April 1991
Vol 14 No 6
That was an old transition line from the 'B' movie era which helped to get the hero out of the action and back to the romance. A month ago I was hedging between a short war and a long war projection. This month history seems to have taken charge of events and we'll go back to focusing on surviving the recession and to the greatest extent possible, improving our financial position.
We're in a recession in most subscribers' areas. The question is more how deep, how long and what do we do about it than who's to blame. As you may have noticed, my crystal ball is acting more and more like a factory second when it comes to pin pointing answers to major economic events. On the other hand, it doesn't take a genius to realize that there's no substitute for cash flow when it comes to facing economic uncertainty. That's what this month's letter will be dealing with.
YOU CAN'T CARRY MUCH WATER IN A LEAKY BUCKET . .
No matter how much gross income a property produces, loss of control over expenses can still put the owner in the hole. Expenses can be categorized as those attributable to ownership of the property itself, financing, and costs of Tenants. Let's take a look at each to see what we can do to make changes that will improve net income.
One of the big traps of fledgling landlords is to buy run down properties in run down neighborhoods. Because they are buying from owners who are less sophisticated than those in middle class neighborhoods – or from a previous landlord who's realized his mistake and is willing to offer succulent terms to the unwitting novice – it's typical to find amateur landlords mired in 'elderly', functionally obsolescent duplexes, tri-plexes, small apartments, etc. with bad financing, balloon notes and mounting repair costs. The main refuge of these owners lies in various local, county, state and federal subsidies which more or less place them at the mercy of tenants and local bureaucrats.
There's quite a difference between a person in the business of buying 'fixer uppers' to rent up and resell and the person who's blundered into a blighted property because he could get in with 'nothing down'. He quickly finds that he can't afford to hire skilled craftsmen to bring his property up to code. He finds himself relegated to the ranks of those who either spend their creative energies dodging minimum housing inspectors or selling out for 'paper' from another enthusiastic amateur, hoping he'll never have to foreclose when the next owner burns out and gives up.
I ought to know. I've been there. I too confronted a recession 17 years ago as the owner of 11 units inhabited by the portion of the population that makes the upper 90% possible. When I refused to deal with the county welfare agencies in placing their 'clients', they promptly hung 117 red tags on the property. They gave me 4 months to clear all the major discrepancies denoted by each tag, or the building would have been demolished. That would have been the good news except for the fact that I owed $70,000 on the mortgage. Unfortunately, this wouldn't have been demolished.
The cost of the repair would have been over $20,000 at rock bottom prices for materials and unskilled labor I might round up. The property returned $2200 per month when fully occupied. Operating costs and payments reduced this to $200 with absolutely minimal repair costs. Required repairs just to clear the discrepancies would have consumed all the cash flow for 8.5 years. There were no buyers who'd take the property in its red-tagged condition at any price. Here's what I did to solve the problem.
My first job was to take stock of my situation. We've already discussed the liabilities. Gleaning through my dubious assets I found that I had tenants. I was motivated. My lender was too. He didn't want the property hack! I had some limited cash, but needed more cash flow. I had enough basic repair skills to at least SUPERVISE the repair activities. And I had lots of landlord friends to lend me advice and support. I'd met most of them at a night school Resident Managers' Course taught in the local Vocational High School. It was sponsored by the local Apartment Owners' Association. If you don't have one in your area, you should start one! It's impossible to overstate the value of a group of active landlords working together to help each other to prosper.
The easiest and quickest source of cash flow was to reduce my payments on the loan. I contacted the former owner (now mortgage holder) and offered the apartments back to him. I'd bought them on a Lease Purchase plan, with $500 per month of the $1000 rents being applied to the purchase price. I negotiated with him for a MORATORIUM on all payments so long as I applied the cash flow toward upgrading the property and removing the Red Tag discrepancies. This gave me $1000 per month additional cash flow to help pay for repairs.
Most of the needed improvements were cosmetic. Paint, new floor tile, fixtures, outlets, appliances, repair of plaster, screens, clearing debris off the grounds, etc. But there were more serious problems involving roof repairs, installing of fire escapes and extinguishers, smoke detectors, etc. We needed plumbing and electrical up-grades as well as certification of all gas operated appliances and heaters that they were all operating safely and properly. I segregated all necessary work by specific apartment and the particular 'system' inside the apartment (windows, heaters, bathroom fixtures, floors, walls, electrical, plumbing, cooking, etc.) I included the 'common' areas of hallways, stairs, storage rooms, laundry rooms, exterior porches and grounds as a separate activity. I estimated the costs of repairs in each area.
