September 1987
Vol 10 No 11
Somewhere along the road to happiness a gap has appeared between the American Dream and reality! The American family is in the process of self-destructing under the incentives provided by the Welfare system, tax laws, permissive society and liberal values promulgated by our educational system and media. The work ethic has been damaged by the perception that success is more the result of guile and luck than patience, prudence and thrift. We continue to consume more than we produce in spite of knowing that every dollar of credit used by ourselves or by our government will have to be repaid. And this repayment will be at the cost of life style, liberty, opportunity and growth either in our lifetimes or that of our decedents.
50 years ago, America was a different country entirely. Although Roosevelt had introduced us to the concept that we were the wards of the government and not responsible for our own survival, most Americans remained pretty self-reliant. So did communities, counties and states. WWII centralized power in Washington, created the need for deficit spending – and ushered in an ever growing bureaucracy dedicated to expansion of government programs and improvement of their own standard of living. Look at some contrasts that have resulted from over four decades of government intrusion into our lives and dreams.
Even in the depths of the depression, it was rare that a man couldn't support a family without his wife working outside the home. Of course, in industrially depressed areas and on farms things were not so clearly defined, but remember, most Americans of that era didn't live in the cities where the bread lines were. People were safe in their homes at night with windows wide open to catch the breeze. Criminals were prosecuted and put in jail to work. It was a common sight to see convicts in striped suits working on road gangs. There wasn't the over-crowding we see today. People, accustomed to the idea that their retirement need be funded by their own efforts, saved. And their savings funded much of the massive capital needs of WWII and the following recovery. Until Roosevelt initiated withholding, annual tax bills were scrutinized carefully and citizens were quick to replace representatives who increased their taxes. Money, deposited into local banks, was invested locally, safely. Banks were solvent. Inflation was virtually non-existent. Interest rates for mortgages were between 2% and 4% clear up into the '50s'. There was a sense of mutual support in neighborhoods and communities as well as responsibility. Schools taught basic education and maintained standards. There were no discipline problems. Graduates were able to obtain and hold down jobs with a high school diploma. And support themselves.
Today we have the good life, right? With advanced degrees and both spouses at work in high paying jobs, we have almost two generations with zero net worth! In 1986, it is estimated that almost half of all American children were born out of wedlock. Crime is rife everywhere. Kids won't accept lower paying jobs because their parents provide them with allowances in excess of what they might earn. And government provides the parents in like fashion through a myriad of programs – at tax payer expense. It's hard to find a 'neighborhood' as such, or sense of community. Instead we have voting blocks – each eagerly maneuvering to extract as much as possible from the government trough for its own benefit. The government safety net reaches from cradle to grave – and with it come controls. Even our 5 year olds have to be registered and pay taxes. Every day television reports violent crime, labor unrest, foreign intrusion into our economic well-being, corrupt politicians and deterioration of our prospects for any kind of future security. Police patrol school corridors while the courts refuse them permission to search lockers for dope. Sexual permissiveness brought on the onslaught of A.I.D.S. which now threatens our whole society.
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Our government is broke. The credit of our citizens, corporations and governments has been stretched to the limit. We can no longer compete internationally and our tax system drives out capital investment which might modernize our manufacturing processes. Foreign money is buying control of our financial institutions, plants and high tech industries. Our farmers are little more than welfare recipients. We live and die by the dole.
HOW FAR COULD YOU GO WITHOUT YOUR CREDIT CARDS?
By now you're ready to stop reading, right? Who needs all this negative thinking? Things aren't much worse than they've always been, and we've always muddled through, right? WRONG! Things have never been this bad in terms of our potential solutions. Suppose you were a Japanese who'd invested in T-Bonds over the past 12 months? You'd have earned about 6.5% interest, but seen the value of your savings drop by over 20% when your money was re-converted to Yen from dollars. How much longer would you be willing to invest in dollars?
If the government were to be unable to raise money via sales of T-Bonds/Bills/Notes to foreigners, it will have to sell them to YOU. How? Simple. Just make all pension plans taxable unless they're invested in US Government Debt! Raise interest rates so that those who normally fund mortgages, credit cards, automobile loans would prefer to lend to the government. Of course, this would deprive America of any hope of capital investment. It would cripple the construction industry, airlines, food/beverage/recreational industries, small business, industrial expansion and vastly increase the hue and cry for additional social services, unemployment compensation, Aid To Dependent Children and cause wide spread depression. But it would insure our elected representatives a secure future in government.
