPTIONS to control the property while you implement your solution. While 10% fee is adequate for routine sales and exchanges, creative structures can earn much more if you first negotiate WHOLESALE terms then create value by means of your structuring of more benefits prior to selling it at retail. Here's how that might work:
MARKET PRICE = 10 times NET operating revenues = $100,000. OPTION PRICE = 80% or $80,000 NET.
By adding in a LEASE BACK or MANAGEMENT AGREEMENT you can find a market for perhaps 12 times NET operating revenues because you've REDUCED RISK to the new owner. That would yield you 12 times the assumed current NET operating revenues of $10,000 or a sale price of $120,000. So far, you've made a 50% profit because of your ability to perform on a lease back. But suppose you also structured into your lease the right to all income above the $10,000 NET? Here, your management expertise will not only create a $40,000 profit going in, but an income stream to the extent you can increase NET operating profits from the property.
(3) You can LEASE/OPTION the property from the distressed owner, building in a comfortable profit margin from the start and retaining any increases in NET operating cash flows until you can find a buyer. Here, you deduct the value of your services from the price you agree to pay for the LEASE and then CAPITALIZE THE RESULTANT NET OPERATING CASH FLOWS to determine your wholesale OPTION price. Using the above figures, suppose the owner is getting $10,000 and you deduct 12% from that so that he is now getting $8800. You then capitalize that by dividing $8800 by 12% so the purchase price on your Option is $73,333.
Now, suppose you were able to increase the NET operating expenses that you were obtaining through your management skills to a net of $10,000 with the same lease/hack as in the preceding illustration. Your market price would have risen to $120,000 as before and your profit would have increased by another $6667. Of course this only works if you're able to actually improve property income performance by raising rents and cutting costs.
Of course, you can combine all these elements as needed to structure a package which will be attractive to both owner and buyer. But let me tell you about another case in which the manager created a lease sandwich position where none existed before. He took over a small 22 unit apartment which had only marginal cash flows. The owner wouldn't let him have an advantageous purchase option, so he negotiated a BREAK EVEN LEASE for 7 years under the terms of which he retained all net income and the owner got the benefit of all the amortization of the loan and any tax benefits that remained under the current law. In a year the new manager cut overhead drastically by removing the current resident couple and by catching up deferred maintenance, installing unit air conditioners, landscaping, and a better class of tenants. He was able to improve rents an average of $50 per unit, plus he was able to rent the two units formerly occupied by the resident managers. His annual net operating income exceeded $20,000 by the end of the year from just this one property. He's working on several others now.
The key to being able to create substantial profits from leases, options, sales or listings is that at no time do you actually own the property even though your income is effectively inflation hedged. Here's what I mean: Suppose Reaganomics creates the anticipated massive inflation following the Congressionally created recession. During the 'down' years, the OWNERS will have had to bite the bullet while the managers skimmed cash fees and operating profits off the top. Now, during the inflationary period, rents will rise as property values increase. On NET leases, all rent increases will go to the bottom line of the manager while the VALUE of the capitalized income stream will increase the real estate fees and option profits to those who've listed or optioned the properties. In some cases all these roles might be filled by the same person reaping multiple benefits.
HANDS-OFF MANAGEMENT SEMINARS: GOING, GOING, GONE . . .
Management has been part of every seminar series I've done for the past 10 years. In 1981 I wrote a 600 page almanac covering all aspects of single family house management. It was too big to read, so over the years I've broken it down into digestible pieces which have been presented under the names of CASH-FLOW MANAGEMENT, EASY STREET, PORTFOLIO MANAGEMENT, and HANDS-OFF MANAGEMENT. Over the 5 years I think I've finally gotten it all out to those who wanted it, so I'm wrapping it up. The course in Philadelphia will be the last in the series. I hope to use up all my books there. I think those who made the effort to attend this series are going to have a tremendous advantage in the coming years over those who didn't!
