December 1983
Vol 6 No 3
Depending upon who you are, where you are, how prepared you are; the next 12 months will offer tremendous opportunity for success or failure. Consider these facts:
1. IRS policy is to tighten the screws on abusive tax shelters.
2. Under proposed legislation, both negative cash flow investments and high interest rate financing will be severely penalized.
3. Changes in the credit markets and Government deficits are likely to deprive housing of long term mortgage financing except under indexed or higher payment terms.
4. Every day there are fewer assumable loans available at low interest rates.
5. Conventional terms will require higher down payments from buyers.
6. Changes on average income levels of the middle class will place most new housing out of reach for most wage earners unless government intervenes in the markets.
7. Except for the “hot“ areas, construction activity will slow down.
8. Investors will have to plan on much longer holding periods and less refinancing.
9. Affordable housing will become a critical political issue as inflation continues to drive costs up.
10. Off-site constructed housing will find less opposition from zoning officials.
Over the past few months we've been citing various trends throughout the economic and political spectrum which support the above scenario. Indeed, subjects for both “The Big 1“ and “Portfolio Strategies“ seminars were selected to provide insights to our readers concerning ways to capitalize on the coming changes. Probably one of the more ominous statistics is provided by the OCCUPATIONAL OUTLOOK published by the federal government. It reveals that the top 15 occupational opportunities which will be offered to starting wage earners will be in career fields which don't require a college education and which, indeed, are not considered to be attractive to the middle class family at all.
The effect of the massive switch to computerization is to LOWER the average wage of the middle class except for a relatively few employees in highly technical and specialized areas of medicine, programming, engineering and higher management positions. Americans have already begun to focus on off-job activities versus career commitments and the trend will gather speed once more unions join in to trade time off and early retirement in lieu of demands for higher basic wages. How will SFH investors fit in?
CHANGE CREATES OPPORTUNITY FOR THE NIMBLE!
As markets dry up for conventional buyers, they open up for innovative and imaginative approaches. And sellers are more prone to listen to non-cash solutions to their problems of ownership. So are buyers. It's up to you to find new techniques which will eliminate negative cash flow, high interest, short term financing as a buyer, and which will place your property on the market in the most attractive position as a seller.
Land leases offer benefits to both parties. Think of how a mobile home park works. One party owns the land and another party owns the residence, paying rent to the land owner. Suppose you bought a house and left the land under it in the name of the seller. Instead of carrying back a mortgage for his equity, he'd retain title to the ground. You'd lease it with an option to buy it later on a long term agreement which might extend for many years. During that time, he'd be receiving RENT instead of getting INTEREST! If you failed to pay rent, he could EVICT and regain the house fairly easily.
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Now let's look at the benefits. Put yourself in the place of either buyer or seller. The buyer can buy with less cash down since the seller is carrying his equity in the land that he retains. On one house I bought, the seller carried a $35,000 equity back as the value in the land even though this was far in excess of the true value. I agreed to pay him land rent which would return him only $1000 per year – about 3%. My option to purchase the land involved a formula whereby the seller realized a percentage of the total increase in value of both house and land together. On a $75M house, he was to receive a sum equal to 35/75ths of the value of the property anytime the option were to be exercised. Thus, the seller also received the benefit of a hedge against high inflation in the future.
Using this technique, the buyer gets 100% write down on the house that he is in turn renting out. The low rent cost on the land allows him a profit margin of house rent over land rent plus low interest rate loan which he is able to assume without any other high interest secondary financing. He avoids risk and negative cash flow. If the IRS is permitted to deny investment interest deductions, his will be minimal.
Looking to the future, suppose you were seeking to liquidate your SFH holdings in a tight market. Why couldn't you be the seller in this scenario? Naturally, you'd negotiate as much cash up-front as you could, and you'd get as much land rent as possible. If you were thinking long term, you'd index your land rent to offset inflation so that the income derived from rents would always have the same approximate purchasing power.
Why wouldn't this technique work admirably when co-venturing with others? Now, when an investor wants to garner tax benefits, he can own the improvements. The “sweat-equity“ investor can own the land. The improvements would generate tax benefits while the land would generate income providing the rents were adjusted appropriately. The entire agreement in any of the above situations would be the Deed of Conveyance which would recite the ownership of land, improvements, land lease terms and length, option. It would be put into the public records to protect all parties, and take precedence over other claims.
