April 1981
Vol 3 No 7
Except for newsletter editors, that doesn’t mean much to anyone else. The man (or woman) on the street doesn’t mind paying a few pennies more for a stamp now and then, but what does a postal rate increase signify? For one thing, that despite Reagan’s anti-inflation stance, the U.S. Government is increasing the costs of vital services by 20%. You may note that this issue is being sent to you early. We’re going to take extra measures to forestall the effects of this increase by getting in one more mailing. Others will have to compensate the best they can or raise prices.
The Federal Reserve Bank of St. Louise publishes a free report called U.S. FINANCIAL DATA which is published every 2 weeks. You can get on the mailing list by writing them at St. Louis, MO 63155. This little booklet has a long history of being able to predict economic fluctuations about 9 months ahead of the major changes. I find one of the charts in it particularly provocative. The Adjusted Monetary Base – almost all the money in the economy – has risen steadily throughout the Carter Administration’s 4 years. Immediately after he lost the election, it flattened out, and stayed flat until mid February. UNDER THE PRESENT ADMINISTRATION IT HAS STARTED TO RISE AGAIN! I’m betting inflation continues for 1981 . . .
That doesn’t mean that we won’t have a business depression at the same time! Look at what just a 20% postal rate increase does to a small businessman like me. It inflates my costs of mailing your newsletter and reduces my operating margin. I must either increase my prices (inflationary), or reduce services by sending your newsletter by second class mail; or seek a wider market by making the letters more general, and consequently less valuable to you the reader. Or might just absorb the costs and be forced out of business, or even decide the profit is too low, and shut down altogether. No matter how I react, ultimately the victim will be the consumer – you!
Businessmen and women everywhere are similarly affected by inflation. They either must raise prices or reduce the quality of their services. Or they can try to operate differently. In my case, I took advantage of another’s distress and bought some extra equipment. This saves on my costs of labor. In other words, I passed my loss of cash flow on to someone else who I no longer will have to pay. Can you see how inflation breeds depression with large numbers of unemployed? That’s how we manage to have STAGFLATION.
There’s an important point to keep in mind when you are planning counter strategy to make money in times of economic turmoil. Depression is generally a more or less regional or local phenomenon while inflation is NATIONAL in scope. That’s why you can read both inflation and depression predictions at the same time given by fully qualified economic experts. So your strategy has to be related to the specific economic environment in which you have to operate.
Don’t be misled by what the national news columnists have to say. Your own observations may be more valid for your locale. I know things are getting a little slow in my area for example when tenants start to pay rents with rubber checks. When it costs them from $50 to $75 for each dishonored check, I rarely have this problem, except when paychecks are running a little thin. I also get feedback from a Security Guard company and from a credit collection agency who are tenants of mine. Their business picks up when the local economy turns down. When I see things beginning to slow down a little, I make small corrections in the way I buy property. I negotiate for better cash flow, even if I must pay a higher total price. In short, I buy SAFETY at the cost of profit.
Suppose I had a chance to buy a $75,000 house for a discounted price of only $70,000 if I’d refinance it at 14% on an 80% loan. The owner would carry back his equity in the form of a single payment note with interest of 12% to accrue for 5 years, at which time the full balance would be due. The market rent at which I could expect this house to remain rented consistently I estimate will average $500 per month over the entire period including vacancy. Depreciation will produce just enough cash flow to cover maintenance and management. What’s my cash flow position? A 30 year 14% level payment, self amortizing mortgage will require $663.53 per month and the tax and insurance bill will add about $150 to that for a total of about $814. The negative cash flow would be $314 per month. I think this figure is fairly typical.
My offer to the owner would be as follows: I’d agree to pay $80,000 for the house if he would sell it to me on the following terms: Annual payments of interest only, $7,000 IN ADVANCE, and balance due after 5 years. I’d try to make the purchase on a land contract (no personal liability) with all conveyances held in trust by an escrow company. Taxes and insurance would be paid by me at year’s end. Here’s what I would have accomplished. First of all, once I had raised the cash payment, I would have positive cash flow for the remainder of the year of $500 per month. If things got really bad, I could use this money to help support some of my other properties with negative cash flows.
