January 1995
Vol 18 No 5
The saying goes on to say, 'Use your ears, use your eyes, then use your feet.' As a 6 year-old youngster, always in a hurry, I was once run over by a car. Metaphorically, as an entrepreneur and investor, it has happened to me a few times since, as well. To the above advice, for property owners, I might add 'use your head'. This month's topic line is particularly apropos in today's constantly changing economic and political environment. Here's a short summary of some of the changes taking place in the coming year:
A number of investment letters are predicting that net inflation will continue to rise in 1995 and that the Fed will continue to raise long term interest rates to combat it. Rising inflation and higher interest rates will make Option and Lease techniques even more profitable for those buying properties. At the same time, an inflationary scenario and recent court decisions are going to make life more hazardous for those who are selling properties and carrying back mortgage notes.
There's unsettling news in the mortgage note market. In Laidlaw Holding, Inc. v. Pollack 94-433, disgruntled mortgage investors who'd lost money on 'bad' loans filed a suit for damages against a mortgage brokerage. This led to a decision by a New York Federal Appeals Court that securities laws would apply to mortgages. The Supreme Court refused to consider reversing the decision. While this was a narrowly constructed ruling, according to the Blumberg Business News this decision opens a Pandora's box of law suits against mortgage sellers under Federal RICO statutes. Most affected would be the $4.3 trillion secondary mortgage market. Real estate could lose a lot of liquidity if a few large judgments were obtained against mortgage companies.
That can mean good news for buyers but bad news for sellers. Loss of market liquidity will motivate sellers to carry back financing on houses offered to the market. But sellers will have to be careful to comply with the provisions of Regulation Z, Section 226.2(a)(17). In short, this says that anyone who, more than 5 times within a calendar year, extends consumer credit payable in more than 4 installments secured by a dwelling, and to whom the debt is initially payable, must provide the debtor a 3-day right to cancel the debt by law.
Now's the time to modify your contracts and Notes to include language which incorporates this requirement. You might add the following; 'In accordance with the federal Truth-in-Lending Act, (12 CFR 226) the maker(s) hereunder may cancel this contract without prejudice anytime within the next 3 calendar days by delivering signed, written notice of intent to cancel to the lender together with all other documents in his/her/their possession relating to this transaction.' In your contracts, you might specify all funds and documents to be held in escrow, unrecorded, until such time as the 3-day waiting period has expired, or until a notice of cancellation has been received by the escrow agent, and all documents returned.
The Republican Congress wants to exempt 50% of capital gains from income taxation. Taxable gains would be indexed to increases in the Gross National Product from income taxes. Reduction in capital gains may carry a price. It may come at the cost of reduced funding for subsidies such as HUD Section 8 and low income housing grants. Now might be a good time to start phasing out Section 8 tenants and replacing them with those who can support themselves. Reductions in federal spending will be felt in all state and local welfare programs. With a sea-change in American politics, this is a good time for HUD landlords to consider adjustments in investment philosophy.
OLDER SUBSIDIZED HOUSING MARKETS ARE VULNERABLE
While we're on the subject of federal interference with the markets, let's talk lead paint. In just 10 short months the federal lead paint laws are going to take effect. That's going to create real problems for owners of pre-1978 houses both in terms of marketability and rental. One U.S. District Court in Maryland recently ruled in Hays v. Hainbruch, Civil No. H-92-1830 that an owner was not liable for lead paint hazard that he knew nothing of, nor had any duty to know of. On the other hand, in Richwind v. Brunson (625A2d, 326, MD.App 1993) the court held the owner liable and the jury awarded the plaintiff $500.000. This isn't going to be something to ignore.
First of all, you should get a qualified inspector to tell you whether or not you have a problem. You may not have any lead paint contamination on your property, or you may be able to get rid of it at reasonable cost. It will be far better and cheaper to do it now than later on when the law takes effect and the government inspectors will be able to supervise how you solve the problem. Next, write to your Congressman's office and request them to send you a copy of the law. Read it yourself. There's a lot of misinformation out there. Depending upon the result of law suits filed in several states, there may be a 'phase in period' during which merely including a written warning to – prospective tenants and buyers will meet the law's requirements. Before you panic, take the time to explore the problem.
