February 1987
Vol 10 No 4
I just received a telephone call. It was from a person who had rejected an offer of mine to buy his property. He'd been holding out for a higher price and now that all his alternatives had disappeared, he was finally ready to accept my offer, made in mid November. The trouble was, I no longer had any interest in his property because it no longer made any sense. He'd failed to recognize that the implementation of the new tax law has changed not only the appeal of some properties, it has also changed their ECONOMIC VALUE!
Real Estate has always been defined as a 'bundle of rights' which convey a range of benefits. Historically, these benefits have been based upon the spendable income that a property could generate to the holder of the rights. And that income has generally been derived from rentals, sales, or use of the property to produce commodities which could be sold or rented. Recently, the tax laws and government policy have produced artificial value in property by changing the amount of spendable income an owner might receive from a given investment. Thus what might have been a mediocre apartment house became an acceptable after tax cash flow generator in the hands of a high bracket investor.
The above situation was aggravated by a decade of inflationary economic policies which created Billions of dollars of paper profits for real estate owners without any effort on their part at all. For those who failed to comprehend the fiscal and monetary influences on real estate, the changes in the economy and tax laws in the '80's' have been devastating. There never has been any magic to real estate. It's value has always depended upon income that survived taxes. When inflation enabled the owner to sell out or to borrow cash on his property profitably, he could command a high price. Similarly, when the tax laws enabled the owner to keep more of his rental income or his sale proceeds after taxes, the next owner was willing to evaluate it on that basis. Finally, when the Federal Reserve made easy credit available in the form of low down payment, low interest rate loans; investors could plunge into highly leveraged real estate ventures with virtually guaranteed profits. No longer!
Rents received on houses bought in 1987 won't be treated so benignly. First, the owner will have to shelter them with 27½ year depreciation rather than 19. And to the extent that he saves money on 27½ year vs. 40 year depreciation, he'll be taxed at a 21% Alternate Minimum Tax rate. He'll also have to be 'at risk' on all amounts that he wants to depreciate rather than enjoying a comfortable margin of safety in highly leveraged property. And, to add insult to injury, on 1987 houses, owners won't be able to deduct losses that exceed the income the property has produced. If he'll take an active interest in management, he might be able to deduct $25,000 against his other income. But he'll be increasingly limited as to the amount of interest, dividends, business profits, wages or salary that he'll be able to shelter with his real estate losses. And that's not all . .
When he sells his property IF he can find a buyer, he'll pay taxes on his profits at his ordinary income rate (up to 28% in 1987, and up to his maximum rate in 1988 and beyond. Congress in its wisdom has foreseen that many investors could be taking massive losses in the wrong kind of properties, so they've allowed those losses to be deducted as if they had been short term losses. Of course, when an aggressive investor has 'pulled his equity out' and used the money to pyramid additional negative cash-flow properties which he's depreciated as fast as he has been able, he could lose everything and still be taxed as if he'd made a gain. It seems inevitable that those who've waited until now to sell will find few buyers at retail.
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IT DON'T MEAN A THING IF IT AIN'T GOT THAT SWING . . .
Cab Calloway has made a living with that song for 60 years. What does it mean? In real estate terms, it means you have to structure in your profits if you ever hope to realize them. We started this letter discussing the bundle of rights represented by real estate. The key to profits in real estate transactions is in being able to manipulate the rights that you need so you can achieve a positive result. Quite often, this is much more important than the real estate itself! When we say 'structure' we're talking about putting the transaction together in such a way as to maximize control over those rights and the benefits which derive from them.
Gobbledygook right? Let me put it another way. Suppose I want income. Then I need to control the element in a property which produces income. Income comes from rents or sales, so I need to control either the LEASE RIGHTS or the SALE RIGHTS, both of which come from power to rent or sell. And these in turn come from a LEASE or Option to Lease; or from a LISTING, OPTION to sell, or to buy, or an assignable contract for sale, or from a position of ownership or as a TRUSTEE with power of sale. So when I structure my deal, I have to arrange things so that I acquire the appropriate rights with the proper benefits. I'll do this with the documents that I use.
Let's start with the right to the income. I'll use a LEASE. I'll peg the rents I have to pay at a lower level than the rents I hope to be able to command from those who sub-let from me. This would be a particularly useful technique anytime the cash flow on a property might be questionable, or in a situation in which inflation has driven prices up so far that fair market rents won't return enough to justify the investment of the dollars that it would take to buy the property. Every time that I hear investors complaining about negative cash flows, I marvel that they don't elect to structure a 'sandwich' lease rather than buying the property. Since the amount of cash flow in the lease is dependent upon the rents rather than on the value, this is a prudent response to a market where only higher priced properties are available, such as exists most of the time in Southern California.
