April 1980
Vol 2 No 7
Let’s start with taxes. In a couple of weeks most of the population will have filed their tax returns for 1979. Many of them will have paid too much! Because of their fear of the IRS; or because of ignorance of recent tax legislation; or as a direct result of their tax-preparer’s efforts to avoid IRS penalties; they will have robbed their estates of literally thousands of dollars in future value.
The REAL cost of taxation to the individual lies in the future. Here’s how it computes: assuming that a 15% yield is available on an annual basis to an investor in most parts of the country, every thousand dollars spent on taxes COSTS the amount it could grow into if properly invested. In other words, if you didn’t spend the cash on taxes, you could invest in at 15% compound return. If you contemplate retiring in 10 years, this could add up to $4,045. In 20 years it would be $16,366. In 30 years it would be $66,211. That’s pretty impressive, but suppose each year you could save a thousand dollars in taxes (or in any other expense for that matter); what might the resulting investment amount to?
If you invested $1,000 in saved taxes each year for 10 years at 15% compound yield you would have $20,303. That would increase to $102,443 in 20 years and to the sum of $434,745 by the end of 30 years. Now think back on how careless and uninvolved you have been about your record-keeping, deductions for business and personal expenses, selection of bookkeepers and accountants. Every time you spend as much as $1,000 in taxes which you could have avoided, you have robbed yourself of a fortune in retirement funds.
Before you count yourself out for lack of time in the above scenario, here are some figures on life expectancy. If you’re now 55, you’ll live about 25 more years. Those retiring at 60 must support themselves 18 years; 65 year olds have 15 more years while 70 through 75 will still pay bills for 10 more years. Of course if you’re still in the midst of your earning years, you’ll probably be taxed more heavily and be able to look forward to even more years in which you will need a source of automatic income.
Tax-saving begins with tax-planning. Too often investors look at the GROSS dollars being received in a sale of assets instead of the after-tax-net-dollars they can expect to retain. Tax impact can push the seller into the 70% bracket as a result of last minute tax-year sales. Use of Lease/Purchase agreements, Option sales, Contracts-for-Sale, Installment Sales are simple to structure and effective in spreading tax costs in such a way as to minimize their impact. An ounce of prevention offsets a ton of taxes.
It goes without saying that good, sharp, competent tax counseling on long term strategy as well as on shorter range tactics is an essential part of any tax plan. Easy to say, but hard to achieve. How does one find/select adequate representation? A little knowledge can go a long way. Start with a tax course at the local junior college or at H&R Block to familiarize yourself with some of the generalities. You will be in a much better position to evaluate tax recommendations once you’ve gained the insights these courses can provide. The tax forms themselves won’t be such a mystery either.
When interviewing potential candidates as tax counselors, select one who is actively practicing his own recommendations in his own account. Packard Motor Company used to advertise: “Ask the man who owns one.” That’s good advice to follow.
WHAT ABOUT THE REAL ESTATE CRASH?
Like all proclamations, this one must be considered in terms of specifics in order to allow its evaluation. It is becoming popular to point to building slumps, unsold house inventories, fall off of construction permits, reductions in National sales of existing housing, etc. as clear evidence that the “real estate boom is over”. Let’s examine the “real estate crash” in terms of the single family house portfolio.
House increase in value because of two primary factors. Because they are composed of 3 basic ingredients: land, materials, and labor, they rise in price at a rate which compensates the builder for increases in costs of these components. Thus, when GOVERNMENT imposes additional land costs through retaliation, site requirements, building restrictions etc.; or when GOVERNMENT increases the tax load on profits and wages, thereby reducing the net take-home pay of both labor and capital; or when GOVERNMENT creates inflation, causing the costs of money to rise proportionately; the costs of housing must also rise if anyone is going to remain in business as a builder.
What happens when the price of housing rises beyond the ability of the new homeowner to pay? This question has been asked almost every year since 1946 when the flood of newly discharged vets descended upon the housing market with their G.I. Loans. The American Dream is ownership of one’s own home. The American public always finds a way to achieve this. Traditionally we have managed to buy our own houses with very little sacrifice. In fact, we pay a smaller proportion of our incomes for housing than the citizens in almost every other civilized country in the Western World. When costs become burdensome, we have traditionally turned to Government guaranteed loans, loan insurance programs, innovative financing, subsidized loans, etc. to revive the market.
