Vol. 16 No. 6
February 1993
IT'S TIME FOR A FRESH BEGINNING . . .
Think back 16 years to 1977. Jimmy Carter, a southern governor with limited experience outside his own state became the President. We were just coming out of a recession and he'd won on a platform of getting the country moving again. The top income tax bracket was 70%, but much of that could be sheltered with real estate. The country was in a malaise brought on by the previous 4 years of political disarray brought on by the aftermath of Watergate. Sort of sounds like 1993 in a way, doesn't it.
For the past few letters, I've been concentrating on the preservation of wealth and the top income tax brackets. Now, I want to get back to the basics of wealth creation because there's a very good chance that house prices might mirror the last half of the 70s as this century draws to a close.
If you track the performance of gold from the time that Nixon freed it to its peak in 1980, those who bought it at bottom and sold it at the top realized about a 50% per year compound return. Those who bought single family houses using available market leverage did even better. I think over the next few years single family houses are going to see a resurgence. Here's why:
Clinton and members of Congress won office in 1992 by promising an end to the recession, jobs, and breaks for small businesses. The problem is, that nothing has really changed to break bureaucratic gridlock that Ross Perot ran against. It will be difficult for any real results to be seen in education, health care, inner city decay, etc. before those Congressmen have to run again. They'll want more immediate results. Real estate can provide the fastest track to a robust economy and Congress knows it! See if this doesn't make sense:
Infrastructure repairs – building roads, bridges, waterways, etc. – are political. Every Congressman wants money for his own district and getting money into the hands of consumers is a long slow process. Besides, there are few votes for the guy who puts in a new garbage disposal plant. On the other hand, think how popular a new Congressman would be who could provide low cost houses with easy terms to the voters. This might be done with bond financing, tax incentives, credit guarantees, etc. Look who'd benefit immediately:
Housing construction leads to land development, new roads, water and sewer lines, growing population (of new voters), a broader local tax base with higher assessed values to fund local budgets, new schools funded with impact fees. A boom in housing construction can put millions of people to work from the most marginal employee rolling a wheelbarrow to environmental engineers laying out new neighborhoods.
Think of all the products that go into a house: carpeting, lumber, copper, glass, fabrics, furnishings, appliances, cabinets, electrical, plumbing, mechanical, heating and cooling systems, roofing, fixtures, landscaping, cement, etc. All of these have to be manufactured, transported, financed, warehoused, and sold. Expansion of housing construction not only provides employment for millions of people at every level, but also provides purchasing power with which to buy housing that all this effort produces.
As new housing is absorbed, old housing is made available on the market for those with lower incomes. People are able to unlock their equity tax free as they trade up. Retirees can augment their retirement savings by selling their homes and exempting $125,000 of their profit in addition to any sums they've invested in both their old home and any new one they buy to replace it. This will take some of the strain off the Social Security and corporate retirement crisis that's looming. All this activity can funnel $Billions into the economy to fuel the recovery. Best of all, it can be done with private funding without adding to the deficit problem and the Clinton administration will get the credit. How can he resist the temptation?
ARE YOU PREPARED FOR NEW OPPORTUNITIES WHEN THEY COME?
If any of the preceding makes sense, each of us has to plan how we're going to take advantage of what might be the last hurrah of this century. Remember, following the 70's market boom, real estate in most areas has been moribund at best and has lost considerable value in many areas. It could happen again. This isn't a chance anyone would want to miss out on when it comes. Only you know how well you're prepared to capitalize on market opportunities that could emerge in the next year. Here are some things to consider:
1. Are you seriously committed to achieving financial security?
2. Have you weighed the costs in terms of sacrifices you'll make?
3. How much of your income are you prepared to invest periodically?
4. Have you and your family agreed upon mutual financial objectives?
5. Have you pin-pointed a specific market sector to work within?
6. Do you have the necessary basic negotiating skills to do the job?
7. Do you understand the various ways to finance property privately?
8. Can you calculate various alternatives involving mortgage 'paper'?
9. Have you developed buying, selling and management skills?
10. Are you constantly striving to strengthen your weak skill areas?
As you can see, regardless of how much opportunity the new administration creates, it will still require hard work and know how to wind up at the top of the heap. Anyone can win the lottery or make lots of money through good luck or being at the right place at the right time. The problem with luck is that it's hard to create when you need it. The vast majority of the real fortunes that have been made – AND KEPT – have been based upon the fundamental skills and attitudes of those who made them. There are few short cuts on the road to success regardless what the TV tape salesmen tell you.
Take another look at the above questions and you'll see that it all starts with your personal and family goals. Assuming that you've taken the time to thoroughly explore these and have reached agreement to minimize domestic strife, you'll need to then be fairly specific in targeting (a) the geographic locale of your market, (b) the size and price range – and demographic profile – of the properties and people within that market, (c) tactical approaches to locate motivated people who own houses you might buy BEFORE THEY'RE PLACED ON THE MARKET, (d) financial terms you might negotiate with a seller or buyer to avoid personal recourse and liability on loans, (e) ways in which to hold title to avoid notoriety, multiple recording expenses and liability. You'll find that success really starts with your planning long before you enter the actual arena.
WHAT ARE SOME OF THE OPPORTUNITIES? WHO WILL BE THE VICTIMS?
I was one of the lucky ones. I got my real estate license in March of 1970 and actually went into the real estate brokerage business a year later after I'd lost my job as a Quality Engineer in a manufacturing company. Those early years provided me with a way to support my family through real estate commissions while learning how to buy real estate for myself and for others. Then the recession struck and I learned how to produce income by being a manager rather than as a salesman. This situation is similar today.