Let's say that you do all of the above and discover that you could have a real problem which would cost more than you can afford to put into the property. You know what they say: 'When the going gets tough, the tough get going.' In short: SELL! When you're talking about contemporary single family houses, in most places across the country, you should be able to market them if you offer reasonable financing. But, if you're talking older, run-down houses or multi-family units, you're going to have to work a little harder.
Start by doing some cosmetic surgery to make property more attractive to the market. This might involve removing some of the surfaces which have lead paint on them. Simply cleaning up properties and removing clutter, repairing windows, screens and doors, replacing fixtures, wall and floor treatments, getting rid of unsightly appliances, repairing cracked plaster, painting is relatively inexpensive when you use 'handy man' type labor. Once you start fixing up units to sell, you may find this to be a real profit center in 1995.
IF THEY HAND YOU LEMONS, MAKE LEMONADE
Look at the market possibilities for someone who understands how to solve lead paint problems by changing roles a little, i.e.: (1) Become a consultant who is able to explain the legal requirements of the law, (2) Become a fee inspector to evaluate the extent of any lead-based paint problems, (3) Go into the rehab and repair business specializing in ridding a property of any problems or getting it ready for sale, (4) Qualify as an appraiser to establish loan value, and/or, (5) Becoming a loan broker, able to round up financing so a potential buyer would be able complete the sale with the seller cashing out.
When you think of it, anyone who is presently engaged in the rehab and fixer-,upper business should be a shoo-in for the lead paint business, and vice versa. You don't have to wait until October to get started. A number of our readers are already up and running as busy entrepreneurs who buy 'sick' houses and restore them for sale into the market. There are two approaches that seem to work well.
In the first situation, relatively modern homes are targeted that have been abused by their occupants. Typical of this type of house would be one that was less than 15 years old and which might have been sold under some sort of subsidized FHA, VA or Farm Home programs. It makes little difference whether the loan is assumable or not, since the house will be fixed up and sold before the lender even notices that a new owner is on board.
The ideal property will be one which can be bought at a big discount for cash to the equity from someone who, for non-financial reasons, wants to sell. A divorce, job change, personal conflicts, etc. might motivate the seller. On the other hand, there could be severe immediate financial problems which only an infusion of cash might solve. In any event, deep discount pricing is the key to this type of property.
As a goal, a 6 month turn-around from purchase to cash sale is envisioned with a minimum of $10,000 net profit after capital, labor, sales expense, closing costs and financing have all been paid for. One of our subscribers has a video tape which shows how this system works in practice. It can be obtained for $39.95 by calling 800-889-2020. It can save you time and money if you're just entering the rehab business. He also publishes a newsletter. He tries to keep about 10 houses in the system during the year. For you folks without a calculator, that comes to $100,000 per year net income. Not bad when you consider that he doesn't do any of the actual work himself. With his program, his houses are usually sold with FHA financing before they're completed to owner occupants who can qualify for a new loan, or afterwards through conventional MLS real estate channels
TAKE-OUT FINANCING IS THE KEY TO OLDER PROPERTIES
The second approach involves older, abused, abandoned, or neglected houses that are in need of extensive-repair, but which can be purchased at low cost from estates, county tax collectors, the IRS, from other landlords, distressed or absentee owners. Everything said here also applies to Mobile Home rehabilitation concepts as well.
The entrepreneur first locates a likely suspect and runs down the owner through the tax records, neighbors, relatives, etc. Then he rounds up private financing via investors through local investor clubs, contacts, relatives, friends, etc. with which to make can all cash-to-the-mortgage offer at a heavily discounted price. The investor secures his loan with a mortgage lien against the property, which must be paid off within a year or so, or upon sale if that occurs first. Incidentally, the investor had better be a real sport, or sophisticated enough to see the real potential in a property. It's to be expected that he could be turned off by most older fixer-upper properties or the neighborhoods in which they're likely to be found.
Coincident with obtaining the property and the acquisition financing via, the entrepreneur also cultivates the acquaintance of an investor in the secondary market who buys first liens. This ideally would be someone with an IRA or corporate pension plan. In a typical situation, for a $50,000 owner-occupied fixed up property first mortgage note in which a credit-qualified buyer has paid at least 5% down, one investor I know of will pay 80% of face value for loans written at FHA rates. He likes to buy them in $200,000 bundles. Let's see how this all works out.
