February 1989
Vol 12 No 4
Bernard Baruch was a financial titan of the 20th Century who made a fortune by getting up every morning and going to the Stock Exchange at 4 A.M.. That was the time when the stock market in LONDON was opening. He'd buy stocks that were at low prices in that market, then at the opening bell in New York, he'd sell them at a profit. He was able to create an immense amount of wealth because he was willing to work in two markets at the same time and to use the difference in TIME to his advantage. That's a strategy that also can be used in real estate and may well become a very fast track soon.
This technique of buying and selling more or less simultaneously in two markets is called ARBITRAGE. Considered in a broader sense, we've all been using arbitrage from time to time in our real estate transactions. And, if we'll take the time to examine the principle, I think it has been a consistent profit producer for most of us. Where it's possible to buy and sell via telex in seconds, and profit earned can be measured in mere fractions of a dollar per share in the stock markets; arbitrageurs typically deal in many thousands of shares in order to get leverage. The difference in real estate is that TIME SPANS are much longer, we deal in much Larger numbers, but in fewer properties, and our markets are a lot less orderly. No buyer or seller in the world can call up anywhere and find out the absolute value or price/earnings ratio of any piece of real estate the way they can with stocks/bonds. We don't have puts and calls, bid and asked quotes. And our usage of a broad array of financing techniques creates differences in value even in similar properties or the same age, size, conformation in the same subdivision, built by the same builder at the same time. Here's what I mean:
Suppose there were two houses sitting side by side in a subdivision. One of them has a fully assumable, fixed rate 10.5% thirty year, level payment, fully amortizing loan. The other has a 7%, non-assumable, 3 year loan pegged to four points over the prime rate. It cost $100,000 to build each one and they're both brand new. What's their value? No one can tell without knowing a lot more about both the Seller's and Lenders' financial condition, goals and time frames. It's equally important that the buyer know as much about him/herself. And we've got to plug in the tax effects of a transaction on all the players in relation to the terms of any purchase/sale/EXCHANGE. If we want to use arbitrage methods we also have to know the market into which we expect to sell and the particulars about any players there. There's a big point to make here:
KNOWLEDGE OF TAXES, PRESENT VALUE CONCEPTS, MOTIVATION TECHNIQUES FOR BOTH SELLERS AND BUYERS ARE BASIC TOOLS THAT MUST BE ACQUIRED IF YOU EXPECT TO COMPETE IN TODAY'S MARKETS.
In my new Fortune-Building Fundamentals workshops, I look around and see the faces of former students who attended my original seminars on buying single family houses some 13 years ago. A few are 'home free' financially, but most are still in about the same position as when they first attended. I think the reason is that they listened to false prophets who promised them easy rewards through trickery and/or guile in lieu of serious application of time, effort, talent, money and their intellect to the prospect of amassing considerable wealth and financial security. The balance of this century will offer unparalleled rewards to entrepreneurs who are willing to work for them. Nothing for those who won't seek out opportunity wherever they can find it and who won't master today's techniques to seize it.
In this issue, we'll expand on the use of ARBITRAGE as it might be applied in connection with Geography, Mortgaging, Use, Leasing, Control, and Timing – maybe even Taxes.
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
SINGLE FAMILY RENTALS DON'T MAKE ANY SENSE IN CALIFORNIA! OR DO THEY?
I spent part of December in the San Diego/Orange County areas trying to disprove the statement above. Sure enough, in the areas with the best schools, jobs, scenery and amenities houses cost almost twice the national average. Appreciation was soaring – had been soaring – for the past 2 or 3 years. It makes sense for people co pay a lot more for a home for their PERSONAL USE located in one of the world's best climates near some of the highest paying job markets in the country. When you take into consideration that the homes also are appreciating at about 10% per year or so, acquisition of a single family home makes a lot of sense – IF IT'S DONE INTELLIGENTLY WITH APPROPRIATE FINANCING. But it doesn't make sense if a person finances 90% of a house with a variable loan which can increase as either interest rates and/or inflation increases. Or one where any personal liability attaches in the event that such a property might later be foreclosed. NOTHING GOES UP FOREVER!
When you buy stocks or bonds, you're concerned with TOTAL RETURN. This includes both the DIVIDEND/INCOME and the CAPITAL GAINS upon resale. The same standard can be used in evaluating a home in a swiftly appreciating area. In both the Southern California and Washington, DC markets – possibly in a few other spots – where there's been a 30 Year long record of almost unbroken appreciation in excess of the national average, it can make good sense to buy high and expect to sell higher if you can obtain purchase terms that will be FEASIBLE while you USE a property, and TRANSFERABLE when you're ready to SELL/EXCHANGE.