Thousands of employees are going to be laid off in defense and related industries. These will include military personnel who are half way through their careers as well as people employed by defense contractors. As military bases scale back, local businesses will also suffer loss of income and profitability. In areas where defense has traditionally played a significant part in the local economy, there is going to be some painful readjustment to the new realities. If you find yourself, as I did, out of work and a little long of tooth for a new corporate career, you may be able to convert disaster into a brand new opportunity by becoming a real estate salesperson or a property manager. Both reward diligence and ability to a degree not often found in other fields of endeavor. Furthermore, you're always paid according to your ability when you work on commission.
If the housing boom materializes as it well might, you'd be in perfect position to profit from the sales of new and used houses. I swiftly discovered that knowing how to finance houses and solve marketing problems gave me a major advantage over those who relied upon conventional real estate training. As interest rates rose and credit became restricted, I learned how to structure property exchanges, seller carry-back financing, leases with and without Options, joint ventures and time sharing. The 70's were good to me.
Sure, I had to start all over to learn a new career, but I swiftly discovered that there's a distinct advantage for the new boy on the block when the old boys think they already know it all. The more I learned, the more efficient I became, and my income jumped by leaps and bounds. By the start of 1976 I was able to retire. This could happen to you too in the current economy. If you start now to prepare yourself, you'll have time before any real boom gets started to learn the ropes. Then, by buying and holding rather than merely selling on commission, you'll enjoy the fruits of any price rise brought on by a Clinton inspired housing expansion or inflation.
Many people will become victims by default by not taking the initiative to change with changing circumstances. They'll grudgingly accept jobs with lower pay scales and fewer chances for promotion rather than seizing upon the new opportunities. When the vast majority makes this 'safer' choice, it will create many opportunities for buying distressed high middle-range houses.
This will add to the already uncomfortable pressure on the mortgage lenders. They're already stretched to the margins on their reserves because of the oversupply of commercial properties they've had to take back. When this same phenomenon occurred in the mid-70's, lenders were delighted to have someone with a track record solve their problems. 'Entrepreneurs' took over the distressed owner's loan without recourse or bought foreclosed property with very attractive financing from the lenders themselves. By learning (or honing) real estate skills now, you'll have the credentials to do this too.
AVOIDING BAD FINANCING IS THE FIRST RULE OF WINNING . . .
Its provocative to be able to finance houses with high leverage loans. But, those variable rate loans which seemed like such a good idea will start to rise as the Clinton administration starts to borrow to support increased government spending. Suppose you were able to buy a $100,000 house from a lender who agreed to provide a 90% loan simply to get the property off its books. Not only were lenders in the oil belt during the real estate collapse in 1987 willing to do this, there were willing to make the first few year's payments interest free and to even build in a payment moratorium.
Now, if you were able to get a $90,000 variable rate 6% loan with a 12% cap, the monthly interest payments would be $450 the first year or so. With rents at around $800, there would be enough cash flow for principal, interest, taxes, insurance, management and maintenance. Look what happens when interest rates rise to 12% (and in 1980 they were as high as 22.5% in California). You'd be $100 in the hole each month on the interest alone plus all the other costs of ownership. You might be able to survive a few houses, but when you expect to buy several dozen, the situation becomes intolerable.
Regardless whether the negative cash flow is caused by interest, taxes, maintenance or vacancies, it can wipe out everything you've worked for. You in turn become a victim. It's much worse when a real estate slump causes prices to drop below the loan balance you owe. This is what happened to investors in New England, southern California, Texas and other boom areas where investors refinanced properties, paying off 'safe' loans and replacing them with loans on which they'd signed with full personal recourse. For most of them, the only way out was personal bankruptcy. That's no way to build financial security. That's why non-recourse seller carry-back loans or institutional loans which can be 'taken over' without liability are my favorite. There are other ways to avoid liability on loans.
TRUST STRATEGIES ARE COMING INTO THEIR OWN . . .
Once upon a time there was a lender with 7 foreclosed houses it didn't want. It was fearful of the liability empty property can create and didn't want to continue to pay property taxes and grounds maintenance. First, a Trust was formed. Then the Trustee approached the lender and agreed to buy the properties with a 20% down payment IF the lender would provide 6% financing for 8 years, interest-only with a balloon at that time. The Trustee signed the loan 'as Trustee and not personally'. This effectively made the loan a non-recourse loan because the only assets of the trust were the houses.
One of the final points to remember when assembling a real estate portfolio is that you should hold title in such a way that the real estate can be held, leased and/or transferred privately without any notoriety in the public records. This can eliminate 90% of the liability from financial and/or tenant problems. And it enables you to build a large estate quietly without notice out of public view.
As your real estate holdings continue to grow taxes will become more and more important. Early on, there will be plenty of tax shelter from your real estate to cover any income. As a matter of fact, in the early years too, you'll be limited to $25,000 of tax write-offs under current law. Using a C corporation in connection with trusts to hold property can provide astonishing tax write-offs together with privacy that's simply not available for unincorporated businesses. In future issues, we'll discuss corporate tax techniques.
By now you've probably gotten the big picture. There's probably going to be a resurgence in house sales and construction which could be brought on by re-establishment of passive loss rules, tax investment credits, lower capital gains rates under the Clinton administration. Preparing yourself for the opportunities both by study and practical experience will enable you to capture income and profits unlike any we've seen since the 70's. Will you be ready?
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