Next, I inventoried my tenants. Some were elderly Social Security pensioners. While they'd be of little value as workers, they made great 'quality control' inspectors who could be counted on to report on any shoddy work. Then, I interviewed the able bodied younger people to determine whether or not they'd be willing to work to clear the discrepancies in order to continue to occupy their rooms. Occupants in two apartments chose to move out. Out of the remaining tenants, I rounded up enough people to work on the common areas at minimum costs. They each signed Contracts which paid them only upon completion of a particular task. For instance, repairing the roof rather than replacing it resulted in a savings of $4500 through the use of my amateur contractors.
Through a landlord contact from my management class, I was able to buy used carpeting for 500 a yard with the pad. It came out of a project that was being converted into condominiums. We first carpeted the halls and stairs, then offered it free to the tenants if they'd (a) lay it themselves, (b) after installing paneling on the lower half walls to cover up dings and dents, then repainting the rest of their units. We were able to hire licensed maintenance men from a large complex during slack work periods. We paid their Resident Manager directly, and he offset their regular wages to improve his own cash flow. We found the local gas company would inspect and certify all gas heaters and appliances at no cost if we'd agree to pay them to replace any defective equipment.
These skilled craftsmen took care of installing plumbing and electrical fixtures and repairing those systems as needed to conform to building codes. We saved the worst unit until last. The unit was a total basket case, so we converted part of it into a laundry room with two used washers and dryers we rented to the tenants. This increased our cash flow while making our tenants happier. The remaining part was joined by a door with a good unit to become an office and storage area for a Resident Manager. We saved $5000 in repairs and side-stepped the minimum housing requirements since these units are no longer used as living quarters. Our up-graded apartments began to compete for better tenants too – at higher rents — so net operating cash flow began to rise.
A word here about appliances and fixtures. It's better to use high quality used appliances than cheap new appliances if you can get them from a reliable dealer who will guarantee them for a reasonable time. In units, as opposed to single family houses, the more you can standardize make, model and size; the easier it will he to maintain them, and the more you can 'cannibalize' parts of one to keep another working. Look for Sears, Wards and rental discount warehouses where they sell scratched, dented and repo units at bargain p ices. Slight blemishes don't affect reliability and can drastically reduce costs. Buying dented water heaters can result in as much as 50% savings too.
Once all repairs were completed on the 11 units, I set about making them more attractive to the market. I renegotiated the price and terms during the 8 month period when the payment moratorium was in effect and paid off the units completely using discounted Notes secured by other properties that I'd been able to buy. The credit squeeze caused by stagflation raised interest rates, thereby reducing the market value of mortgage Notes once they'd been capitalized at the higher rates. (Divide the annual income stream by the current market rates to get the capitalized value. For example, $1000 per year of net income on a 10% note is worth $10,000. But, when the market discount rate is 20%, that same Note is only worth $5000.) When these can be used to pay off debt at face value, it not only frees up equity in a property, but effectively gives you a discounted price in the process. Recession offers you many chances to trade discounted 'paper' this way.
Marketing the property required that we have someone there all the time to show it and to keep it looking good. We discovered a crackerjack resident manager in one of our Tenants who'd demonstrated a high degree of initiative and responsibility during our re-hab project. We made him this proposition. He agreed to lease the apartments from us for 100% of 9 units rent. He got to keep all money from the laundry and pay telephone we set up in the hall, late charges, lost deposits and the rent ups. He lived there free. He did all maintenance at no cost to us. The units began to generate cash flow.
There was no financing available for these units, so we 'packaged them' with 4 single family houses and sold them to an investor. Because we agreed to lease them back from him at a guaranteed NET INCOME for 2 years, he was willing to buy them with a piece of DISCOUNTED PAPER secured by better property. It works both ways when parties are motivated. We paid them off with paper and sold them for higher quality paper. In hundreds of paper seminars around the country, rarely does anyone discuss QUALITY. No pocket calculator has an extra button with which to plug in the likelihood that a loan will go had or the property security drop suddenly. In tough times, Quality is much more crucial than Quantity. New Englanders are learning that today. So are Bankers everywhere.
