August 1981
Vol 3 No 11
6 months into the new Administration, events are beginning to cloud any clear view of the future as pressure groups clamor for legislative relief. Major influences on the Single Family House portfolio involve several key areas: Taxes, Financing, and Regulation. In turn, these interact within the overall Economy, and are affected by the flow of capital and shifts in population both Nationally and Internationally. Let’s take a closer look at each of them to see if we can devise a course of action.
LENDING INSTITUTIONS ARE ASTRIDE A POWDER KEG – AND COMPETITION IS HEATING UP!
Business bankruptcies and mortgage loan defaults are at record levels in many parts of the Country. Areas with highest mortgage delinquencies are Chicago, Pittsburg, and Cincinnati. San Francisco, Atlanta, and Little Rock show few defaults in spite of a fairly active investor market in SFH. This suggests that loan repayment problems are related more to industrial slowdowns than to speculative activity in housing.
This pattern jeopardizes lenders with heavy commitments in areas which are also showing high population outflows. I was approached by a major lender in one such city with a compound problem. This company’s loan portfolio was loaded with low yield level payment mortgages. At the same time as the newer, high interest rate loans were going into default, the real estate housing market had collapsed. Older loans were not being refinanced. In effect, this lender was paying current market rates on C.D.s, but had few takers for the money. Their outflow of interest payments was being supported by low rate inflows, and they were losing money by the bucketful.
Meanwhile, back at the ranch, the Government is declaring open season on all financial institutions by de-regulating the industry. S&Ls, Insurance Companies, Trust Funds, Credit Unions, International Banking Conglomerates, Retail Outlets, Stock Brokers are all coming into the banking business. New savings instruments are being developed to woo the saver; new tax incentives are being planned. At the same time, the Government itself will have to compete for funds. Typically, Treasury instruments take funds out of the market, driving interest rates up as available money is soaked up to pay the Federal Debt. Or, alternatively, the Feds simply create money and pay their bills with it. This drives the dollar down on foreign exchanges, creates additional inflation, and forces the lenders to increase interest rates as a hedge against the future.
Lenders are scrambling to survive. They are consolidating and merging into monster financial institutions to fight off foreign banking interests. They are offering additional services in areas in which they have little experience. This is especially true of Savings and Loan Associations. Colonial Savings and Loan of Shawnee Mission, KS following the Stockton, CA example (Sept. 79 letter), has established a $99,000 VISA Card based upon equity of a house; and this plan is spreading. Stockton reports that much of the funds are being used speculatively. Easy, expensive, short-term money can lead to financial distress in short order for both borrower and lender under this plan. And the S&L Industry doesn’t have the reserves or experience to stave off major problems. Lenders are adopting aggressive as well as innovative responses to the marketplace.
Lenders are turning to myriad mortgage schemes to entice profitable long term loan businesses. We reported on the FNMA Wraparound Mortgages last June. Some lenders are beginning to use this same approach to non-FNMA loans. A Dallas scheme has spread to Florida, called the “Rich Uncle” program. In this instance, a private lender becomes a co-mortgagor on a new loan, putting up a portion of the money for the down payment and monthly loan payments. In return, he gets a specified return or a share in any future appreciation. This program goes under a variety of names in different parts of the country. It is called Equity Sharing, Shared Appreciation, Participation, etc. It has yet to be tested in court as to whether a Security has been conveyed, or whether there is an ostensible partnership between lender and occupant. What happens if one person doesn’t meet his commitments? Who gets sued in Foreclosure? Incompetency hearings?
Adjustable-Rate Mortgages have interest rates tied to an inflation index. And Variable-Rate, Negotiable-Rate also provide for adjustment in interest rates from time to time. A Price Level Adjusted Mortgage has been proposed in which principal as well as payment amount would be adjusted to provide for inflation protection. Graduated Payment Mortgages and similar spin-offs emphasize lower payments in early years, with higher payments after the first few years. What do all these have in common? THEY EFFECTIVELY TRANSFER EQUITY TO THE LENDER OVER THE TERM OF THE LOAN.
As the lender’s income shrinks he can offset this by charging higher interest rates. This creates a situation in the housing market whereby the average payment that the average wage earner can qualify for will not buy the average house that the average builder can build! When the time comes to “roll over” the loan, or adjust the interest rate or payments; in all probability the buyer won’t be able to make the new payments. This is essentially the position so many people found themselves in during the 30’s. On a recent trip to Canada I read about one family whose monthly payment rose from $800 to $1350 per month after a “5 year adjustment”. They had to abandon the house to the lender in lieu of foreclosure. Can’t the same thing happen in the United States?
