June 1981
Vol 3 No 9
The Prime Rate is once more rising – and long term financing is still too high to sustain any market rebound in the housing business. As a result, the entire nation is facing a serious housing shortage. This will be translated into rising prices and higher rents everywhere in existing housing. For the first time in history, the price of an existing house exceeded that of a new house on the average by almost $2,000.
The cause of this value inversion of comparable SFH is attributable to the cost of money. Buyers facing a choice of assuming an 8% level payment, self amortizing loan on an existing house versus paying 14 ½% – 15 ½% on a variety of less attractive financing plans, have been opting for the low cost loans, leaving new construction and builders in the lurch. For 2 years we’ve been emphasizing the importance of avoiding high cost financing and working harder to get properties with assumable low rate loans. Now we’ll take a look at some of the benefits of this approach.
In a tight market, sellers face the choice of awaiting the return of lower interest rates or of selling on less-than-ideal terms. Suppose you purchased a house worth a fair market value of $75,000, taking title subject to an existing 4 year old VA loan in the amount of $50,000 at 8% (these are assumable by law). You pay $5,000 down and agree to pay 17% interest (simple) to accrue and to be due together with the principal amount of $20,000 in 5 years. The existing loan payments of $366.88 plus an estimated $100 per month for taxes and insurance would about match fair market rent over the holding period to give approximately a break-even cash flow. Look at the result.
If the house appreciated at 14.7% per year (average), it would be worth $150,000 in 60 months. Total loan balances on both loans would be $91,384 leaving a profit of $58,616 on your $5,000 investment – or 63.6% COMPOUND ANNUAL YIELD over the period. The effective rate of interest you would have been paying would have been 12%, however the CASH FLOW even with a high cost second Trust Deed or Mortgage would have been safe. By combining the low cost 1st with the 17% second, you create a viable financing structure with an investment yield well in excess of that available from comparable investments.
The seller hasn’t done badly either. His 5 year pay-off amounts to $43,849 so he’s happy. Suppose you had been able to increase rents just 10% per year. You would have been able to take about $2400 out in cash flow tax free over the period. If you bought several like this, you could sell some of your properties to pay off the 2nds and continue to retain the 8% with an additional 21 years of life on the ones you keep. With rents running at that time at about $750, your portfolio could be yielding as much as $300 net per house per month. With as few as 14 houses, you could be collecting about $50,000 per year net income, without the need to borrow against your equities any more.
The bankers all understand this approach to profits. During the past month I’ve received over 30 letters from lenders who have sold loans to Federal National Mortgage Association (FNMA) of “clause 17” fame. They’ve finally come out of the closet and decided to reap some of the benefits of assumptions themselves, only they don’t call it “assumption”. They call it the “Fannie Mae Resale Program”. They will allow any house with an existing loan owned by FNMA to be refinanced with a level pay, 30 year loan at interest rates BELOW current market at 95% of market value for new owner-occupants, 90% for refinancing by owner-occupants, and 80% refinancing by investors up to $98,500 for SFH.
Perhaps this is one good idea whose time has come. In this cash-starved economy, the FNMA refinance program could save more than one desperate homeowner or investor who has been trapped by short term, high cost financing. One case we saw involved a $70,000 house with a $38,500 balance at 7.75%. Under FNMA rules, it can be sold to a new buyer for $3500 down, 11.5% 30 year level payment, self amortizing $66,500 WRAP-around loan. An existing owner-occupant could pull out about $24,500 in cash and an investor might extract $17,500 on essentially the same terms. The new loan would avoid the hazards of the variable and adjustable rate mortgages, shared appreciation, and medium term financing generally available today. At the same time, it opens new vistas of opportunity for all.
Here are some ways you might use FNMA’s program. Suppose you’ve bought SFH using private financing and have had the foresight to provide for substituting collateral as we’ve been recommending for several years. To raise cash, you “move” the loan off of the SFH onto another property which might be ineligible for an FNMA loan, exposing the underlying low interest rate loan. Then you can borrow your equity out in cash. You might cooperate with another investor and each purchase a house AS YOUR PRIMARY RESIDENCE from the other, obtaining a relatively low interest rate 95% loan while raising cash. If you want to “bail out” of SFH as some counselors suggest, your properties will be readily saleable at the low FNMA RATES. More to the point, you might improve your position too.