Otherwise, I could put the $500 per month into a Money Market Fund to earn interest. Currently, “Rowe Price Prime Reserve Fund” (see June 1979 issue) is paying over 19%. That means that about $6550 would have accrued before the next $7,000 payment would be due. I’d have to pay another $1800 in taxes and insurance, too, at that time, so this would cost me $2250 in out-of-pocket cash in 12 months. This comes to $126.50 per month less than the owner’s terms would have provided, and there would have been no monthly pressure to meet payments our of dwindling reserves. At the 5 year point, how would gain compare between the above approaches?
Assuming a 10% appreciation rate compounded annually, the house would be worth $120,788 in 5 years. Equity over the paid down mortgage would be $51,667 but this would have to be reduced by the accumulated negative cash flow value. Compounded at 14% it would have a future value of $27,065. In effect, negative cash flow INCREASES my investment with each payment, thus my gain will have been reduced to $24,602 once this has been deducted from my apparent equity.
Using the same method of calculating profit, the apparent gain under the alternate purchase terms would only be $40,788 because my unpaid loan balance would still remain at $80,000. But I can add in about $6,500 in rents collected the last year that have been earning interest in the Money Market Fund, since the loan was paid in advance. This totals $47,288 gain which I again must reduce by the compounded sum of the monthly negative cash flow ($2250 per year for 5 years at 14% – $14,873) leaving $32,415 profit. Because of structuring terms to avoid high interest rate institutional financing, I’ve had comfortable ANNUAL payments, higher tax deductions, no liability, and made $7813 more.
This approach to investment strategy exploits STAGFLATION. Through highly leveraged non-recourse financing I can pay “too much” for a house that is extremely susceptible to inflation if prices rise. And at the same time, I’ve limited my risk of loss through annual payments which will give me time to work out problems before they become hazardous. The seller is motivated by the prospect of being paid a reasonably large lump sum payment in advance.
That’s a great plan, but where do I get the $7000 to pay the first year’s interest payment? Everyone knows that you can make money if you HAVE money. What can we say to the person who has everything it takes but money? We’ve been saying it for almost 5 years. Be creative! That doesn’t mean going to the bank and paying 18% for short term lines of credit. It means to employ techniques that meet the needs of the seller through means other than cash! We’ll assume that you have equity in your home.
Let’s brainstorm a little to see if we can’t find a way to buy houses AND hedge our bet a little using leverage. Suppose you wanted to buy the same house as before. To establish some ground rules, we’ll assume that it has a $45,000 loan on it with payments of about $500, including 9% interest, and the owner has a reason for selling other than to just make a profit. With a motivated seller, much is possible.
You might try to buy your own note back. In the December 1980 issue, we explained how a banker agreed to pay cash for a wraparound note and mortgage. In effect, you could agree to pay the lender a higher interest rate and a larger annual payment in return for allowing you to pay in ARREARS. Once a seller makes the decision to accept an innovative offer, it’s usually an indication that he accepts you as being credit worthy. It’s just one more step down the path to negotiate a later payment. Say you offered him $8000 per year with $1000 in advance, and the balance in arrears at year’s end. He might find that to be attractive. One the other hand, you could close the sale once you had found a renter. With $500 rents, and $500 deposits, plus perhaps another $500 in last month’s rents, you’d have your down payment plus cash. And you’d have 12 months to save up for the annual payment.
Why not consider co-venturing with a Tenant on the purchase? If the owner isn’t interested in allowing you to pay in arrears, perhaps you could find a tenant who would pay a full year’s rent in advance for the option to extend for 2 years at the same rent, also payable one year in advance each time. We’ve presented techniques in prior newsletters whereby tenants have bought the right to stabilize their rents for up to three years. If you tenant pays you in advance that have the same effect as if you paid the seller in arrears, since none of the money would be yours.