That means that you should be seeking out VACANT, HIGH EQUITY houses which the owner is MAKING PAYMENTS on, but which he/she can't or won't rent. Variations might be to find rental properties which are soon to be vacated. You can find these by COLD-CANVASSING THE NEIGHBORHOODS, talking to people, listening to rumors/leads and moving swiftly to follow up DIRECTLY WITH THE DECISION-MAKING OWNERS. Too often, insertion of a middle-man broker can't be overcome because he/she doesn't know enough about the REAL NEEDS of the owner to properly evaluate your offered terms. Rarely will the broker know enough about finance to comprehend the variety of benefits available to the parties or enough about taxes to even perceive the beneficial strategies which might be built in to your offer.
Here are two examples that have just been given to me by two people in San Diego.
(1) Individual now renting wants to buy. (a) Locates empty rental. (b) Contacts first Agent who happens to pick up the phone – NOT THE AGENT WHO LISTED THE PROPERTY. (c) Agent doesn't know the house or owner. (d) Refuses to take any kind of lease/option offer. No deal!
(2) Individual cruises same neighborhood. (a) finds empty house, (b) researches owner AND ADDRESS WHERE TAX RECORDS ARE BEING SENT, (c) discovers owner is on the way overseas and parents are tired of managing the property, (d) tragic death of remaining daughter has motivated them to sever ties to the area, (e) both owner – now without free management – and parents are ready to make a deal at a reasonable price on lease/option terms to solve the problem. Possibility of both owner's and parents' houses being acquired at same time.
THERE'S MORE THAN ONE WAY TO SKIN A CAT . . .
Just prior to my Anaheim workshop, I spent a few days looking into mobile home parks and rental opportunities. Attendees were astounded to learn that a person could buy a 1500+ square foot mobile home in an AAA park with security guards, exotic planting, good financing in the middle of Orange County for $37,000 in an area surrounded by $200,000+ homes. Where rents were averaging above $1000/mo, this home could be rented for $750. If 100% financed, payments and park rents would have been only slightly above this amount.
Put yourself into the shoes of an investor who's a cash buyer. You'd probably be able to shave $7000 off the price for a quick purchase. Lot rents ran about $350/mo. That means your pre-tax gross would be $4800 per year. And since mobile homes require very little maintenance, you might expect. to NET almost that much. Now let's discuss the yield as compared to a rental house which might easily cost three times as much with about the same rents. In the case of the mobile home, there's a small personal property tax, so let's say your PRE-TASK NET would be $4500 on c $30,000 investment. That's a 15% yield. With the same arithmatic applied to the $90,000 alternative SFH rental, our return would be 57. But suppose you'd financed both transactions at 10.5% for 100% of the cost? Only the mobile home would be making any sense. And remember, the house would have much higher maintenance and tax costs than the mobile home, so Your return would he much smaller on it.
So how might arbitrage fit into this picture? Suppose you owned a $150,000 house which had enjoyed rapid appreciation today. It's near the top of the cycle. Wouldn't it be a wise decision to SELL, buy a replacement property through the use of attractive seller financing for Your use to obtain partial tax relief, and to use the balance of your cash to buy mobile homes that you could rent out for a cash flow return? Remember, to the extent that your personal replacement house cost as much as your original house SALE price, it will shelter any taxable gain on the sale of your original house. On the other hand, if you abandon your former residence and rent it out, then you can EXCHANGE under Section 1031 by selling it for cash, using the cash to buy replacement real estate(mobile homes with land) at discount. Suppose you could sell in the conventional market but buy in the distress markets for all cash at 80% of true value. Your arbitrage between those markets would earn you a 20% profit which would be tax free until you failed to re-invest your gains.
You may have noticed that there were multiple uses of arbitrage if you define the transfer between tax code sections 1034 and 1031, seller financing on a replacement home versus cash on sale, changes in investment property from houses to mobile homes, and changes in geographic location from a residential neighborhood to one where mobile homes are permitted, When your yield can be tripled this way, that's how fortunes are made. But the most profound example of arbitrage above is that you performed the arbitrageurs' function by virtue of your PERCEPTION OF THE POSSIBILITIES rather than by getting up at 4 A.M. and making a transaction in a different GEOGRAPHIC market per se. Let's look at that.
GEOGRAPHIC ARBITRAGE IS MAKING FORTUNES FOR SOME PEOPLE TODAY!
I live in Florida where real estate values even in this dynamic market are far below the national average. $50,000 rental houses in good neighborhoods with assumable non-recourse financing abound. I can buy houses on the water for less than the average rental house in San Diego. But I don't. Why? Because I can buy approximately the same house in Mississippi for $35,000 near the Gulf Beaches. I'm not buying there either. I'm selling. Why? Because I can buy the same house in Houston for $25,000. And if I work at it, for considerably less. I've recently been discussing a price of $10,000 with one particularly distressed person. But I don't because I can buy brick apartments from banks and distressed owners for $4,000 per unit if I'll buy lots of them and I can even get very favorable financing from some sellers. I can even do better than that from time to time.