I expect this void to be filled by someone else, but beware. There's a quantum difference between single family house management and any other kind. Before you listen to a new guru, ask a lot of questions to ascertain that he's teaching you from his own experience and knowledge, not because he found one of my old books. And watch out for all those special leases and forms. We've found that few of them work without special insights into tenant psychology and your local landlord and tenant laws. There's no real secrets to being a manager, just the usual hard work, dedication, sacrifice, wear and tear that you, the entrepreneur, have learned to live with in the landlord business. So don't let anyone tell you there's some sort of secret on his particular tape or easy home study course. It's not that easy and it never has been. But for those who took the course and who put it to work, I think the future is going to be bright indeed.
Those who attended the 1986 Hands-Off Management seminars have seen a fundamental change in emphasis. It's growing more institutional. The current rental contract has a couple of new twists which incorporate a Tenant Screening Service, a Maintenance Coordinator, a collection service which is married to an eviction service, the use of simple computer programs to eliminate lots of the 'grunt' work, rebate checks which have replace our old 'discount rent' program, and written permission from the tenant to have us explore his credit rating and to input negative performance reports into the credit reporting and tenant screening agencies. We've been replacing that portion of the program originally oriented toward selection of the INVESTMENT house with an explanation of how the skilled manager can earn additional cash from both INVESTORS and HOME OWNERS once he or she has installed various repair, credit, check cashing, and small appliance services.
I see some fundamental changes coming about in the world of real estate which are going to reward those who own properties capable of producing cash-on-cash yields that compete with alternative investment choices in non-tax advantaged areas. That means, if your houses can be sold and the cash invested long term safely at yields in excess of those provided by your after tax cash flows, perhaps you should sell them. On the other hand, if you enjoy the active management of your own assets and your skills can enhance their performance so they can EXCEED other investments with commensurate risk and effort, you should HANG ON for dear life. For the past 3 years I've been advising you in these pages to cull your losers, pay off bad financing, sell for cash when you can and to exchange for better properties. That's what I've been doing. I think it will pay off in 1987.
Don't get hung up on imaginary equities, physical charm, 'location' unless they can produce above average rents or sale profits. Properties lose value just as they gain value – because of market demand. Watch your markets carefully to be sure you make the right decision with regard to each individual property. The QUANTITY of properties you own doesn't necessarily have any bearing on your degree of success. Rather, it's the quantity of INCOME you can command over your lifetime with respect to your needs and those of your dependents. Here's some arithmetic to help you make your decision:
Suppose you owned 20 houses with a value of $75,000 each and with fully assumable loans equal to 50% of the value. Let's say that you signed notes with full personal recourse in the event of default. And suppose these houses AVERAGED $6000 in rents each year out of which you realized approximately $2000 net profit after operating expenses not including the value of your own management. You'd be getting $40,000 per year after taxes on 1½ million dollars of assets and $750,000 in equity or about 5.33% return. That would compare roughly with your bank savings account, but you'd have an inflation hedge built-in in the houses at the price of liquidity, work, and risk.
If you were to sell 10 houses and use the proceeds to pay off 10 completely, look at what you would have accomplished: Management effort would have dropped by 50% along with operating costs. This could even be more, since you'd probably sell off your worst 10 houses. The remaining 10 would be free and clear. You'd be out of debt. You'd be able to keep about $5000 per house out of the rents because of reduced maintenance and interest expense/administration costs/ vacancies, etc. Your income would increase with less work and risk. So would your yield. So would your spare time and enjoyment. So would your SECURITY. With free and clear property, a depression becomes an inconvenience, not a life threatening economic disaster. But there's a much larger dividend:
Your exposure to law suits would have dropped by half. And your TIME would have doubled. If you choose, you can SELL YOUR SURPLUS SKILLED TIME to other owners by setting up management services businesses, mortgage and small loan brokerages, credit and collection businesses, home warranty services, maintenance services, check cashing services. All these are low cost, high profit businesses which complement the needs of landlords and owners. In my view, this is where the future lies for the small entrepreneur in real estate. It is a perfect outlet for your offspring who are going to find opportunities shrinking in all but service industries. Entrepreneurs who move swiftly to fill the need are going to have a field day. You'll have to learn something about operating a small business and ways to apply this to management services.
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