There are several things you might offer a tenant besides stabilized rents. You might offer him a purchase option at a price which would equitably divide the gain from the property between you according to the amount of cash he’d provide. Or you could just as easily let him buy one-half at the time of closing, and live in the house so long as he paid the rents. What you’ve done is to market your ability to structure acquisitions. He puts up the money and you put up the ability. Of course, in this situation, you’d have no management responsibilities, and you’d have help with cash flow.
If you already have other tenants, don’t overlook them as a source of cash for co-venturing purchases. They’ll be acutely aware of the costs of housing. It should be easy to convince one or two of the advantages in putting up the cash for another house you might buy. You can offer them an option, a leasehold interest, or a partial interest. It’s only a hop-skip and jump from this point to you’re actually allowing them to buy the property from you by assuming responsibility for your payments and agreeing to divide the profits with you in 5 years or so.
I presently own 4 houses with a former tenant with whom I co-ventured. And don’t overlook the parents of younger couples. Quite often, they’d like to see their offspring settled into a home of their own, and they have cash saved to fund it. The same emotional ties exist between mature families and their elderly parents for whom they might want to buy a house to offset inflation. In both of these cases, there may be cash values lying dormant in insurance policies that can be tapped. It would be far more beneficial to invest that money in a house for CURRENT financial relief than to sacrifice comfort in order to leave inflation-ravaged dollars to heir.
Let’s not overlook the best form of low risk inflation hedge around. An Option captures future appreciation at the risk of only a fraction of its value. But who’s going to sell you an Option when everyone knows that inflation is going to drive up prices? Those who have problems that Options will truly solve. People who need CASH; but who don’t want to give up the USER benefits of home ownership are likely prospects. When you buy an Option, in effect you’re just like any cash investor who agrees to share future profits on a house. Everyone I know seems to be looking for this person. Perhaps you should make an effort to find the person who needs an investor.
When buying an Option, you pay for the rights to future appreciation in a property. If you buy this Option with a Note calling for installment payments, the seller can either discount the Note for cash, pledge the payments to secure a loan, or use the monthly cash flow to offset operating expenses. That’s a clue as to who the likely candidate to sell an Option will be. He’s a person with high fixed overhead and insufficient cash. He’s a speculator with negative cash-flow houses! He’s a real estate or stock broker! He’s a car or boat dealer! He’s a high bracket wage earner who needs cash to pay income taxes! He’s a poor credit risk! He’s a home owner who can’t afford his monthly payments! He’s a builder with stagnant inventory!
If you buy an Option, the seller gets tax-free income. If you use non-recourse, interest-only balloon Note due at time the Option is exercised, you might deduct the payments as interest. And if you sold your Option for cash at your basis, there wouldn’t be any gain! You’ve managed to sell your paper for cash at face value. Better yet, you’d probably be able to sell the Option for a profit! That’s cash flow!
But we’re interested in finding hedge positions in this uncertain climate. So suppose you sold only one-half of your Option for a profit. Say you bought an Option on an $80,000 house for $10,000 payable at $100 per month and sold one-half interest for $6,000 payable at $200 per month. You’d have $100 per month cash flow, and if the property went up, you’d realize a profit on your half Option plus a smaller profit on the one-half that you sold. If the real estate market saw a slump and your Option was to become worthless, you’d still have made a profit, even in a falling market!
Another hedge you might consider would involve buying an Option with a NOTE as above while simultaneously selling an Option for CASH on another house you owned. The cash would be tax free and it could be invested in deep discount bonds for income to support your Note payments, for break even cash flow. If the depression comes, the Bonds should rise dramatically in value, giving you a capital gain, plus income. If inflation should run away, the EQUITY you’ve purchased with DEBT will have provided a terrific inflation hedge which will yield great profits. If things remained flat, your bonds would continue to yield income, and it’s doubtful that either Option would be exercised, so the results would be a wash. In effect, your Bonds would have been acquired at no cost to you, and the income would continue until you sold them.
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