Almost the entire CONSTRUCTION INDUSTRY together with owners of recently financed houses has been excluded from this program for all practical purposes. Suppose you were able to refinance 3 houses you had owned for 3 or 4 years and obtain $100,000 in cash. At the present time, you would find myriad opportunities awaiting you. You might buy discount mortgages or Trust Deeds which currently are yielding about 35% for cash flow, or deep discount bonds which you could offer distressed builders for unsold inventory at face value. We found a situation in which the holder of a 3rd Mortgage was being squeezed out because the 2nd mortgage was being foreclosed. We bought ½ interest in the 3rd for cash which he used to pay off the 2nd. This puts us BOTH effectively in 2nd position. Under the terms of the 3rd mortgage, the amounts paid on the 2nd were ADDED TO THE REMAINING BALANCE. Thus, the value of my investment increased over 100% immediately should I decide to resell it.
In the April 1980 issue we discussed the uncommonly high yields of “split wraps”. Let’s see what we can accomplish with a “DOUBLE SPLIT WRAP”. Suppose we pulled our equity out of 5 houses in cash with 11% FNMA loans which were wrapped around original 8% Trust Deeds. Immediately we might offer the properties for sale with $1,000 down, and we’d agree to carry back a 15% loan, interest only as follows: Value of $70,000 Original 1st of $35,000 with payments of $256.82. We take out $21,000 tax free, financing 80% at 11% with payments of $533.30. This would amount to approximately breakeven cash flow at the prevailing market rents provided tax benefits were added back in. under our “soft” terms, we should be able to boost the price to $80,000 with a Double Wrapped loan of $57,000 and a junior lien of $22,000 which would be due in full in 4 years. Payments of $612.28 per month would apply ONLY TO THE 4 YEAR LOAN which would fully amortize in 48 months. In the meantime interest would accrue and compound on the underlying $57,000 loan at 1.25% per month which would be added to the principal. What have we accomplished.
By paying our own payments of $533.30 out of the $612.28 we’d get $78.98 per month positive cash flow. Taxes, insurance, and maintenance would be paid by the new owner. At the time the junior lien was paid off in 4 years, the principal on the wrap would have grown to $103,475.23 with payments of $1293.44 on a house which has been appreciating at about 14.78% per year to a value of $125,975. The owner’s equity will be $22,500. Our monthly cash flow will jump to $760.14 for the next 26 years plus the $100,000-plus balloon. The buyer’s yield on $1,000 will have been 117.79% compounded for 4 years if he sells out. We will have received $21,000 via FNMA, $3791 in cash flow, and $48,672 in net pay off. On the other hand, if he was to continue to pay our yield would increase dramatically. Now, multiply these results by the 5 houses we started with and you’ll see the tremendous potential of the FNMA refinancing package.
Why does FNMA offer us this refinance program? Because their own wraparound financing improves their own yields and upgrades the overall value of their portfolio. For the truly passive investor, FNMA stock can be purchased in anticipation of the yields that will be forthcoming once this program goes into full swing. In February 1981 we detailed how Peter Fortunato used essentially this same approach to sell wraparound mortgage to his own banker. For those of you who aren’t able to participate because the loans you have weren’t previously bought by FNMA, you might try to deal directly with your lenders as he did. Pete and I will be conducting a 2-day clinic on June 27, 28 at the Ramada Inn in Woburn, Mass. to illustrate and explain innovative financial formulas. The cost will be $150 per person. We’ll try to present all new material at that time.
THERE CAN BE HAZARDS IN THIS PROGRAM! The new loan may not be assumable even though the prior loan was. There may be heavy pre-payment penalties in the early years. New loans may carry personal liability. Net cash-flows from properties will change. Your comfortable positive cash-flows could turn negative. You’d be surrendering safety. The best uses of FNMA financing is for producing direct profits as has been illustrated, or for de-fanging short-fuse, high-interest rate, and dangerous financing which you may have placed on property, at time of acquisition.
Now might be a time to start cooperating with other investors. You might find a way to exchange a non-FNMA loan house for one that can be refinanced by offering the owner a profit. By surrendering some of your “paper” profit to protect your equity investment, you might gain cash-flow in an older loan at low interest rates by trading off your FNMA house. Instead of gaining a price profit, you could exchange for better cash flows. This might be a lot less expensive than “Equity-Sharing” with a tenant, or borrowing.
Sharing equity with a tenant is an expensive way to cover negative cash flow! It opens up an interesting legal problem. While Rent Control legislation was defeated in Pasadena and courts have ruled against it in Santa Monica, and Section 8 funding is now tied to absence of rent controls; it will become more and more prevalent. There are now about 60 MILLION TENANTS who are becoming increasingly militant. Rental housing is at a 35 year low point. The Institute of Real Estate Management (National Association of Realtors) estimates that BY 1990 over 10,000,000 HOUSEHOLDS WILL HAVE TO DOUBLE UP just to find a place to live. In Florida, Arizona, Utah, Colorado, and Nevada it is already critical. Nationally, the vacancy rate is just over 4%. The battle lines are drawn and owners can expect a vigorous fight over tenant’s rights versus those of the entrepreneur/investor.
