May 1990
Vol 13 No 7
REAL ESTATE AND PAPER – THE ULTIMATE PARTNERSHIP . .
For some reason or other, creative real estate has grown into two different camps. Some people swear by PROPERTY OWNERSHIP AND CONTROL while others passionately believe that they can divorce themselves from the problems of real estate ownership by concentrating on ways to make money with real estate 'paper'. Who's right? Neither of them – – and both of them. Why? Because the world of property and paper are being merged in the more creative reaches of both mortgages and real estate.
Before getting into the latest dynamics of the market, let's review the basics. First of all, what do we mean when we say 'paper'. The most conventional application used by many people refers to real estate NOTES. These are simply promises to pay made by the 'maker' (who has made a promise to pay back a certain sum of money plus interest, as the case may be, in return for property which has been conveyed to him/her by another party whom we'll call the Lender/Payee). So far so good. So what's tricky about that? The terms of payment! These can be crafted to produce a range of benefits for both lender and borrower. Let's look at a few.
From the standpoint of the lender, he can include several interesting provisions into his Note language. We're all familiar with non-assumable loans. These place a limit on the flexibility of the borrower with respect to subsequent sale of a property used to SECURE the Note. Normally, the lender wants to (a) satisfy itself that the Note will be just as marketable and secure after a transfer as before. It does this by making anyone who would assume the note QUALIFY for a loan under the lender's usual underwriting standards. (b) It also gives the lender an opportunity to re-write the loan to produce a higher return at the expense of both the original and replacement borrower. The end result of these machinations is to make any property securing such a loan LESS LIQUID.
Lenders have an awesome arsenal which they can bring to bear on the hapless borrower who doesn't take the time to read every word in Notes and MORTGAGES, or DEEDS OF TRUST. Hey! We've just introduced a couple of new words. Mortgages and Deeds of Trust are SECURITY INSTRUMENTS which attach a specific property or properties to a promise of future performance. A promissory Note is legally enforceable against all who have promised to pay. What many people don't realize is that all legal promises can be enforced against those who make them. What other kinds of legal promises are there? If you sign a LEASE, LICENSE, CONTRACT, OPTION – all promises of future performance – these can be SECURED by a Mortgage or Deed of Trust. And the conditions of the transaction can be expanded to include ADDITIONAL COLLATERAL, CO-SIGNERS, FUTURE ADVANCE CLAUSES, VARIABLE INTEREST RATES, and INDEXED LOAN BALANCES. It keeps on getting more complex doesn't it?
We might as well dispose of these new terms before we move on. Suppose you were lending me money on something which you thought of as highly speculative – such as rental houses, new constructions, condominiums, land development, a business; might you not want some additional security for the loan? So you'd ask me to place a Note & Mortgage on some additional property. Or get someone to GUARANTEE YOUR REPAYMENT of that loan. Both of these can be ruinous. What you'd be doing, in effect would be to reduce your risk as a lender at the expense of the borrower's increasing his risk by placing additional assets at risk – and by ENCUMBERING them so that they wouldn't be available in the event he had to raise cash later on. So you'd be IMPROVING THE RISK/REWARD RATIO while the borrower would be forced to settle for the same rewards, but with much greater risk.
A word of advice. Never borrow under such conditions. Nor ever CO-SIGN!
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CO-SIGNING IS WHAT STARTED THE LA BREA TAR PITS . . .
A couple million years ago a dinosaur got his foot stuck in a primordial bog on Wilshire Blvd. in L.A. He bellowed for a friend to help him out, and the friend also became stuck in the mud. Eventually, the pit was filled with the remains of all of the creatures who either came to help, or to victimize those who were stuck. Change the names a little and you've got the typical co-signer, who comes to the aid of an associate who doesn't have enough additional collateral. So the friend PROMISES TO GUARANTEE that the original borrower will pay as agreed, or the friend places his own assets at risk to give the lender more security for his loan. And like our dinosaur, the friend is drawn down into an early financial demise because of his good intentions.
The moral of this story is that, if you're going to co-sign, you might as well borrow the money yourself and then lend it to your friend. You're probably going to have to pay it back anyhow. This way at least you can mark up the interest rate when you lend it to him. But there's a certain amount of hazard even doing this. There were a couple of hard-charging young guys in the Northeast who borrowed at 18% and loaned it to their old hard-pressed pal at 24% (What are friends for, anyhow?). Then their old buddy filed for protection under Chapter 7 of the Bankruptcy Code. He got off the hook. They're still paying back their 18% loan. Welcome to La Brea!
