May 1985
Vol 7 No 8

IT^'S HARD TO GO BROKE TAKING A PROFIT . . .

1985 – the next 6 months will be critical! Consider that Congress must either pass new tax Legislation – or extend the current moratorium past July 1st – or the new IMPUTED INTEREST rules will go into effect automatically. The new rules permit the IRS to tax sellers on interest they^'ve never received while permitting buyers to deduct interest they^'ve never paid under certain circumstances. In general, seller carry-back paper on their own homes is exempted up to $250,000 and there are special rules for farms and other installment sales. But the net effect of the new law will be to increase opportunity for those who fully understand its ramifications and to reduce profit for those who don^'t.

 

In October 1985 the WINDOW PERIOD for loans which have due-on-sale clauses will expire. There are a couple of factors to consider here. First of all, that will mean that real estate as a whole will become a little less liquid because of the inability of buyers and sellers to transact business without the necessity of refinancing. Now, we all know of ways to circumvent the Garn-St. Germain law when buying a house. But when it comes time to sell that same house, it is much more difficult to convince a neophyte buyer that our strategy is sound. We^'ll have walked into a financial trap in which we buy easily, but need buyers who can qualify for loans in order to liquidate our investment.

 

Let^'s look at the net effect of these two situations, say, in November 1985. On the one hand, creative financing will be difficult to implement when we buy from sellers who aren^'t owner occupants or who are selling more expensive properties. And even on smaller properties which might be exempt from the new tax law restrictions, the necessity of refinancing the non-assumable underlying liens make sales conditional on institutional interest rates. Even now, those rates are beginning to creep upward. What will they do when EVERYONE has to turn to the lenders for refinance money? They^'ll make it a lot harder to raise cash or to carry paper. And they^'ll make real estate much more illiquid.

 

This situation will be aggravated by the new, tougher look the IRS is taking at properties which don^'t show positive cash flows when they incur high interest expense. At this time there^'s a $10,000 investment interest limitation which could be dropped to $5000. This means that the higher interest rates will make real estate a lot less attractive to potential investors just at a time when an estimated $30 BILLION dollars in balloon notes will be falling due from all those optimistic folks who signed notes reading “5 years and balance due^“. Fortunately, this scenario presents opportunities as well as disadvantages.

 

NOW^'S A PRETTY GOOD TIME TO SELL.

Suppose everything I^'ve premised above actually comes to pass? It seems to me that a lot of the amateur investors will be flushed out of the market. It's already happening in Las Vegas and Houston. Market uncertainty is keeping lots of money from the institutions and syndicates out of the single family house markets just when many people had hoped to cash out. One fellow from San Diego gave up title to 130 houses out of 150 because he could no longer hold '. He^'d have been smart to sell before the final hour when no one was willing to offer Lm a reasonable price. You might be too if you^'re treading on thin 'Ice. Even solidly financed investors might improve their positions by culling their marginal properties now at retail; replacing them later at distress prices. This month we^'ll take a look at ways to sell or to convert property into better houses or secure Notes which we can use later to 'buy in' should prices fall later on.

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Here are some quick ideas on ways to transfer properties advantageously even in a slow market. Because real estate sales activity and trade practices vary from area to area, some might be more useful than others for you. Keep the rest in your file for the day when you might need them, or you might be able to create a transaction in another area.

 

1.   Raise the commission, don't drop the price! Agents get paid a percentage of the sale price. When you lower the price, they earn less. When you raise the commission they earn more – and hopefully will work harder on your property. When you can attract the best sales people, you increase your chances of selling your property faster.

2.   Use unconventional techniques like a raffle where it's legal or an auction. A raffle can be done in conjunction with a fund raising drive whereby the charity springs for the costs of advertising in return for all the money over the amount you want to sell for. And the auction can include a minimum bid or an up-set bid which must be surpassed in order for the sale to be final. Terms can include a variety of cash, paper or trade-ins to suit the market and to attract the most bidders.

3.   Exchange for larger and/or smaller properties plus cash and paper, personal property, cars, boats, toys, art objects, stocks or bonds, etc. to broaden your market. The number of cash buyers is only a fraction of the total number of non-cash buyers. It pays to learn to exchange to create property transfers which can often be tax-free.