They'd never raise mortgage interest rates, would they? Think back to 1974, 1982 or 1987! But there's a better way. Suppose they lust print the money they need? Terrific! We'll all get paid with bigger pay checks whether as entrepreneurs or salaried employees. And we'll all pay at higher tax brackets each quarter. We'll all consume more, so our manufacturers, farmers, employers will be able to expand. Real estate will take off again. So will Gold, Silver, Diamonds, tangibles. We'll build paper fortunes. But, we'll also spend paper fortunes paying for the good life just as we did during the Carter years. As has happened over the past 20 years REAL SPENDING POWER WILL DIMINISH and with it our life style. It will cost more to run government, more to operate cars and heat houses, more to pay for labor, materials, management. And these expenses will have to be paid for out of cash, not with growing equity. So the cash crunch will persist, interest rates will rise to match inflation, real estate will become less liquid. But we'll be able to pass along our mismanagement to other generations. Who? Our children, grand children and parents!
The only losers will be those who trusted in someone else to provide security. Look around you. Who do you personally know who is 100% self-sufficient financially? I'm talking about having free and clear shelter, automobile, personal possessions; capacity to operate without the use of credit for any purchase or for business operations; having control over an income stream independent of any government agency sufficient to maintain their desired living standards indefinitely in the face of inflation or depression, or war? The list gets to be pretty small doesn't it? How 'bout yourself? Where do you stand?
Now we come to the crux of the matter. As an intelligent, thinking reader of investment newsletters, can you reasonably expect to enjoy the level of comfort you now do for the balance of your life? What about your kids, how will they fare? Are you willing to see the elderly on fixed incomes become the victims while you enjoy financial security? My point is, that each of us has a responsibility to 3 generations – ourselves, our parents and our children. In this period of the longest lived and greatest recovery in our history, we're barely able to support ourselves even with everyone working and with our home mortgaged to the hilt. What will we do when the cycle turns down? What will government do? It will become more determined to collect higher and higher taxes. They're already dismissing the Tax Payer's Bill of Rights on the grounds that it will reduce revenues – forget the moral implications of illegal use of force to collect taxes.
IT'S TIME TO START INVESTING IN YOUR FUTURE . . . and to stop SPECULATING
How lucky are you? Were you lucky enough to get into real estate in 1975 when 8% assumable loans at 100% leverage would generate positive cash flows? Were you lucky enough to buy into the stock market in 1982 when it was hovering around 760 on the Dow? Did you buy Gold when it was $35 per ounce and get out at $850? Or silver at $3.50 and get out at $50? Have you started a business and been bought out by a syndicate in the 80s? Have you won any of the big bets over the past 15 years – or have you merely gambled? If you're under 45, you haven't been around long enough to have seen a real down turn. Your perception is that everything will come out alright regardless of what you might do. You're at a serious disadvantage because you've seen the gamblers win time after time while the investors have plodded along at a snail's pace building solid financial security.
In every game, there comes a time to get out – or at least to hedge your bets. Think of the economy like a fly ball at a baseball game. For a while it soars into the blue, but inevitably, it must return to earth. Our economy is poised to return to earth! Now's the time to put your house in order. First let's talk about debt.
Either you don't intend to do anything, or you're going to respond to this letter. If you've been using consumer debt, stop. The best investment you can make at this time is to pay off all consumer debt and to stop using it. Your return will be the same rate as you've been paying plus the safety of having free and clear assets. The discipline this will take will better prepare you for a future with less spending power and will give you the incentive to look for supplemental sources of income. You'll swiftly discover how much farther your income will stretch without interest payments on debts for items which have already been worn out or consumed. Now let's look at your portfolio.
Array your mortgage debt in sequence by payment, then by interest rate, then by loan balance. Select a property with the worst combination of cost and income and get rid of it. By selling off your worst case offender, you can either use the cash (or the payments if you're carrying back a mortgage Note) to pay off or offset another loan. In a hypothetical scenario, suppose you had 6 properties, all leveraged at 60% with a value of $75,000 each and mortgages averaging $45,000 or a total of $270,000 debt. If you sold 4 of these (assuming that discounting of the loans would equal costs of sale), and used the proceeds to reduce the loans on the others, you'd end up with 2 free and clear houses plus $30,000 in cash or paper. You could hold the cash as a buffer against future uncertainties or invest it in other properties. But you'd be out of debt with high cash flows from your rentals. These cash flows could be saved and added to the $30,000 and used to buy another house free and clear in the distress markets from others who acted less prudently than you.
This is conservative strategy, but how many speculators do you personally know who are far enough ahead of the game to get out and to have a safe income stream indexed to inflation? We tend to focus on the WINNERS and to overlook all the losers. Consider how few of the Gurus who preached leverage and Nothing Down techniques actually achieved any financial security /vs/ those who are broke, bankrupt or missing in action. On the other hand, spend a little time with the biographies of successful people and you'll see that being conservative in your investments is the key to true prosperity and financial security.