THE NAME OF THE GAME IS TO LIMIT YOUR LIABILITY WHEN YOU MAKE A PROMISE . . .
By its very nature, a promise denotes something you're going to do in the misty future. Hence, no one can be absolutely certain that things will work out as planned. It seems fundamental to me that a person wouldn't risk EVERYTHING THAT THEY'VE DONE RIGHT IN THE PAST for a hope that the future will prove as bountiful. That's what is actually being done when you sign a promissory note, lease, contract personally with FULL RECOURSE. If something should prevent your keeping your promise, you've placed everything else you own at risk. There are several ways to limit liability.
1. Choose something other than a promise to build your fortune on. Rather than sign a Note with 100% financing, use a LEASE/OPTION with the right to cancel.
2. If you have to buy something on credit, use a form of LAYAWAY. Isn't that what you're doing when you buy using an INSTALLMENT SALE CONTRACT (also called Agreement for Deed, Contract for Deed, Bond for Deed, Bond for Title, Land Sale Contract, Uniform Sales Contract depending upon the area you're in)?
3 If you have to provide personal guarantees, try to limit them. Thus, you might agree to be personally liable for a PORTION of the obligation. It could be the first 20% of a loan. Or 100% of a loan/lease/contract for 1 year. Or it could entail a series of RELEASES of LIABILITY predicated upon your unbroken payment record. Or, as any particular time period, payment schedule, build-out phase, sell-out phase is completed, a commensurate amount of personal liability would also be phased out.
4. You could do business as a CORPORATION or TRUST, possibly as a LIMITED PARTNERSHIP which, by it's very nature, limits the amount of personal liability you'd be exposed to.
5. And don't overlook just plain making a safe, simple loan which you CAN'T DEFAULT ON. I like PERFORMANCE NOTES. In so many words it says that I'll make payments on a certain date and in a certain amount ONLY SO LONG AS THE INCOME FROM THE PROPERTY WILL PROVIDE IT. At any other time, 100% of the NET INCOME will be used to service the debt, but it won't be declared in default so long as those terms and conditions are met.
6. But there's an even better way to work on limiting liability. This is in the area of HYBRID DEBT/EQUITY contracts. These lead the field of creative finance for the '90s.
A LITTLE CROSS-POLLINIZATION CAN GO A LONG WAY . . .
Back in the late 1970's when inflation was running in double digits, lenders were producing a dazzling array of financial debt instruments which effectively INDEXED THEIR LOANS TO THE INFLATION RATE. For instance, suppose I borrowed $100,000 at 16.5%. If inflation continued to rise, then the interest rate would be increased to offset the deteriorating value of the spending power of the dollar. What a beautiful concept. As inflation drove resale values skyward, the interest removed more and more of the profit from the owner, giving it to the lender.
Of course, I had to go one better. At first, I indexed the interest rate to the FHA rates. Between 1977 and 1981 these went from about 8% to about 16.5%. And then my big breakthrough came in 1978. In that year Senator Jesse Helms from North Carolina got a rider attached to a bill which made it legal to INDEX ALL INSTALLMENT SALE CONTRACTS TO THE PRICE OF GOLD. Remember, during that period gold went from about $150 per ounce to $850 per ounce. I began to index the PRINCIPAL too. Instead of writing a mortgage loan for a fixed interest and principal, I wrote only 1 year Notes or Contracts with a built-in option for the borrower to either pay if off completely, give me a deed in lieu of foreclosure and vacate, or the right to cancel the original loan and to write a new one at the then-current interest rates and at the then-current market price or – in lieu of good market comparable sales from which to derive a price – at a price which reflected the increase in the Consumer Price Index over the preceding 12 month period.
But we made another breakthrough in the early 80's. We created a CONVERTIBLE LOAN. Under its terms, we had the right to demand payment with 30 days notice. In the event that the loan weren't paid off in full, we had the built-in RIGHT TO CONVERT OUR DEBT INTO EQUITY IN THE PROPERTY BASED UPON ITS VALUE AT THE TIME THE LOAN WAS PLACED. This is quite an instrument. It is full of advantages for everyone. Let's look at what might be a typical situation.
Suppose you were an investor caught in the Tax Reform Act of 1986. In 1990, you'll only get to take 10% of your excess passive losses from rental real estate over and above the $25,000 that you'll get as an actively participating owner. But the real problem is that some of these losses are from PAYMENTS OF CASH TO SERVICE DEBT. It's one thing to not get your full depreciation benefit. At least you're not writing checks to cover depreciation. But when you write $10,000 in checks out of your household account, then don't get to deduct that expense in the current year, it adds insult to injury.