Anytime that the lender is not irrevocably committed to a set payment schedule, he has effectively transferred all his risk to the borrower. Efforts of the buyer to resist this entrapment by assuming older, low interest loans with level-pay, full amortization over 20 – 30 years are being bitterly fought by the banking community. From coast to coast the “Due-On-Sale” clause is being contested in the courts. In spite of California’s Wellenkamp and Glendale decisions, or Florida’s legislature’s action to kill a bill permitting a Due-On-Sale, the battle goes on. The Federal Home Loan Bank Board has a set policy that State Laws don’t override their policy with regard to alienation. Clause “17” in the Standard FNMA Mortgage continues to be used to intimidate would-be investors from having access to those favorable loans. A movement is afoot to make it the law of the land that no mortgages can be assumed at all. Lenders have been telling the Reagan Administration that they must pass their costs on to new buyers in the form of interest rate increases in order to survive. Hearings are being scheduled.
Innovative entrepreneurs continue to sidestep the issue through the use of Land Sale Contracts, taking title “Subject To” existing loans, using Leases and Lease Options or pure Options and Land Trusts. In Illinois banks have fought back by demanding they be named as Beneficiary on Land Trusts so that clandestine transfers of property can be controlled even when it has been placed into Trust. It seems doubtful that head on confrontation with lenders is going to yield a solution to the problem. The Realtor lobby has run a distant second to the Banking lobby so far, and entrepreneurs are losing the race almost 2 to 1 in the courts.
Inability of the housing market to obtain feasible interest rates has put more pressure on housing. Builders and developers have had many of their tax incentives removed just when they need them the most. Interest rates currently exceed the appreciation rate of new housing, thus investors have little incentive to risk capital in what could be a losing scenario. Companies like Merrill-Lynch are moving into this breach with capital and organization. They are buying Real Estate Companies, developing subdivisions, financing mortgages, enticing funds with “Ready Assets Accounts” that the lenders can’t match. This could signal the end of mortgage companies as we know them.
GOVERNMENT REGULATIONS ARE BEING FELT MORE AND MORE IN HOUSING
The give and take of pressure groups is being felt by investors and consumers alike. In Los Angeles, a zoning ordinance was passed making it legal to park a mobile home on any lot zoned for single family housing. As you can imagine, this went over well in Beverly Hills. Now they are trying to define a mobile home as something IMMOBILE, fixed to permanent concrete foundations, with minimum square footage in excess of that usually associated with mobile homes.
In Indiana, the courts have decided that when a lender sells an existing loan to another lender, it unconditionally guarantees payment and must make good on default or foreclosures. Suppose a due-on-sale clause is imposed by the second lender. The first lender will have to take the house back if no one else bids. In Colorado and in South Carolina, courts have held that a Wraparound loan on the first mortgage causes it to lose its seniority. It is no longer a first mortgage! When a lender allows a loan to be assumed, in some States a new Note and Mortgage are created to reflect additional interest and payment terms. And this new instrument loses its position as a claim on a property. What might have been a first mortgage could turn into a 3rd mortgage! That might be something worth checking on if you are being asked to sign a new note.
In Illinois, Park Forest South Village just adopted an ordinance making it mandatory that each non-owner-occupied house be inspected prior to occupancy. They’ll only take 5 days to do it (they don’t understand vacancy costs, apparently). The cost to the owner will be $20. If owners don’t obtain their certificate of occupancy, the fine will be $250 to $500 per house per incident.
Inclusionary Zoning has been in effect in areas of California, Colorado, Virginia, Maryland, and New Jersey for several years. It requires a builder to build special low-to-moderate cost housing in order to get permits to build housing for the marketplace. In order to build low income housing on high income land, the builder usually takes a bath, or passes along the costs to the high income residents. Now this program seems to be catching on. 21 additional cities and counties are putting this type zoning statutes on the books. All this does is to drive the non-subsidized housing out of the market, raising costs to taxpayers and to all who must pay for housing. In California alone only about ½ of needed housing was built in the past 12 months to serve the growing population. As demand for housing increases, so will rents.
