November 1979
Vol 2 No 2
A new crisis is upon us or rapidly approaching, depending on your area of the country. No, it’s not a crisis of confidence. It’s a liquidity crisis. Hard money loans, where they are still available, are commanding interest rates of 15 ½% plus on short term commitments (90 day demand loans). The demand for loans at any interest is continuing to increase as small businessmen and speculators are caught in the squeeze of lower (if any) profits and higher costs of business due to inflation.
As this cycle continues, opportunities to acquire investments of all types at major price discounts will abound for those who have ready cash. This is a natural occurrence. At the time cash will buy the most, it will be the hardest to obtain. Many will not be able to borrow at any prices and will be forced to liquidate assets in order to survive. Those who purchase these assets, and can afford to hold them, will reap enormous profits.
Today is the day to buy some liquidity. Liquidity is a benefit for which you will pay a price. However, the benefits will outweigh the costs when obtained in the right way. Two obvious ways to lay your hands on some cash are to (1) borrow it, or (2) sell an asset. Both of these alternatives, when they are available, have their disadvantages. Assuming we have the choice to either borrow long term against an asset, (i.e., refinance a house) or sell, let’s examine the costs of each.
Taking an average of the interest rates across the country on non-owner occupied investment houses, we find that 12 ½% plus 3 points (this would approximate 13%, no points) is the rate quoted when the money is available. With a goal of raising $50,000 cash, we find that by refinancing 3 houses at 70% loans appraised at $70,000 on which we owe $30,000 each, we will net out a little over $50,000 in cash after closing costs of $6,000. Before the new loan, our interest rates averaged 9 ½% and now they are 12 ½% costing us a 3% spread on the $90,000 in old loans or $2700 annually or $225 per month. The total new interest cost will be $147,000 X 12 ½% or $1531 per month which will virtually guarantee negative cash flow.
The alternative to borrowing as described above would be to sell enough property to raise the $50,000 in cash net after taxes. In nearly every city I visit, houses are selling at all time high prices. Using two of the same houses as in the above example, we decided to sell for cash to existing loans.
In times of rampant inflation and high investment yields, never carry back conventionally structured financing when selling your assets. The cash value of any purchase money note that you carry back would be substantially less than the full face amount. The longer the term of the note, the less its value.
A cash sale of $70,000 each, paying a total of 8% in commission and other selling expenses, would net us a little over $68,000. Assuming our basis in the property equals the loan balance, (a valid assumption when you buy with high leverage) $68,000 + would be taxable at long term capital gains rates. Use your own tax bracket to figure your costs, but if we were in the 50% bracket, our tax liability would be $68,000 X 40% X 50% or $14,000 +.
In both of the above cases, we ended up with slightly over $50,000 in cash when the dust settled. Let’s compare the advantages and disadvantages of each.
When we refinanced, we retained the house, keeping the appreciation on the $140,000 asset we sold in the 2nd example. Plus, we retained the depreciation on $60,000 less the land value (over basis), and we picked up some negative cash flow (probably over $100 per month per house). Our cost in the year of refinancing will be the loan closing costs of $6,000 and additional interest, $18,375 (12 ½% on $147,000), less $8550 (9 ½% X $90,000) or $9825 for a total of $15,825. The loan cost cannot be expensed and must be capitalized according to the tax law. Hopefully, the cash we derive from the refinancing can be reinvested at short term high interest rates to offset the high interest we are paying.
When we sold, we gave up the appreciation and the depreciation of the asset. Our cash flow probably changed from a breakeven position to a positive of $400 + per month (before taxes), if we invest short term at 10% ($50,000 X 10% – – 12 = $416). As for our costs, the 8% commission and closing costs would be deducted from the sale proceeds at closing, but the $14,000 tax liability would not be due until the following April 15th. If you closed in early January, that would give you over 15 months to reinvest that money before you have to write a check to Uncle.
There are some strong arguments for selling instead of refinancing if (1) interest rates and closing costs are high; (2) you own several properties so that selling one or two is not a substantial sell-off of your portfolio; (3) you are a Broker/Salesman and can avoid part of the sales and closing costs with your business connections; (4) you are in a low tax bracket; (5) you can sell at a high price early in the calendar year (quite probable should you live in a seasonal area like the Southwest or South); and (6) you own a property which you would like to dispose of anyway because of management or cash-flow problems.
In either case, the cash you realize should (1) be invested immediately in a high yield, short term safe investment such as T Bills or money market funds ($50,000 un-invested costs you $14 per day); (2) not be used for non-investment purposes (Boats, planes, trips, etc. This temptation can be overwhelming and must be stifled.); (3) give you the confidence and ability to take advantage of many buys which will probably have short term negative cash flows, but will yield tremendous profits in the long term.
