June 1984
Vol 7 No 9

IS YOUR CRYSTAL BALL AS CLOUDY AS MINE?

The real problem with reading a daily paper or in watching the evening news is that you get too much information – and much of it is contradictory. I have a tendency to want to make adjustments in my investment portfolio with each piece of news. If I were to actually do this, one day I'd be up to my ears in Gold Shares, then I^'d go into currency hedges – maybe Yen. Tax sheltered investments might be attractive in April while income property would come in handy when bills came due. Let^'s not forget T-Bills or numismatic coins. At one time or another all these might seem appropriate.

Thank heavens I^'m already heavily committed to single family house investment. In the very worst locations, it seems that the real estate crash really amounted to about an average of a 10 – 15% decline in the price of housing over the past 3 years. The stock market saw that much decline in the past 90 days or so. And with houses, because their liquidity depends upon availability of long term mortgage money at reasonable rates, it^'s difficult for me to over react with the news. It really doesn^'t pay for me to read the daily paper because there^'s very little I can do about the news. More importantly, there^'s very little that can happen in the world which will affect the value of my SFH very much. I depend upon long term trends to make money, not short term – possibly manipulated – media events. Let^'s take a look at the trends then.

 

THE GOOD NEWS IS . . .

According to the US Census Bureau, household formation is building at a rate 3 times as fast as that of a year ago. There are 112,000 new households per month, and Chase Econometrics thinks this could increase to 150,000 by the end of the year. Most of these new families will be RENTERS because they^'re being priced out of the housing market. This bodes well for all kinds of rental properties. The prices of apartment projects, mobile home subdivisions and parks, bread and butter houses are exploding as the advantages of real estate investment attract money out of the stagnant stock market and jittery precious metals markets.

Accessory apartments – single family houses which have been modified to permit more than one family to occupy them – are increasing. The American Association of Retired Persons has found that over half of all homes with more than 5 rooms are occupied by the older segment of the population. By 1990 the US Census Bureau calculates that we^'ll have 95 million households with 2.5 people or less. The needs of both older and younger families will require low cost housing at prices too low for new construction to meet. The obvious solution will be even more ^“doubling up^“ in accessory apartments. While most accessory apartments exist in violation of zoning ordinances, more and more communities are ^“legalizing^“ them. Here^'s why:

In the first instance, an older couple can supplement their income • renting out space to another couple. Both will be able to stretch their incomes this way. In the case of younger couples, they can co-venture a purchase with either older couples or other young couples. Lenders are beginning to recognize this market and to make loans to un-conventional occupants. It^'s not difficult to see how an older couple with solid financial reserves might qualify for a loan, then share their quarters with a young couple who would have the earning power and energy to make a contribution toward payments and maintenance. This would work well in a situation where a ^“fix-em-upper^“ were bought.

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There are other advantages with accessory apartments. In contrast to duplexes, co-investors can buy nicer homes in better neighborhoods at higher prices. Homes can be modified much more easily and less expensively to make them suitable for two families. In one area I saw a sample of just how far this can go. A house with a daylight cellar was converted into 4 small apartments – all of which were rented for $250 per month. It only requires that plumbing be extended to provide for kitchen and bath arrangements. With the new modular plumbing units and stove/refrigerator/sink units, this works well.

Another plus is that accessory apartment conversions DON^'T LOOK LIKE IT. This affords the owners the opportunity of converting the property back to a conventional SFH for sale or refinancing. There^'s just one front door, one garage, one side walk. In many communities, the original conversion wouldn^'t even be noticed. For this reason it^'s hard to get a handle on the numbers of illegal conversions, but Rutgers Center for Urban Policy Research estimates that in a single year there were over half a million conversions.

Even in newer, smaller homes it^'s easy to create additional rent-able space from a garage, pool cabana, game/family room. It^'s important that your high density rental doesn^'t attract objectionable traffic, parking problems or commotion which would annoy the neighbors. And selection of tenants is critical so that one doesn^'t irritate another. The positive impact on cash flows is awesome when one starts getting two rent checks with only a minimal additional investment. This concept is a viable bridge between buying low income, high management, high cash flow rentals without much chance for growth in value and buying great properties for appreciation with negative cash flows.