Rent Control will be the battleground for the rest of this decade! The occupant pays the bills for high interest rates, taxes, zoning restrictions, and risk. As builders and investors build less housing, increasing demand will compete for ever decreasing supply. Rent will rise, and with it tenant militancy. Frustrated families faced with higher inflation will try to hold down housing costs by means of legislation. In New York last June the Rent Control commission approved rent increases equal to about ½ the inflation rate. This almost precipitated a riot among affected tenants – and the owners still weren’t able to obtain a reasonable yield from their investments.
The Senate passed the housing bill with a provision precluding Section 8 funds being used in cities that have rent control ordinances. The House Banking Committee has inserted a clause in their bill which will give tenants a voice in landlords’ decision making process with regard to rents, conversions to commercial use or condos, security releases such as partial sale of adjacent owned land and major improvements. Both of these bills will be modified before final passage, but it’s a sobering thought that the property owners are not being consulted during the deliberations.
In Berkeley, students are given mail-in cards on which they report rents they pay. These are compared to permissible amounts under the Rent Control Laws. Landlords have fought back, flooding the mails with false information in an effort to discredit data held by the Rent Control authorities. Now the Postal Inspectors are investigating to see if they can prove mail fraud. And the fight has just started. It will worsen.
As opportunity waxes and wanes across the land, major changes are taking place in our population which will directly affect our well-being. Let’s take a quick look at the economy and the hot spots for the near term future as far as single family houses go.
SINGLE FAMILY HOUSES CONTINUE TO OUTPACE ALL OTHER INVESTMENTS!
In spite of all the havoc in the real estate market, we’ve still got the only game in town. Gold, Silver, Gems, Collectibles, Stocks, Bonds, have taken a bath these past months. If you ever wanted to buy something other than houses, now is your chance. The IRS is bearing down on “Tax Shelter” schemes, Investment interest limitations where there is no offsetting income, AND ON IMPUTED INTEREST RATES. In typical fashion, they have declared that their previous policy of allowing a 6% installment interest rate to be used until July 1st has been rescinded retroactive to last September 29th.
For those long term investors in Single Family Houses who have held on, rental income has steadily climbed, and houses continue to appreciate even when sales slump. Recent tax rulings tend to support this investment. Upcoming legislation could mean a bonanza for real estate. Under proposed rulings, houses will enjoy 15 year write down without consideration of salvage value. Passive income will be taxed at a maximum rate of 50% the same as earned income. This includes both rents and long term capital gains. And it means that the effective maximum tax rate on gains will drop to 20% if we sell. Under the recently passed installment sale act, even these taxes can be deferred for years to come. And the revised estate laws could enable us to pass on as much as $600,000 tax free to our heirs. Or we can place our houses into a corporate pension plan and even improve on the after tax yields that we presently enjoy.
Of course, we’d better buy houses in areas that are going to prosper. Military spending will increase incomes near shipyards, and manufacturers of aircraft, engines, electronics, missiles, armaments, and components in cities like St. Louis, Philadelphia, Seattle, Dayton, and Detroit. Florida, Texas, California, Washington, New England will reap the benefits. Chase Manhattan’s Econometrics Department predicts that employment will grow at 3 times the National average in Tucson, Phoenix, Houston, Beaumont, Austin, San Diego, Tulsa, Las Vegas, Albuquerque, and Broward County, Florida.
Portland, Minneapolis, Dallas, Denver, San Antonio, San Francisco, San Jose, Sacramento Salt Lake City, Boston, Baltimore, Honolulu, Kansas City, Oklahoma City, Orlando, and Tampa will fare above average for a variety of reasons including political and business environment, quality of life, employment, growth, and fiscal soundness. The South and the West accounted for 75% of new construction this past year. This could lead to some overbuilding in some areas such as Dade County, Florida. Furthermore, as the older cities learn to cope with their problems, they’ll revive. At the same time the emerging metropolitan areas will experience growing pains over the next decade, as 17,000,000 new households compete for housing and expanded community services.
IN THE POTPOURRI DEPARTMENT:
Alex Herbage publishes the IMAC ECONOMIC NEWSLETTER. If you’ll write to it at CAPRISERV S.A., P.O. BOX 235, GENEVA, 3, SWITZERLAND and mention The CommonWealth Letters, you’ll receive a FREE 4 WEEK trial subscription. Use a 40 cents stamp for airmail.
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