In the future that I envision, it's folly not to use indexed agreements when you are the lender! By indexing the principal, interest and rents to an aggressive inflation index, the lender insures that the money (or equity capital) he lends is repaid in constant dollars. It's legal to index repayment terms to gold prices by equating the amount owed to an equivalent number of ounces of gold which you could elect to receive in lieu of cash. If inflation drove the price of gold higher than the dollar, you'd take delivery in gold and convert it to dollars or the creditor could simply pay that equivalent amount in cash.
On the other hand, the borrower NEVER wants his debt indexed, since he loses any gain from inflation that leverage might provide him. He looks for long term, level payment assumable loans that he can either pass along at a profit or repay with cheap dollars. He avoids institutional financing other than FHA, VA or other financing which is at low rates, self amortizing, long term and assumable without any change in terms by other parties. Most of the institutional financing available today DOES NOT meet that criteria! In fact, it is designed to enable the lender to capitalize on inflation and rising rates at the expense of the borrower. And, as rates rise, it makes the collateral less and less marketable.
Here's where understanding the concept of rents versus interest comes into play. We all understand how “wrapping“ a low interest rate with a higher interest rate produces a high yield. Can you see how leasing a property long term at one payment rate while, at the same time, renting at a higher rent short term can produce a corresponding yield and cash flow? Many sellers who are adamant at selling with low interest terms turn right around and rent to someone at rents which aren't anywhere near as costly. Let's face it, aren't you doing the same thing right now? Do your rents produce a 12% annual net yield? One technique you should start using is the long term lease sandwich position. And by leasing long and renting short, you're always in a position to adjust your rents to offset inflation to produce the cash flow you want. Of course, appending the lease to a purchase option is more icing on the cake. But you needn't make the option the criteria for doing business with someone willing to lease to you long term. The cash flow will be plenty.
KEEP ON THE LOOKOUT FOR NEW WAYS TO PYRAMID BUR ESTATE AND CASH FLOW.
At the Big 1 seminar in Orlando in October, Terry Strine enlightened us all on the potential of mobile homes in the investment and speculative areas. In a way, MH can be made to perform as well as SFH. First, let's look at them from the dealer's viewpoint. Take a drive through some of the high grade MH parks in your area and note what you see. I've discovered that there are FOR SALE signs, FOR RENT signs, vacant sites, vacant MHs. Further it seems that the owners of sites and vacant homes are as amenable to long: term lease sandwich offers. Here's how it works.
Any MH park owner wants to fill vacancies just as any landlord does for SFH. You might offer long term guaranteed cash flows on the sites, then offer them separately to others with a cash flow spread. Or you might do the same with the vacant units. But the real cash comes from buying on quick cash terms and re-selling. Terry recounted to us how he can buy a slightly used 2 bedroom unit in a good park for from $5000 to $6000 and re-sell it in the market for about $10,000. Often for cash! He can get “same day“ approval for owner occupants who might want to purchase from him, providing they have good credit history, and he can do this several times each month!
By controlling sites via long term leases, then putting NEW units on them, it's possible to work with dealers too. He typically can buy brand new units set up on his lots for about $14,800 – $17,500. This would be for a 14'X70' unit with all the goodies. Financed at 100% at 15% for 15 years, payments would only be about $260 per month. He can re-sell these units for about $5,000 profit within about 60 days. It only takes 10 deals like this each year to earn $50,000 as a dealer. And if there are plenty of lots around, you needn't even tie up the lot with a lease. Of course, profits can be even more attractive if you've negotiated low lot rents and take a spread on these too.
Some people prefer to be landlords. You have to be careful to control the lot rents and the payments, but Terry knows one person who is able to capture $50 – $80 per month per MH, and he has several of them which he is renting. Later on he'll sell them to his preferred tenants on seller carry back paper. I hope he's learned how to index it.