Are you prepared for rent controls in your area? Use of a discount rental contract, assignment of all maintenance responsibilities to the tenants, and equity sharing will mitigate the effects of rent controls. In the June 1979 CommonWealth Letters we published 5 or 6 strategies which would seem to offset any rent control legislation we’ve seen. Most of these involved tenants owning a partial interest in their living space. In many areas, ownership by a tenant eliminates him from the benefits of rent control laws. Thus, shared equity arrangements could serve to protect your capital as well as helping with cash flows. On the other hand, what do you do when your shared-equity tenant fails to pay the rent?
Will the courts support your right to evict someone who also has an ownership interest? Would your interests be deemed to be merged with those of your resident? You need to be cautious to properly structure any shared equity plans to avoid any clouding of title, vested interest, and ownership rights without specific performance. You’ll need a buy-out agreement, default penalties, disclaimers as to partnership interests etc. What will you do if your tenant becomes incompetent, divorced, bankrupt, or deceased? If you have been negligent about establishing the legal niceties, you may be placing yourself into jeopardy. You should look into necessary insurance protection as well.
A lot of attention is currently being focused upon the SFH as an investment vehicle. The California Department of Real Estate deplores the “Nothing Down” movement and private financing arrangement (because they can’t regulate them?). Warnings are being published concerning tax consequences, financial hazards, impending housing collapse, etc. In the final analysis, those who have followed the precepts in this letter – only private-lender or low interest rate loans that permit positive cash flow, straight-line depreciation, strict accounting for all cash disbursed or received, selection of feasible properties in areas where rents will be in the middle of the market, and non-recourse financing have little to fear. On the other hand, syndicators beware. We’ve been approached by several people who have gone into the business of buying groups of houses and reselling them to investors. This could be hazardous to one’s health – particularly when there might be SEC violations, management problems, and massive negative cash-flows in the event of temporary vacancy situations. It’s better to move a little slower – and avoid risk.
We no longer accept damage or security deposits! For some time we’ve been offering the tenant a “First Right of Refusal” Option for which he pays approximately one month’s rent. This is paired with a merit “bonus” for exemplary comportment which enables the tenant to recover his Option consideration provided he has met all terms and conditions of his rental contract. This eliminates a lot of the problems associated with accounting, disbursements, forfeiture, etc. from our standpoint while it gives the tenant a feeling of security knowing that we won’t lightly sell the property while he is there.
We’ve learned of another approach to increasing cash-flows with Options. The tenant pays the normal deposits and market rents, but is offered a first-right-of-refusal option for about 10% more. This option can be extended each month by another payment, or it might be paid for on the installment plan by such payment depending upon how it has been structured. Benefits to the tenant: if he wants to buy the property, he will get first chance and all his option consideration will count toward his purchase price and down payment. No one else will be able to buy the house and move him out until he has been given a chance to match the price and terms. Benefits to the Owner: Cash flow which will be tax free until the tenant either voids or exercises the Option. The tenant will tend to continue to renew his rental contract once he has an equitable interest in the option to protect. This will reduce vacancy, collection, and turnover expense and enhance cash flows. There will be increasingly more control over the tenant as time goes on. He will have more to lose by any form of default on the rental terms.
We’ve already started to get positive feedback from some of those who attended the Las Vegas Cash-Flow Management Course. Several liaisons have been formed with other graduate students with the object of mutual support and sharing of opportunity. A couple of people have started sending out periodic bulletins. Meetings are being set up. We will set aside an entire evening to further organize alumni (ae) in Orlando at the Management Seminar in October. Almost 70 people have already registered, so if you plan to come, don’t delay. Send $350 to us and we’ll confirm your space by return mail (or we’ll take plastic money if you send your credit card number and expiration date (M/C or VISA ONLY)).
Savings and Loan Associations are in precarious condition in many areas. They are finding it difficult to compete for savings in the face of mounting pressure from Money Market Funds, Treasury Bills and Notes, and a rebounding stock market. In the next few months, Treasury borrowing will push rates even higher. While FSLIC will attempt to protect funds of borrowers, any money tied up will deprive you of liquidity for that time. We prefer Money Market funds and “T” Bills which we buy directly from the Federal Reserve. Give your local library a call and find the address if you want to switch into a safer depository for your own money. Don’t be reticent about discussing things directly with the officers of your local S&L – and even demanding to see their operating statements.
Copyright Sunjon Trust All Rights Reserved
Quotation not permitted. Material may not be reproduced in whole or in part in any form whatsoever.
1-888-282-1882 www.CashFlowDepot.com