4.   Offer the property for sale, NOTHING DOWN to people who have solid credit ratings and who will buy with FULL RECOURSE Notes and mortgages or Trust Deeds. Get them to secure the paper with additional collateral which they or their relatives own, using a 'blanket^' mortgage which ties several properties to your carry-back Note. This way they^'ll be able to buy without any cash, but you'll be certain to get paid regularly.

5.   Sell on a Lease/Option. Get 10% – 15% up-front as Option consideration on a short term (1- 2 years) basis and tie it to performance on a Lease which carries full responsibility for all maintenance and prompt payment at slightly below market rates. Negotiate a sale price which is ½ way between current and future market estimates.

6.   Sell at below market prices on cash-to-mortgage terms, but retain the option to buy the property back in 3 – 5 years by returning the cash plus the principal payments made by the buyer with a reasonable (i.e. 10%) yield. This gets the property sold during the window period and avoids imputed interest problems while preserving your profit/equity and giving you appreciation as well as cash today.

7.   Use #4 above, but do what the car dealers do, ADD CASH REBATES to beat the competition. Next, structure your carry back 'paper^' to provide for higher than market payments or price; or a loan with escalating payments to provide for quick recovery of your cash.

8.   Subsidize either the down payment or the loan payments to enable the buyer to qualify for a new loan which will cash you out. Build the subsidy into the price or structure it as payment on an option to buy the property back at a future date which can be arranged between the parties to suit their needs.

9.   Sell only a part of the property for cash, and keep the rest. On a $100,000 house with a $50,000 loan, get the buyer to pay $25,000 cash or terms for .5. He pays you rent on your half, and payments on his half. You can sell the other .5 to someone else, later.

10. Divide the property horizontally as in #10, or vertically by selling only the house while keeping the ground, and letting the occupant lease the ground; or divide with a Leasehold interest which allows the occupant to possess/rent/use the property for a specified period under a long term lease, or by an Estate for Years and Remainder in which the buyer pays cash for ownership for a stated period after which the property reverts to you as Remainderman. Of course, you can sell your Remainder to someone else.

 

Creativity can^'t be limited to buying only, it should encompass financing, sales, management and maintenance – even the way one holds title. And with a little effort, you should be able to see how you as a buyer can use the same approaches to buy creatively in the next few months once the market turns in the buyer^'s favor.

CREATIVITY AND ^'PAPER^' MAKE A GOOD TEAM.

Just as the innovator can earn above average profits from buying and selling real estate, so can he also do it with paper – if he^'s careful. I've warned readers in prior issues about the hazards of taking gaper for granted, so first I want to be specific on that score. Here are some things you should check out when buying paper from others:

1)    Learn how to evaluate paper in terms of quantity, quality and durability. Let^'s take these one at a time. What a Note/Trust Deed/Mortgage/Contract is worth starts off with the value of the income stream that it represents, not what's written on it. If buyers of Bonds paid face value everytime, there would probably be no bond market. The same is true of real estate paper. The value lies in the eyes of the beholder in relation to his desired yield. So one must know the yield one needs, the amount of payment, the number of remaining payments and the interval between payments. Once this has been ascertained, one can either calculate the present value of that income stream using a calculator, or one can get someone else to do it for him. But it will probably require a calculator. It^'s deceptively complex when you try to estimate present value without doing the required calculations. But that^'s only part of it.

What about quality? It does little good to calculate present value if the FUTURE income stream fails to materialize. That^'s what quality is all about. You've got to be certain your paper is adequately secured so that the payor loses more than the payee in the event the payments aren't made as promised. And even well secured debt can cause loss of yield when one has to resort to the courts to compel payment. So one must examine both the collateral that secures a debt as well as the commitment on the part of the debtor to pay it off. This involves appraisal of property values, search of title to prove ownership and prior liens, and adequate documentation to place the security at risk in the event of default. It also entails a complete review of the payor^'s credit history which reflects his attitude regarding intent to repay.

 

Last but not least, there^'s the durability factor. Financial planning must take into consideration the time over which an income is to be received. A friend of mine is making payments on a car which was completely demolished in a wreck. Only his sense of honor compels him to do this. The collateral securing his loan no longer exists. That^'s why it^'s important to insist on full recourse, both corporately and personally when accepting someone else^'s promise to pay to enhance durability of the income. Look at the previous payment history of the maker and his equity over the loan to get a feel for his sense of obligation toward payment of his debt. Don^'t forget insurance!