Two books are valuable guides in the event you are considering this approach. THE GROUP HOUSE HANDBOOK, Nancy Brandwein, Jill MacNeice and Peter Spiers, published by Acropolis. LIVING WITH TENANTS: HOW TO HAPPILY SHARE YOUR HOUSE WITH RENTERS FOR PROFIT AND SECURITY, Corren Bierbrier, The Housing Connection, P.O. Box 5536, Arlington, VA 22205.  And if you plan to co-own, then read PARTNERING, Lois Rosenthal, Writer^'s Digest Books, 9933 Alliance Road, Cincinnati, OH 45242.  This will increase cash flow, reduce risk, make today^'s financing feasible, but HEY, HEY HEY, BE CAREFUL OUT THERE. It also will require more management effort.

 

AND THE BAD NEWS IS . . .

Commencing with the first quarter of 1985 – maybe even sooner – the stopper is going to blow out of the bottle one way or the other. A lot of tax proposals have been put on the back burner in this election year. None of them are particularly favorable to SFH investment. Most of them will have the effect of decreasing your after tax cash flow either through denial of interest deductions, reduction in your depreciable basis, stretching out of useful lives, imposing new criteria as to what comprises ^“abusive tax shelter investment^“ versus what is a viable income investment or business asset. Owning negative cash flow properties could be especially risky in terms of audit potential.

The same housing crunch which will drive rents upward and fill our new accessory apartments will also create political pressures to hold down landlord profits. When in doubt, city fathers all across the land will be under pressure to impose rent controls, tighter minimum housing standards, increased property taxes to provide for subsidized housing. Because these will be locally inspired, they^'ll be applied locally. One town could have rent controls while a neighboring town might not. On the other hand, the Carter administration was considering FEDERAL RENT CONTROLS. Who can say what the election might bring. But it pays to be wary – and to have contingency plans.

Just to brighten your day even more, interest rates have already started to ooze back up. Regardless of the effect on the recovery, that will put a hold on the housing market. Construction dropped 26% this spring. All those balloon notes which will be falling due over the next 2 or 3 years may require financing at ruinous interest rates and repayment terms – OR THEY MAY NOT BE REFINANCEABLE AT ALL! This may be the last call for you if you have to pay off balloon notes anytime within the next few years.

What would drive interest rates up? New social programs which would increase the deficit and subsequent borrowing. Anything which would cause foreign funds to be withdrawn from our financial markets and T-Bill/Note/Bond sales. A rise in the rate of inflation which is reflected in a drop in purchasing power of the dollar. Federal Reserve or Treasury policy. As you can see, about the only thing one can say about the interest rates is that we have no control over them. The best we can do is to try to structure a course of action which would hedge our position whatever they do.

THE GOVERNMENT DEBT PYRAMID CONTINUES UNABATED . . .

There never has been a democracy which survived intact in the history of the world! Check that out. See if you can give me an exception. We the people are the real culprits. Ask yourself if you wouldn^'t like at least one more round of inflation so you can unload your property and liquidate. Naturally, once you hold dollars, you want to stop anything which would cause them to buy you less. But until then, you NEED that inflation to drive your investments upward. And so do the people with no assets at all. They need cheap dollars to pay back their bills and to support their life styles. So do all elected officials who need cheap money to pay off their campaign promises. Keep a close watch on Israel. They^'ve been doing business on borrowed funds for their entire existence. Now they^'ve lost control with TRIPLE DIGIT INFLATION. LET^'S SEE HOW LONG ISRAEL^'S CITIZENS RETAIN THEIR DEMOCRATIC RIGHTS.

So how bad is it? If we never spent another deficit dollar, the debt we now have will COMPOUND at 10% to more than $7½ TRILLION. And if we continue to overspend in our budget by just 10% per year – that^'s pretty realistic – the debt will compound at 10 to $38 TRILLION. And if we spend as we^'ve been spending these past 4 years, the debt will be at $77½ TRILLION. INTEREST ALONE WILL BE OVER 10 TIMES OUR PRESENT DEBT. There^'s no way we can produce enough to pay it off. That^'s a lot of IF^'s, but why worry, it won^'t happen in our life times, right? WRONG! Those figures reflect what can happen over the next 15½ years. Right or wrong, it pays to invest in inflation hedged assets – like SFH! It^'s a shame that none of our millions of bureaucrats can compute compound interest, isn^'t it?