Analyze the actual cash cost of this liquidity and ask yourself whether the flexibility and peace of mind it would afford you, would be worth the price. Now, how many people think Gold is an investment? The recent gyrations which Gold has enjoyed have certainly sent many speculators scurrying to their savings accounts to cover losses. We have often said that an investment in Gold is not liquid, as the people who hold it never sell. It’s either going up or going down, and in either case they are afraid to let go because they may lose potential profits. In the stock market, these types of investors are called “Pigs” and they often become the losers.
Howard Ruff, the Editor of “Ruff Times”, pointed out in this month’s issue that many “Investors” who have been burying Gold Kruggerands were finding it difficult to sell, when not impossible, because event he dealers were afraid of getting stuck with a load of Kruggerands at $4oo when Gold may go to $375 the next day. The same thing happened to silver investors to a lesser extent. While many people, who purchased Gold at $200, are still bragging of profits, a typical $60,000 house purchased with $10,000 down (obviously purchased by an amateur), which appreciated at fifteen percent last year, (way below the average for the right house in the right area) would give the investor about the same capital gain, PLUS RENTS AND DEPRECIATION. Which one will appreciate the most next year?
UP YOUR RENTS! Across the country the combination of increasing population and slow housing starts have created a shortage of rental units. In many areas, this is now being compounded by a slowdown in house sales. Many houses are sitting vacant; for sale, not rent. Many landlords are worried about the recession and are making the false assumption that because of what they are reading about a “National” slowdown, that they should not or cannot raise their rents. Survey your market. The recession, especially as it affects real estate will be regional in scope. Even though sales slow down, the rental market may continue to strengthen in your area. Most areas have had rents lagging behind increases in property values, and now is the time for this gap to close.
In the event you find yourself in a market where landlords have every reason to raise rents, i.e., the demand is greater than the supply, try to inform the other landlords in your town that a rent raise is due. Maybe an article for the local paper explaining why rents are increasing or even a paid public service announcement, stating that many landlords will be raising their rents 20% to compensate for last year’s inflation, would be in order.
If you feel that your area is too soft to raise rents, remember that you effectively raise the rent when you delete services. For example, you may rewrite your lease to place the responsibility for all maintenance on the tenant, or add a clause which will require the tenant to paint the property or make other improvements which he can do in lieu of increased rents. Increase your late charges if your state law permits it and add a bad check charge of $10 or 5% of the amount of the check for returned checks. These will increase your cash flows should the economy get tougher.
From the readers’ corner, I just finished “How to Survive and Prosper In the Next American Depression, War or Revolution”. (Written by Financial Management Association, Inc., 3928 Iowa Street, San Diego, CA 92104). Not as far out as many “Doomsday” books in spite of the title, this one is well written by a panel of undisclosed, but well informed businessmen. Although not specifically real estate oriented, I would recommend it for its scenarios of the monetary devaluation which seems to be unavoidable in the relatively near future.
I just returned from the Miller/ Schaub Graduate Seminar in New Orleans. Over one hundred and forty Trustees of the CommonWealth Trust compared notes on how the economy was changing across the country and how it would affect our investment strategy. Overwhelmingly, inflation and Government regulation seemed to be the primary factors which will help or hinder investors, depending upon their approaches.
Builders everywhere are feeling the effects of the tight money and are beginning to suffer with high priced inventories of unsold houses. Review the strategies presented in John Schaub’s book, “Investing in New Homes”. Builders typically continue to build spec houses as long as the banks will loan them money, even when there is no market. At some point, the constructions interest the builder is paying (usually over the prime rate), will total an amount greater than his profit and he will be ready to sell.
Approach a builder who cannot unload to the general public and offer to take over his payments. In the event he has a real equity, but no market for it, offer to share the profits with him after it is sold and you have received all of your invested cash back. For example, a builder with a $70,000 house and a $60,000 loan would be making payments of about $650 per month. The house should rent for $400+ so it will cost about $250 per month to hold in the event you rent it to generate cash flow. Offer to take over the payments with the right to rent the house and fund the negative cash flow during the holding period, say two years. At the end of two years, you will sell the house and split the profits 50/50 after you receive your cash back. In the event the house would sell for $80,000, you would split a profit of $7,000 each after you recovered your $6,000 (250 x 24). You would have maximum leverage, high tax shelter, and minimum risk due to your low investment. Avoid signing personally on a new loan. The banker should be sufficiently motive to allow you to take title without a formal assumption.
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