We'll assume that things proceed according to plan, and after a few weeks, the property has been put back together and sold with the seller carrying back a mortgage. This mortgage would be tailored for a specific discount mortgage investor. Upon closing, the note is immediately sold to the mortgage investor for cash and the original investor is paid off and his lien cancelled. The entrepreneur also is paid his profit in cash based upon a 20% discount on his mortgage. As a practical matter, MLS sale and finance costs might easily have cost him as much as 12 or 13% if he could have found a qualified buyer and an institution that would make a loan on this older renovated property.
When confronted with what might seem to be some real negatives in the economy and political spectrum, many people act on the defensive. It's far more profitable to take the offensive and look for opportunity. For some, working the rehab market may be just the ticket. There's a place in this type of program for entrepreneurs, handy-man tenants, for both short and long term passive investors, and for 'packagers' who can assemble mortgages into sale-able packages and take a small percentage for assembling and servicing them. Best of all, there's a new loan program tailored to the needs of the fixer-upper specialist.
There are a variety of loans available, even for non-owner occupants. For investors, it's hard to beat the FHA 203K loan program. Initiated in March 1994, for 1-4 family residences owned for at least 6 months, an investor can obtain 85% of the market value plus 100% financing of the costs to repair a property so long as repairs exceed a minimum of $5000. That’s about what a roof, floor and paint job might cost in my area. Now for the good part:
In a property is to be fixed up and sold within 18 months, the total loan amount can be bad on the highest loan to value ratio available to owner occupants. The difference between the loan amount and the amount actually disbursed is escrowed until the property is sold to an occupant. If the owner-occupant is a ‘first time home buyer’, he can qualify with nothing down, thus the difference in the loan amount and the sale price can be held by the seller as a second mortgage lien legally. If the property is not sold within 18 months, the escrowed funds are paid back to the mortgage company to reduce the loan principal balance due. This program can add a lot liquidity where it’s needed.
First Fiduciary, 1(800)653-2600 buys mortgages and contracts. They recently offered to buy a first mortgage on an investment house discounted to yield 11% for cash. That’s a pretty fair rate in today’s market, but naturally, it would be subject to change. The owners are savvy real estate and mortgage people who can evaluate a proposition quickly. They are looking for reasonable loan-to-value rations. Give them a call.
INDEPENDENT CONTRACTORS ARE BECOMING A LIABILITY
One of the weak areas in any sort of fixer-upper program is finding reliable people to do the work. The wrong person in the wrong spot can do a lot of damage to the property. Worse, he can do a lot of damage to your financial statement if he is deemed to have been an employee rather than an independent contractor. It pays to take extra pains to avoid employer status to escape the liability caused by unlicensed contractors who don’t have workers compensation insurance for themselves and those that they hire.
In this cruel world, the IRS is actively seeking out those who were hired as ‘contractors’ and who failed to pay payroll and income taxes. In return for giving up the names of those who hired them, they receive more lenient treatment, but that’s not true of the ‘employers’. Once the IRS determines someone to have been an employee, then the fun starts. The employer gets to pay up all the back taxes that should have been withheld plus penalties and interest. The ‘workplace’ is surveyed to assure that it’s in compliance with all the OSHA directives. Pension plans are audited to make certain that the ‘employees’ were all included and funds set aside for them. It goes on and on.
There are few ‘safe harbors’ except to hire firms that regularly and consistently hold themselves out to the general public as licensed contractors. For under $100, Advisor Software (800) 237-8400 EXT 442 sells a computer program to indicate whether or not your ‘contractor’ might be deemed an ‘employee’ based upon hundreds of court cases and state laws. If you hire people who work for at least 5 other ‘employers’ from whom they receive Form 1099s, pay for their own workers compensation insurance, work under written contracts, pay for their own tools, transportation, work clothes, safety equipment, etc., set their own schedule, receive payment based upon job versus an hourly rate; they are probably not employees. There may be another way to avoid ‘deemed employees’.
Instead of paying a person or persons, why not pay a thing such as a corporation or a Limited Liability Company. Neither of these can be deemed an employee. Neither has any rights to your pension plan. Neither is covered by OSHA or employee payroll taxes. With 48 states having passed Limited Liability Company Acts, most people can form an LLC. It’s cheap, simple, effective, requires little paperwork, and protects both the worker and his boss from liability.
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