On the other hand, suppose I've got a surplus of idle cash that's not doing me much good. The market's flat. Interest rates are dropping. I'm looking for a passive investment (that means that I don't want to work, run any risks, be liable for any tenants, or have to fill out a lot of tax forms each year). We agree that I'll re-finance your debt and re-structure the terms as follows. Instead of paying 12% interest, you'll only have to pay me 6%. In addition, I'll get 50% of the profit in the property upon demand or at a point we've agreed on in the future. In the interim, you'll continue to manage it and do all the work. Let's see what some of the numbers might look like:
Recently I had a chance to lend $73,000 to someone who'd found a $109,000 house that could be bought for $73,000. Rent would have been about $800/month, but payments and tax/insurance impounds would have been about $950 causing $150 negative cash flow monthly in addition to vacancies, operating expenses and maintenance. The solution: a SHARED APPRECIATION MORTGAGE. Pete Fortunato and I worked this concept up a few years ago, and it is explained fully in his PAPER COURSE seminar. You can contact him at (813) 392-7290. It works like this. I can put up $73,000. I'll get $654 per month for 60 months which will compound to $53,412 if I invest it at 12%. If the house appreciates at 8%, its value will be about $160K in 5 years. After repaying my $73,000, I'll also get 1/2 of the $87,000 gain. This will be $43,500. My total passive yield will be about 10+% per year compounded overall. That's not bad in a market where T-Bills pay almost 10% less. It's not bad for the borrower either. His cash flow swing is about $300 per month from -$150 to +$150 and nothing down.
There are other intangibles inherent in this kind of financing. The positive cash-flow margin to the borrower makes the loan a lot less risky for the lender. We've been discussing risk/reward ratios. Shared appreciation loans improve this considerably. The share of the appreciation might be deemed additional INTEREST on the loan, GAIN on the investment, or a combination of both under the terms of the loan agreement. All of the positive cash flow will be sheltered by the depreciation without any need for calculating passive loss carry-forward. The lender is in first position in the event of default. The tax consequences are ambiguous. But they become positively murky in another variation.
Suppose I, as the lender, wrote a loan contract at 6% interest, but also included an Option for 10% of the property which I could buy for $100 each year of the loan until it had been fully repaid. After 5 years, I'd have collected the same amount of cash payments as in the preceding example on page #3. But at that time I'd own 50% of the property. At the time of sale, my share would have to be paid off, yielding LONG TERM CAPITAL GAINS. These would be taxed at the prevailing tax rate. But with all this talk about lower gains rates, that could be better than interest. Now, the question remains as to what other tax benefits I'd be entitled to. If it were my money that paid for the property, and I was enjoying the rights, duties, benefits and obligations of ownership by virtue of this hybrid financing arrangement; the IRS might deem me the EQUITABLE TITLE HOLDER and true owner of the property. If so, should my payments be treated as interest – PORTFOLIO INCOME – or as RENTS? Nobody knows! Neither the courts nor the IRC has successfully dealt with these HYBRID debt/equity arrangements. Writing a DEMAND NOTE could tip the scales my way.
THERE'S MORE THAN ONE WAY TO SKIN A CAT . . .
Paper makes property more or less liquid depending upon its provisions and the yield to maturity. Conversely, property makes paper more or less liquid depending on its DESIRABILITY as collateral. As you can imagine, the care taken to structure terms becomes of paramount importance – especially when a future sale of either property or paper is being contemplated. It's a good idea to discuss any particular strategy with someone who specializes in property or paper re-sales.
It pays to line up potential paper-investors BEFORE you find the property to buy. Some of them will want SAFETY above everything else. Some will prefer YIELD. Some will be ORIGINATORS of loans. Some will want to be DISCOUNTERS who will offer a flat discount (i.e. 25% of face value), then use the paper to buy other properties or to RE-DISCOUNT into the paper-market. By understanding their requirements, you'll be able to round up financing regardless of the state of the institutional lender market. Consequently, you'll be able to consistently be a BUYER in a buyer's market, and a SELLER in a seller's market.
The use of PRIVATE MONEY FINANCING can't be overstated when it comes to building an estate using high leverage. By structuring loans to provide acceptable yields to both lender and borrower with comfortable margins of safety, liquidity and personal liability, both the loan and the property securing it can be made more attractive. In the 90's, we're going to experience fantastic changes beyond anything we've known. Maintaining balance with a flexible stance is going to be important. Private financing helps when you're creating the partnership between property and paper to distribute benefits to both borrower and lender. Institutional sources of credit are unable to respond to entrepreneurial needs.