Before you rush out to buy leveraged properties so you can ride this tidal wave of debt, don^'t forget that they can INDEX YOUR MORTGAGES TO INFLATION TOO. Isn^'t that what all these adjustable rate loans do? Maybe you should start thinking about getting some properties free and clear? And maybe you should begin to use Options to buy houses. And perhaps it would be a good idea to start becoming concerned with privacy of ownership too. Because the near-term future holds even more potential surprises.

ONLY 2 MORE STATES REQUIRED TO CALL A CONSTITUTIONAL CONVENTION . . .

There^'s already a FEDERAL TAX LIMITATION/BALANCED BUDGET AMENDMENT to the US Constitution being circulated. It was passed by the full Senate in 1982, but not by the house. Advocates of this act (SJR 5, HJR 243), which was drafted by Milton Friedman, maintain that it will force politicians to limit spending, balance the budget, limit our taxes. But there are some risks as well. Since we've never had a constitutional convention, we don^'t know exactly how to proceed. Remember, the same quality of political professional is going to be running that convention. Anything could come out of it! And all the pressures being applied to Congress will be applied to representatives at it too.

Our Constitution was drafted by some pretty dedicated men. Who knows what form a new constitution might take. Changes could be imposed on our concepts of property rights, civil and criminal law, rights of citizens. Visualize how a National convention is run now, and that might give you some idea of the way our new Constitution could be drafted. I can^'t say anything about what changes might occur in the way our nation is governed, but I want to protect my assets regardless of any new laws. You do too.

THERE^'S ALWAYS SOMETHING YOU CAN DO TO ENHANCE YOUR POSITION. .

In this letter we^'ve discussed inflation. That^'s easy. Invest in income SFH in areas where your rents can keep pace with inflation. If you can afford it, exchange some of your low equity houses for free and clear property. Or sell some, and pay off loans on others. Or get several people together who can invest with you so you can avoid any debt at all. In the event that rent controls are threatened, there are several ways you can escape them legally. They all involve the tenant^'s having some sort of ownership interest. He might be buying an ^“accessory^“ apartment rather than renting it. If he pays interest equal to what rents might have been, then that interest can be indexed to any inflation, and he will be renting your ^“money^“ instead of your property. He^'ll be outside any rent controls. Many of these techniques were explained in the JUNE 1979 ISSUE in more detail. Review issues over the past 6 months and you^'ll find many ways to protect your portfolio.

Just to spark your creative juices, consider these techniques. Sell someone the right to rent your property for a long period – say 5 years – at today^'s net rent. If I paid you $3,000 for that right, then I^'d be gambling that I could raise rents an average of $50 per month for 60 months. Any more than that would be pure profit. On a $500/mo house, that would be a pretty fair bet. And you^'d have sold a management job and taken out $3000 in cash up front. Of course you could EXCHANGE me that leasehold for a small lot if I didn^'t have cash. You could even accept a leased car, a time share, the use of my boat. But you^'d be immune from any rent roll back wouldn^'t you? Now, lust change the the players. Buy that same right, and you get the cash flow just the same is if you^'d bought a discounted note. Sell that right, and you^'ve got a locked in tenant or manager with no vacancies for 5 years with ;table cash flow income.

If you don^'t want to buy or sell a LEASEHOLD position, buy or sell Options. If you want an inflation hedge, peg the Option price to a price or formula by which you get the benefit of inflation. Even if they index your debt balance, it won^'t affect Options. Inflation will still be working for you. The person who^'d be willing to sell you an Option would be someone with a need for cash who was reluctant to give up ownership of an asset and who would be unable to borrow that cash in the market. Any credit crunch would trigger this situation especially with billions of dollars in balloon notes falling due in the next 3 years. When you encounter this situation, be prepared to act on it fast.

 

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Quotation not permitted.  Material may not be reproduced in whole or part in any form whatsoever.