KNOWING THE FUNDAMENTALS IS THE KEY TO SURVIVAL .
I'm not going to own any more low income housing! As liability claims rise, fewer and fewer people will be around to buy them from me. I'm going to stick to housing that people in the middle of the market can afford to buy. I think that being able to negotiate and to structure feasible financing is much more important than buying high risk properties in blighted and declining areas. That means I'll have to continually brush up on ways to use Leases, Options, Trade Ins, Guaranteed Lease Backs, Seller Carry Back Financing more effectively. And I'll have to acquire and maintain skills to help me evaluate the present and future potential of properties without regard to appraisals which may or may not have been made by a qualified professional.
I'm also not going to rely upon any form of government rent subsidies! During the 70's recession, the government deficit was about $30 Billion with lots of room to grow. Not so this time around. 1991's deficit will pass $350 Billion, thanks to Desert Shield. Over 300 bills have already been drafted to increase Veterans Benefits for those involved. Moreover, shrinking Gross National Product coupled with exploding claims generated by the rising unemployment rolls are going to create a social welfare vise which will be tightened by the shrinking tax base at every level. 1 don't want to have properties full of people who can't support themselves if/when the welfare programs start to collapse.
MOBILE HOMES OFFER INCREASED QUALITY AT DECREASED COST
Low income rentals typically offer higher cash flows at the cost of much higher management effort, risk and liquidity. The challenge is to raise the quality of income while maintaining high income yields without increasing management effort/costs. Burned out landlords characteristically run to 'paper', selling out marginal properties to those who still have the vim, vigor and vitality to take them on as landlords. But that paper is fragile indeed – as was illustrated when I renegotiated my apartment house loan.
When dealing with Mobile Homes, the picture changes. First, let's agree that a bad tenant in a Mobile Home is lust as bad as one in a slum. There's a difference when you rent to Social Security pensioners in small parks. Zoning controls feasibility of doing this, however, when you can put 5 – 8 single wide units on an acre, rented exclusively to retirees, it can be one of the highest yielding long term investments.
In Arizona recently I was offered 2 acres on which there were 9 finished pads for single-wide mobile homes. Well and septic were up and running. The dealer agreed to set up 9 refurbished used units and deliver them with the land for $90,000 total. The catch was that I'd have to find financing elsewhere. At $275 per month, I could have kept them full. Let's look at the cash on cash return based on gross rents and a cash price:
$275 per month for 12 months times 9 units = $29,700. divided by $90,000 = 33% return.
The fascinating thing about renting to retirees is that most of the extra costs of turnover, vacancy, maintenance and collections simply disappear. Both the owner and the retiree/tenant want the same thing: TRANQUILITY. To the extent you can provide an attractive, secure setting for a reasonably modern, well kept mobile home, you'll be able to rent to nice people. In 1985 we put $16,667 down on a 23 space park located on the water. We've never added a dime. Cash flow has paid all the payments, property taxes, management, insurance, vacancy and allowed us to buy 4 additional homes to rent out.
There are just as many opportunities with mobile homes and parks as there are with any other kind of real estate. A subscriber recently bought 87 spaces in an up and running Texas park for just over $1000 per space. Another fellow we know is buying up 2 acre parcels and putting mobiles on them, then wrapping them for resale to owner occupants. Still others are involved in supplying financing for used units. They buy 1st Liens on units in parks which are discounted to yield between 25 – 30%. Very little collection problems have been reported with this kind of paper. But you should be careful to also include an Assignment of Lease on the space on which the mobile home stands as additional collateral in order to be sure you'll have some place to park it if you ever had to repossess a unit.
In any recessionary environment, every penny possible has to be coaxed out of your investments. Otherwise, you could be forced to liquidate at the absolutely worst time, wiping out years of effort. Now more than ever, it's time to return to the basics of buying properties to produce cash flow yields so you'll be in position to reap the whirlwind of inflationary gains which are surely due to come. That means you've got to be able to evaluate the real worth of a property, negotiate terms that will produce cash flow and protect those income streams with aggressive maintenance cost controls.