I like single family houses because they do so well whether in a down turn or an inflationary epoch. Free and clear houses will always command some level of rents with a reasonably equivalent purchasing power so long as there isn't a mass exodus of population. On the other hand, holding mortgage paper can be hazardous during a depression when income is less certain and courts loath to invoke foreclosure judgements. In inflationary times, the purchasing power of mortgage paper gets wiped out at the rate of the inflation. Only first mortgages can be relied upon, and then only if the property is worth more than the debt. Even a small portfolio of two or three free and clear houses can assure an income comparable with most retirement pensions – and with much greater probability of being paid. Bear in mind that corporate and government pension plans can go broke too. Not houses.
BUT WHAT IF YOU'RE JUST GETTING STARTED . . .
It's pretty hard to be conservative if you don't have anything to conserve. If you HAVE to use leverage, at least try to be as prudent as you can while doing it. Here are some rules: (a) Use as much private financing as you can /vs/ institutional loans. In almost every instance, private sources will cost less, require less qualification to make the loan, be more flexible with the terms, and be more accommodating in the event that some future exigency requires the loan to be modified in some way. Sellers are the best sources. (b) Don't use variable rate or short term loans with balloon payments or renegotiable rate mortgages. In the early 80s we saw interest rates shoot up to over 20% – ruining many of the people who'd expected inflation to save the day. Anytime you're FORCED to renegotiate it's really not a negotiation, it more closely resembles extortion. Beware, be safe. (c) Avoid any personal recourse outside the property itself. Make it 'sole security for the loan' and have this written in both the Note and the Mortgage/Trust Deed. Sign 'corporately' if circumstances permit it /vs/ personally. Today in the Northeast many speculators are now finding themselves with loans in excess of property values, but since they signed with full personal recourse, they'll have to continue to pay whether or not they lose the property.
Loan terms themselves create value in property – and destroy value. Suppose you had a chance to buy a distressed property by paying off a defaulted 2nd mortgage and taking over the 1st at a price 20% below fair market value. It might be possible to pick up a quick $15.000 in equity on a $75,000 house tax free. What would the equity/profit be if there were a $54,000 NON-ASSUMABLE 1st Mortgage which would be called in the event you did that? Can you see that the non-assumable loan has destroyed the equity in the property for anyone without the means to qualify to assume or pay off the underlying loan? Put yourself into the place of the distressed homeowner looking to you for salvation. He'd NOT BE SAVED in this case simply because he was too eager to sign a non-assumable loan with full recourse.
It seems clear that there will be inflation aplenty in the next few years, and with it an increase in interest rates. That's the bad news. The good news is that there will be millions of FULLY ASSUMABLE FHA AND VA LOANS resulting from all the 'equity loans' being made under the new tax act and from all the refinancing done in 1986 at low interest rates. The trick is to handle the equity held by the owner. And the best way of all is with the old tried and true SINGLE PAYMENT NOTE. No payments. No interest. Nothing until the property has been sold. Who'd accept that? Anyone with a genuine reason for selling not based on financial considerations or profit. Think objectively for a moment. Isn't a listing, a lease and/or an Option more or less the same thing. Don't they too manage to control a property's equity and income for a period of time when drafted correctly? The person who signs them has been 'motivated' to do so. Put yourself in his/her place and see if you too wouldn't do the same.
Suppose you had to move to a new location – for any reason from job transfer to divorce to care of aged parents or to a better school district. You'd have to pay rent or payments in the new location as well as continue to pay for a vacant house – or one rented to strangers. It's likely that any rents wouldn't cover all expenses plus management fees. Wouldn't you be amenable to a suggestion that a solvent, responsible person would make the payments and give you your full equity at a later date when the property were sold? If you could be assured of this, having had all your doubts removed and the Note for your Equity fully secured, wouldn't that be better than continuing to make payments each month? Keep in mind that each additional payment REDUCES the yield/profit far more than the loan balance.
From the buyer's standpoint, with no second loan payments to make, the property should provide a cash flow with a reasonable equity and with feasible 1st loan terms. Again we can see that the original note terms bear heavily on the solution of real estate problems. If there's little equity, or high interest, or short term pay-offs, or non-assumability it can make even the above terms less than attractive. On the other hand, since there would be no interest, and positive cash flow, the limitations imposed by the new tax law wouldn't have any effect at all. Moreover, this approach to leverage yields all the benefits offered by inflation, without the risks that might accompany severe recession or even a depression.
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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