This is where the second of the primary factors above comes into play. As a Nation, we refuse to relinquish our “right” to comfortable housing. We exchange those of our government representatives who impede our access to housing for others who will respond to our need for it, AND THEY KNOW IT! When construction slows, so do the other industries which support it. Lumber, real estate, glass, copper, roofing, steel, appliances, financing, carpet, paving, landscaping, insurance, Unions, etc. are all involved in the housing industry. They rise and fall with it, and so does their contribution to taxes.
As construction slows, pent up demand increases. Even though mortgage costs temporarily slow the market, THE DEMAND REMAINS UNDIMINISHED. Eventually it creates another real estate “boom” at even higher prices. It is much like a holiday in the securities markets where at the opening bell, thousands of eager traders rush onto the floor to fill the orders placed after closing. Prices don’t plummet in the housing markets just because sales do!
Even now lending institutions are beginning to respond to pressure from the housing industry. We NEED 500,000 more houses than were built in 1979. In most areas, buyers who could qualify seemed quite willing to borrow at unheard of interest rates to assure themselves of their American Dream Home. The new budget’s promise of even more drastic inflation makes acquisition of the single family house even more imperative. At the same time, the prospects of rental controls at the Federal level as a tool to combat rising rents promises continued shortages which will be reflected in higher costs.
The single family house is fast becoming the only currency the little man has to protect the value of his assets. It is both a store of value and a medium of exchange. It rises AHEAD of the inflation rate, and is easily exchanged for dollars, gold, gems, and other real estate in the National Exchangor Networks which flourish all over the country. Even now, it can still be purchased with as much as 100% leverage. Little wonder that buyers continue to confound the experts in growth areas by BUYING.
The key to investing in the single family house lies in structuring financing which permits high interest rates, but with monthly payment constants which permit a degree of safety to the investor. With the decade of the 80s we will experience a growth rate in housing that will be phenomenal. Many of today’s readers will be multi-millionaires within the next 10 years by using creative financing methods, exchanging, and enlightened management techniques which create cash-flow incomes completely sheltered from income taxes. Very few other investment vehicles anywhere will perform as well!
GOOD MANAGEMENT IS A KEY FACTOR TOO
As local governments tinker with the rental markets through the use of various ordinances and statutes, they deprive the Owner and Resident alike of many of the benefits ordinarily available in single family house rental investments. Because they spend their working lives in a non-profit environment, it is difficult for the typical government employee to make decisions in the real economic world.
What they fail to perceive is that every piece of legislation creates a cost in the form of taxes or operating expense which is ultimately passed on to the tenant. Thus, every time land is set aside for parks (off the tax roll), other land becomes a little more scarce, hence more expensive. When housing is constructed on that land, it too costs more, so rents must be adjusted upward to maintain feasibility. When the bureaucracy establishes rent controls to effectively pass on their imposed costs to the Owner, he eventually closes up shop, abandoning the building. This too, is removed from the tax rolls, and the process repeats itself. Both owner and tenant are victimized.
Creative management can effectively reduce the effects of governmental interference. Use of the discount lease helps to offset rent controls, especially when it is coupled with the contractual obligation of the tenant to perform all maintenance. Let’s suppose fair market rents are $400 for a 3 bedroom SFH. Under the terms of your discount lease, the tenant agrees to perform all maintenance and to make prompt rental payments for a discount of 15% ($60) per month. YOU SET THE RENTS AT $450 DISCOUNTED TO $390. For decent housing in a tight market, this works well. Now, enter Rent Controls. They usually specify some base period in the past from which rent increases will be allowed (often totally ignoring increases in the GPI over the same period). To counter sneaky Landlords, they also often require the owners to maintain the premises to the same standards as during the base period. Now let’s see how the discount lease works.
Because the tenant has always had full responsibility for maintenance, there is no further imposition of costs on the owner in this regard. Because the lease costs have been maintained at a level $50 or so above fair market values, the discount can be reduced each time a rental increase is necessary, thus effectively raising the amount of rent the owner will receive while obeying the letter of the law.
Creative collection techniques which employ discounts for annual rents paid in advance, credit charge-card collections any time rent is overdue, rents secured in advance by chattel mortgages on furniture and vehicles, voluntary deductions by the tenant’s employer from pay envelopes, prepaid rental credits earned by the tenant by performing services such as lawn care, painting, and even collections all help the owner to hold down while maintaining reasonable cash flow to meet expenses.