But the way to really maximize your return is to own the park! Then you can secure your base income via lot rents, make dealer profits by being the exclusive dealer for any person in the park and capturing both that profit and the tremendous profits on re-sale of trade-in units. But it takes cash and interest rates are high – right? Wrong! That's where syndication comes into the act. First, you find the park that makes sense. The nicer the better. Or at least, it should be one that you can improve with only superficial cosmetics. Next, you option it for long enough to round up interested investors. Using their money, you buy the park and place it under management, reserving unto yourself all rights to be a dealer in park units or in new homes. You get a profit interest in the equity, the cash flow, the management and the sales operations. If you need help on this, don't miss Terry Strine at his next appearance – Los Angeles in March at The Main Event – another Miller/Napier seminar for subscribers.
AVOID INTEREST EXPENSE WITH ZERO INTEREST RATE FINANCING.
Who in the world is going to offer you terms without interest? The same folks who offer you nothing-down terms – people who have non-financial reasons for selling SFH. Believe it or not, the average American doesn't give a hoot about interest! Pretty strong words, but I think I can prove it. Currently there are some $350 BILLION in 5% demand deposit savings accounts, even when money market funds will pay 8% – 11%. Informed investors still borrow from credit card accounts at 18% or from Sears revolving accounts at 22+%. And I'll bet that YOU have money in a checking account earning NO INTEREST AT ALL!
The key to avoiding interest expense is to deal with people who don't place top priority on interest! This year I bought 23 properties from a trustee who was liquidating a trust. Terms: ZERO INTEREST. He was merely following the beneficiaries' directions. Here's another situation which illustrates my point. Recently I was told of a seller who had taken back a house in a foreclosure action. He had wiped out some of the secondary financing, so he had already captured a huge profit. He was greedy for even more. He had paid about $26,000 and the house was free and clear of debt. It had a value of about $52,000 but he was asking $64,000. He wanted $700 per month in cash flow payments. In this instance, the seller's greed was a controlling factor. He was focused on his high price, not on interest. The offer was for $64,000 at $700 per month for 91 months with the balance due at that time. He received his payments as desired and his price, but no interest. He will be completely paid off in about 7½ years. The house will rent for only about $500 per month, so there will be $200 per month negative cash flow.
Let's explore the potential here a moment. Assume for a moment that all rent increases will be offset by maintenance, management, and vacancy. $200 per month negative for 91 months will add up to $18,200 without regard to discounted present values. At the present value of the property, $52,000, there will still be a net profit of $33,800 even if there is no further appreciation in value. If tax laws are changed to eliminate interest deductions and depreciation this will still be a good investment because elimination of tax benefits always serves to slow construction. Shortage of living space is usually reflected in increased rental income. It's hard to see any way the buyer can lose on this house IF he can meet the payments and IF he doesn't sell it. In 7½ years his cash flow at today's rents will be $500 per month net. Ten houses like this will enable him to retire on about S60,000 per year in less than 8 years!
The lesson here is: learn to trade off appreciation for interest. It's safer, it's cheaper, it provides more overall cash flow, it's less vulnerable to IRS attacks. If you need help on the $200 per month negative cash flow payments, consider selling ½ of the property to someone for $26,000 at 12% interest only, nothing down, no liability. That will yield you $260 per month. It will cut your risk in half and provide for someone to pay ½ of the operating expenses. And you'll still have $26,000 coming to you in cash at the end of the 7½ years. He'll get to depreciate that half at his basis. If he wants all the depreciation, you can retain ownership of the land and sell him ALL THE HOUSE for the same amount, subject to your underlying obligation which will be amortizing swiftly. He can then simply pay you the same $260 as RENT without any balloon payment at all.
DON'T OVERLOOK CORPORATIONS IN YOUR STRATEGIES FOR THE FUTURE.
In so far as the upcoming legislation restricting interest expense deductions is concerned, they won't apply to property held inside corporations! Charles Considine (619) 231-1977 in San Diego offers an outstanding seminar on the tax aspects of using this form of ownership of property. A corporation offers accounting periods unrelated to calendar years, lower tax rates, pension plans to further reduce cash income, use of convertible corporate debentures to buy property without any mortgages or other security, concealment of the identity of the buyer to the casual observer and special tax considerations. If you haven't looked into corporate benefits for yourself and your heirs, now is the time.
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Quotation not permitted. Material may not be reproduced in whole or in part in any form whatsoever.
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