Now, the plot thickens. If I were to assume that rents are going to climb – as this new tax law might suggest – then I'd negotiate a long term, level payment rent. For instance, suppose today's rents were $500. Then I'd negotiate a long term rental of maybe 3 years with the right to renew the lease for another year or so. As the market rents my sub-tenants paid rose, the rents I had to pay to the owner would remain constant, so the profits I'd make would also rise. On the other hand, if things didn't work out as expected I could let my option-to-lease expire without any liability after the initial 3 years. Or I could renegotiate my position to remedy my cash flow situation if the owner were amenable.
Suppose instead of my forecasting that rents would rise, my crystal ball foretold that prices would lead the way in coming inflation. Then I'd try to control the income from a future sale rather than from monthly rents. For this I'd use an Option, which is merely a right to buy or sell at some point in the future under specific terms and conditions. I might negotiate with a distressed owner to pay $100 per month for a 5 year Option on a house that might be worth $150,000. A house in that price range would rarely command rents at a high enough level to pay an 80% mortgage, but with an Option, I wouldn't be responsible for payments. The $100 I gave to the owner would help him ease his own cash flow woes without the need for repayment. Of course the actual payment amount would vary with each case.
Now, suppose prices rose by 3% per year. At the end of 5 years, I'd have $6000 invested, but the house would be worth $173,891. That would amount to over $23,000 value without any work on my part at all. Of course, it would accrue to my Option rather than to the house, since I'd be entitled to everything Over $150,000 any time the house were sold. If things began to resemble the '70's', the price could easily rise at 15% per year – even higher. Then, after 5 years, the house would be worth over $300,000 and my Option worth over $150,000. There just aren't any other investments to compare with an Option on a house when inflation strikes because of the extreme leverage that's obtainable with minimum risk. Who'd give you such an Option? Anyone who needed more INCOME or maybe help with MANAGEMENT.
THE DISTRESS MARKETS ARE HEATING UP . . .
Suppose the recalcitrant seller who called me too late were really in trouble, is there any chance he'd sell for a lower price? Do you think he might be willing to 'hand it back to the bank'? Is there any chance that he'd PAY someone to take over the property? Is there any way you could profit from such a situation? The answer to all these questions is YES! It's already begun to happen. Consider that in 1987 thus far I've had two corporate Vice Presidents calling me on their nickel to offer me their assets at less than 50% of the listed price. A local developer is willing to walk away from a 32 house subdivision if he can find someone to refinance the property and take him off of his liability for the loans. He'll give up an ostensible $20,000 in equity on each house to save himself. Banks will too.
Even your card-carrying, terminally imperceptive banker realizes that he's a short hop away from becoming the owner of lots of marginal investment real estate whether he likes it or not. Those prudent/lucky owners who signed non-recourse loans can simply hand the property back and walk away, leaving the banker in the soup. As you can imagine, this can generate a remarkable climate for negotiation. Your first ploy should be to get the payment and the interest rate reduced to enable your properties to start to generate positive cash flow. You might negotiate to make your loan assumable to enhance the prospects of your being able to sell it to a homeowner. Change variable rate loans to 30 year, level payment, fully amortized, fixed interest rate loans. Get any personal liability removed in the event of a future economic calamity. Otherwise, let the banker 'buy back' the house at the loan balance if it no longer makes any economic sense.
At a foreclosure sale held in November 7 or 8 lenders attended to insure that the properties were sold at least at the loan balances. THERE WERE NO OTHER BIDDERS. In only a few instances did the lenders bid in the properties at the minimum bid. Almost all of them bid the full loan amount, thereby removing all contingent liability and the possibility of a 'deficiency judgement' from the borrower who was being foreclosed. Why? Because, had the lenders bid a lower amount, that would have been tantamount to admitting that the houses WEREN'T WORTH THE LOAN BALANCE. Hence, the entire lender's loan portfolio would have had to be re-evaluated in the light of market response to the sales. Under these circumstances, most lenders who have made heavy real estate loans would be BANKRUPT with liabilities far exceeding assets. They just can't afford to have this become public knowledge. Needless to say, I don't maintain cash reserves in a lender with large portfolios of mortgage loans.