Naturally, use of creative concepts at the point of purchase builds a firm foundation for positive cash flows from the rental house portfolio. Denis Koelsch, Coveted White Belt Award Winner for 1978 suggests the buyer ASSUME any outstanding chattel mortgages or “add-on interest” financing in connection with a house purchase. Because these are direct reduction loans which are reduced each month by the amount of the payment, they are in effect interest-free to the buyer who DEDUCTS THEIR FACE AMOUNT from the cash due at closing. Often the sellers are just as happy to be relieved of the obligation for payments, and indeed, might have been planning to use the cash to pay off these bills. The buyer can thus buy with less cash and thereby increase his yield.
Interest-only loans also create benefits. We recently purchased several houses with an investor using a “split-Wrap around Mortgage” (Pete Fortunato and Jay Turner’s course on creative paper teaches more about this). Here’s how it works. The existing loan is assumable in the amount of $45,000 at 8%. The investor gives the owner $10,000 in cash, and then resells it to the Landlord for nothing down as follows: First, the Investor creates a “Wraparound Mortgage” at 12% for 25 years with payments of $484.48 on a loan of $46,000 ($1,000 more than the originally assumed loan). The balance of the investor’s equity is carried back in a 3rd Mortgage of $9,000 with payments of $90 per month interest only at 12%, with the balance due and payable in 5 years. Let’s take a look at the yields enjoyed by both parties in this arrangement.
Our Investor pays $4,167.84 per year on his underlying 8% mortgage, while he collects $5,813.76 on his 12% “Wrap”. Thus, his $1,000 investment is earning him the difference each year of $1,645.92. This is 164.59% yield on that investment! The balance of this investment ($9,000) earns 12% or $1,080 per year. Because it has a reasonably short term, it can be sold or pledged to recover most of the $9,000. If he can do this often, the Investor stands to command a handsome return with little effort.
What about our friend the Landlord? Assuming that he has bought a $55,000 house at fair market value, he can expect it to double in value in 5 – 7 years in most areas of the country. If we say that it appreciates at a compound rate of just 10%, we can see that he will be earning $5,500 per year on his investment. His yield depends on the negative cash-flow he will be experiencing. His house should rent for about $450 per month in most regions, and his debt obligations are $575 per month. In 12 months, he will have paid $1,500 out in fully deductible negative cash flow. His first year return will have been between 275% and 350% depending upon vacancy and maintenance costs. His effective costs of borrowing will have been equivalent to an interest rate of less than 2.7% ($1500 costs for $55,000 asset) with NOTHING DOWN!
What makes this formula work so well? It works because of the leverage obtainable to both the Investor and the Landlord in combination with cooperative tenants who pay the major portion of the costs. It’s easy to see that the price of the property had little to do with the yield. Creative terms produced the high returns.
Steve Rubinstein of Worcester, Mass. sent us an entry for our ODDITY SHOP. The Managing Director of the Realtors Retirement Trust, sponsored by the National Association of Realtors admits that monies in the retirement plan are not invested in real estate. Another source indicates that Money Market funds are the primary targets of real estate brokerage firms’ pension investments. Should we tell them about houses?
We’ve been using Money Market funds creatively these past few months (see June 1979 issue of CommonWealth Letters) to continue to earn money while waiting for checks to clear. We pay all our IRS taxes with Money Market checks, and we now place checks into escrow with instructions that they NOT BE CASHED until the transaction is closed. Each time we write a Money Market check (which is earning about 12%) we send a replacement check into the Fund in the same amount. In this way we maintain our balance which is earning interest, while satisfying our creditors. Sometimes it takes 2 or 3 weeks for the checks to clear while we enjoy the interest.
The government, in an effort to kid the public out of inflation, now claims that the CPI is OVERSTATING the rate of inflation as a result of the increases in the costs of housing. Instead of 14% in 1979 Alfred Kahn, our Inflation Czar says it should be less because A HOUSE IS NOT AN EXPENSE, IT IS AN INVESTMENT WHICH RISES AT THE RATE OF INFLATION. He says people who own them should not have their incomes adjusted to compensate for inflation, since that would amount to paying them twice! Maybe we should put him in touch with the Realtors Retirement Trust.
If we were going to take a long hard look at investment vehicles other than our trusty SFH, we would include managed Southern Slash Pine acreage just outside small towns in 40 acre tracts and at Mobile Home Parks or sites which we could condominiumize, with utilities to the site. Cheap housing is on its way out, and Trailer sales are going to boom as younger couples and retirees turn to manufactured housing.
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