 

2)    Once you understand paper, then learn to acquire it. You can do this several ways. You can buy paper at discount from people who need cash. Many times they^'re sellers who^'ve carried back paper on houses they^'ve sold. You can buy discounted paper from people who are in the business of buying and selling paper. You can usually find them in the yellow pages or in the. classified sections of the newspaper. You can acquire paper in the Exchange marketplace if Exchangors meet in your area. Or, best of all, you can acquire it from people to whom you^'ve given it as a result of prior transactions when you've bought from them and they've carried back your paper.

 

My favorite kind of paper is that which I carry back when I sell a property. I know the value of the collateral (my own house that I sell), I know the terms (I was the person who drafted them initially), I know the durability and quality (I know the makers personally and have checked them out prior to the transaction.) And, usually, I^'ve indexed the paper so that it provides me with an inflation hedge in terms of both principal and interest.

 

Here^'s what I do. The Note and Mortgage signed by the buyer are for only one year. At the end of that term the entire balance is due in full, in cash. The maker has 3 alternatives. He can pay me off. He can give me back my property. Or, he can sign a new note and mortgage in which the principal and interest have been adjusted to reflect any deterioration in the value of the dollar as measured by the rate of inflation over the preceeding year. These figures are available at most libraries. In this way, the paper I take back appreciates at roughly the same rate as my underlying security until it is paid off and the property has been fully paid for in cash.

 

3)    Paper^'s best use is as a form of currency in lieu of dollars. I learned this from Peter Fortunato (P.O. Box 271447, Tampa, Florida 33688). Think of it this way. If you could manufacture dollars just like the government does, you could buy anything you want. If you have equity in property, you might choose to CREATE paper secured by that equity simply by making out a note and mortgage secured by your house and offering that to a seller to purchase his house. Since his house equity would not be encumbered in this purchase, it would belong to you free and clear (assuming it had been free and clear to start with). You could then sell it, and keep the cash more or less tax-free – since your purchase price and selling price might be about the same, even though you used paper to buy with and received cash as a result of the sale.

 

4)   When you can buy paper at a discount, then use it to acquire property at full face value, you've effectively discounted the price of what you^'ve acquired. Gary Mansfield originated the concept of using listed BONDS which could be purchased at deep discounts during periods of high interest rates to buy properties. Sellers liked bonds with which they were more comfortable more than carry-back paper or other people^'s paper which might have been acquired at discount specifically for use in purchasing property. So Gary would first seek out listed bonds with discounts of 50% or so. Next he'd make an offer to buy using the bonds at full face value as currency. Upon acceptance, he'd buy the bonds on his line of credit, convey them to the seller, accept the deed to the property and as soon as possible either sell it for cash, or place a long term mortgage on it to provide funds with which to pay back his line of credit. Voila, he was buying at 50% on the dollar with 100% leverage. On a $100,000 house, his costs were about $55,000 with positive cash flow.

 

5)   When you create paper, you can draft into it many benefits. Some of these clauses might give you the right to buy the paper back for cash at a specified discount. Or they might give you the right to match any discount purchase offer the payee might receive if it were offered for sale. (It might be wise to structure a 90 day period in which to raise the cash after the other buyer^'s offered funds had been placed into escrow. This will serve to validate any other offer, since few bogus offers would survive that amount of time in escrow.) You might forbid the payee^'s assigning the paper to a third party. Or you might make it ^'open ended^' – thereby giving yourself the right to borrow additional money from the payee if the equity of the security were to appreciate. You could structure the right to replace the collateral with another property, or an insurance bond, or other paper of equal value – or NOTHING AT ALL after you'd established your credit worthiness.

6)   Don^'t overlook using corporate paper. You can buy paper at discount, or generate it from property sales, exchanges, etc. Then contribute it to a corporation and create corporate paper against the value of the assets. This melds all the various income streams into one which forms the basis for the corporation^'s promise of payments. Not only does it permit you to use created paper without personal recourse, but it avoids tying up specific properties which you might want to sell prior to the paper's being paid off. And it gives you full access to creation of bonds, corporate debentures, convertible stock and a host of other forms of paper for use in creative transactions.

 

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