Buying out of my own area is harder than buying around the corner, but buying in a distressed market and selling in an appreciating market gives me virtually RISK-FREE LEVERAGE. Suppose I were to sell a $150,000 house in California, New Jersey, Washington, New England – anywhere there has been rapid price inflation – and pay off the underlying $50,000 mortgage. I could take the money to Houston and buy 25 free and clear, vacant apartments on a couple acres of valuable land. Suppose I never rent the property? While I'd have no INCOME, my expenses of holding would be minimal. Now, suppose in the next 10 YEARS, the Houston market recovers sufficiently for my units to then sell for $20,000 each? That's only ½ of the cost to reproduce them today! My COMPOUND ANNUAL YIELD WOULD BE 17+%! MORE IF WE HAVE ANY INFLATION! Look at the hedge position. In the event of a depression, free and clear vacant property can't be lost. In the event of inflation, my yield will be indexed to the overall economic conditions. Would my high-priced house do as well for me?
I'm using TIME to work for me in conjunction with what seem to be reasonable expectations. And I'm using GEOGRAPHY to give me advantages I can't find at home. If I were to buy OCCUPIED APARTMENTS in the same area, it would cost me about $12,000 per unit. I'd have to borrow the money at VARIABLE rates. This would produce NEGATIVE CASH FLOW in that market – that's what makes it a 'distress market' – and I'd have all the management headaches without any of the profit. That's why my approach is so radical – I DON'T WANT RENTAL INCOME if it's going to cost more than it's worth and lower my Yield. Oddly enough, most investors in Houston don't understand that simple fact – operating expenses exceed rental income even in free and clear properties because of vacancies, maintenance and taxes.
YOU DON'T HAVE TO GO TO THE MOON TO MAKE MONEY . . .
In Houston, the big losers are the owners who're paying managers to rent out units which can't cover their costs. Look in the telephone book and you'll find hundreds of rental managers eager to work for you for a commission OFF THE TOP. The moral of this story is to BE A MANAGER, NOT AN OWNER. Most managers are paid fees based upon GROSS RENTS. Typically, this might be 5% in a large 400 unit complex. Assume 50% vacancy @ $300/mo average rents and you'll see that $720,000 in rents would be collected per year (300 X 12 X 400 X 12) with a fee of $36,000 paid to the manager. The owner would be losing his shirt! Any manager who could improve on this performance would be able to negotiate a % of all increased cash flow because of the dramatic improvement in the owner's position.
Every dollar of increased marginal revenue produced by the rent rolls would pay 3¢ to the manager, but 95¢ to the owner. His VARIABLE costs would rise, but because of the nigh FIXED costs of taxes, insurance, general upkeep, etc., his NET INCOME WOULD INCREASE by about 500. That's leverage of about 10-to-1 between owner and manager incomes with any increase. Capable managers need not settle for mere fractions of these increases provided that they can actually turn rental properties into flaying propositions. This requires that they understand cash flow controls, rent-up techniques, preventative maintenance programs, budgeting, etc. BOTTOM-LINE MANAGEMENT is the key to profitable properties.
How would a manager plug arbitrage into his own profit structure? By NET LEASING an apartment at it's current income, then increasing the grosses as above, the manager and the owner become the same person when it comes to divvying up the profits. Look at these numbers. Suppose you, the manager, LEASE the apartments from me, the owner, so as to share gross increases in the rent rolls on a 40/60 basis. We improve the 50% occupancy above to 75%. Gross rents go up to $1,080,000. You get $144,000. I get the rest. Your income has risen from $36,000. Mine has risen from $684,000 to $936,000 after management's share of the gross income. Do you think I'd really resent your huge fee for making me over a quarter million dollars? Because the LESSEE effectively BUYS THE RENTAL SPACE at a price and sells it at another to the tenants, he earns an arbitrage return far in excess of management fees. And he takes a risk position to do this as any entrepreneur might. Think about it.
THE MORTGAGEE SOMETIMES CAN ARRANGE TO SHARE OWNERSHIP AND LEASE INCOME TOO . . .
About 10 years ago SHARED APPRECIATION MORTGAGES were tested in Florida. Under this scheme, lenders charged lower interest rates and payments in return for a piece of the action should the property be sold at a higher price later on. Peter Fortunato developed this to a fine art in his new PAPER COURSE. We've been using it strategically to hold and to sell properties. As arbitrageurs, we can buy with cash or on negotiated terms, then sell with low payments, low loan-to-value loans, at low prices because we cal participate in any eventual profits the buyer might obtain in the future. By creating loan terms that a property can easily/safely generate, my loan is made more secure. Cash flows from the operations strengthen the borrower – especially in times of economic distress. And they make the project much more appealing to a potential investor, who would willingly buy in to get the financial terms we're able to structure. The combination of management strength and intelligent mortgaging create property values out of otherwise unacceptable properties.
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