The level of distress in any area depends on several factors: availability of investor/vs/home-owner loans at low interest rates, speculator and investor activity and that of tax-shelter promoters in the area, presence of investor groups which promote highly leveraged acquisitions, and local depression in the economy caused by high unemployment, plant closings, loss of markets (such as in the oil patch), political interference leading to high taxes and re-location of entrepreneurs and those who create jobs. IT'S CRITICAL TO KNOW THE ROOT CAUSE OF ANY WIDESPREAD MALAISE TO SEE IF YOU CAN AVOID BEING DRAWN INTO IT!
If the entire area is depressed, and likely to remain so, it's entirely likely that you'll have a difficult time making a profit even though you buy low. You have to sell or rent high if you expect to prosper, and economic depression doesn't lend itself to that aspiration. On the other hand, if an otherwise healthy economy is experiencing widespread distress and a high level of foreclosures of investor's houses; then there's a real chance that you'll be able to turn the properties around and enjoy high gains. So you have to find out WHY properties are in foreclosure and be certain you have the solution before you jump in. In Florida, the Challenger disaster has created severe distress in the Cape Kennedy area among those who relied upon the space program for income. The same is true in Texas in the oil patch but for an different reason – the price of oil and international competition. Both are economic disturbances which real estate expertise may not overcome, so one should tread carefully when contemplating investment in those areas even at bargain prices. When it comes to distress, in 1987 you ain't seen nothin' yet. Get ready for it!
JUNKER PROPERTIES GENERATE MANAGEMENT PROBLEMS . . .
Since I stopped giving my Hands-Off Management seminar I've been beseiged by calls from people with management problems. Many of them have made the same mistake, they bought properties at very low prices which only the lower 25% of the population could/or/ would live in. Just as soon as their tenants can afford to move, they do – and the owner is faced with another vacancy after repairing any damage. Some distraught landlords elect to rent their properties under subsidized housing programs such as Section 8 under the illusion that this will cure all their woes. This can afford temporary increases in cash flow and some management relief, but at a cost. First of all, they will have moved from being independent entrepreneurs to being government wards subject to the whims of the administrators of each program. And their incomes will be subject to government policy and budgeting. Finally, when their tenants move and they have to return to the real world of market rents, they may find they won't be able to function financially.
The principal argument for buying El Cheapo houses is that the return on equity is much higher than on mid-range properties. Viewed strictly from the rental income approach, this is often true, but owners overlook the costs/value of their own management effort. Rarely can one implement a Hands-Off system with cheap properties wherein tenants perform most of the maintenance and collections are virtually automatic. Instead, the El Cheapo owner finds his weekends filled with collections and maintenance with his weekdays taken up by eviction actions and possibly law suits. Those who live in sub-standard houses frequently are served by a host of social and civil law agencies who are paid for by the owner, but who provide free legal services to the tenants. Thus, evictions are delayed, maintenance costs can be much higher than on more expensive properties, and tenants become much more militant. In short, the owner would probably earn a much higher return on his EFFORT if he just got a weekend job at an hourly rate.
When one adds in the cost of his own management effort, this reduces the yield on the EQUITY to a much lower rate. And when one considers that management of cheap houses boils down to trying to collect rents and to keep the properties maintained, it isn't much fun. Conversely, when one manages better properties at the median point in the rental market, the owner can concentrate on honing his system into a net cashflow producer which requires only minimal effort to keep functioning.
There is one exception which might bear mentioning with less expensive dwellings. The best, lowest priced housing available anywhere is the mobile home. For $25,000 you can buy a double-wide with many amenities including central heat and air, screen porch, carport, etc. If you have a dealer's license which is usually fairly easy to get, you can buy at wholesale prices even cheaper. Trailer lots are advertised at about $10,000 in many areas and mobile homes attached to their own lots can qualify for both FHA and VA financing. When these become available as rentals, they can become much more desirable than sub-standard conventional houses to both landlords and tenants. Of course, this market also enjoys a distressed component in which both lots and units can be bought far below the above prices. Rental mobile homes in good parks can attract much better tenants than marginal houses.
The coming year will impose new requirements on managers that they generate the maximum cash flow from each rental property in order to use all the remaining tax benefits. Net cash flow is produced not only by higher rents, but lower expenses. To the extent that managers can improve both of these they'll see their property values increase proportionately.
Copyright Sunjon Trust All Rights Reserved
Quotation not permitted. Material may not be reproduced in whole or in part in any form whatsoever.
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