February 1983
Vol 5 No 5
Even the most astute investor can fail! He can select the best investment in which to place his money. He can time his moves to the moment. He can test the political winds carefully. He may gauge the primary economic trend perfectly. And he can STILL FAIL! Why? Because, when markets become irrational, there's no logic that guarantees success. I don't care whether we're discussing financial, commodity, real estate or securities markets; there's a time for caution. This is just such a time.
Our country is undergoing fundamental changes which could invalidate economic forecasts, short or long term. We're transitioning from a manufacturing, heavy industry base to a service industry based society – more specifically, an INFORMATION based, high technology society. This adjustment is producing contradictions as various segments of the economy struggle to adapt. Consider a conservative President who supports record setting tax increases, or a Consumer Price Index reflecting less than 5% inflation when our monetary base is exploding at 20% per year. The highest unemployment in four decades matched against the highest EMPLOYMENT in actual numbers of workers in history. The most productive farmers in the world being given farm products to sell at tax payers' expense to sell to Russia – our avowed enemy. $200 Billion deficits generated to save inept political leaders in countries around the world who oppose us in the United Nations. Only the very brave – or the very foolish – would predict where this will lead us in 1983.
About the best thing we can do is to weigh the probabilities of general trends and try to formulate a strategy. Reagan got a clear message in November – put people back to work or be replaced! There will be token mutterings about budget balancing, but public proclamations will dwell on the advantages of an expanding income tax base rather than cutting back on expenditures to balance the budget. Get ready for STAGFLATION. Look for higher prices, easier money, higher taxes as incomes rise, and perhaps CONTROLS.
Government itself; local, state, and national, poses the greatest threat to the future for investors in real estate. In Pittsburgh a sheriff refused to hold foreclosure sales and the judge backed him up. In Oak Grove, Illinois they're trying to force owners and tenants to get permits to rent premises using arbitrary standards for regulation. In Boston they're controlling rents based on the CPI regardless of actual expenses of the owners while across the river in Cambridge, they're putting a 1% surcharge on rents to pay for rent control administration. The IRS is going to charge corporations extra when they sell their depreciable assets – 15% will be ordinary income and the rest capital gain. Managers will now have to file 1099 and 1096 forms reporting all income over $600 they've paid to owners or be fined up to $25,000 for failure to report. And they're making their first move on GOLD in Congress – a proposed bill will make it illegal to hold KRUGERANDS!
Beware a government who has run out of cash! California is a case in point. Jerry Brown used up all the surpluses. Now what will happen to social programs? Property “use“ taxes? Income taxes? We can expect a new level of viciousness at all levels. New taxes will be matched with more aggressive collections, barrages of propaganda about “tax cheats“, “elimination of loopholes“, “fair share“. Where not prohibited by law, property taxes will soar. Subsidized rent may be in jeopardy in the face of falling revenues.
The Federal government can merely print money they need – or hold the banking system at ransom to manipulate interest rates. They're doing that now, but the system is running out of money. What they do to remedy this will set the investment climate for the coming year. This month's letter will explore some possibilities for you.
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
NOW'S A GOOD TIME TO HEDGE YOUR BETS.
Winning gamblers know when to bet against themselves. Anytime the stakes are too big, or the players too powerful, or the odds uncertain; it's not a bad idea to lay off some of the risk and to take a smaller profit. The stakes could be your financial security! If you lose assets now, it will be a lot harder to recover them tomorrow. The government has become speculative. What's more, they can change the rules without regard to moral issues – as they did with the recent tax increase and as they'll no doubt do with Social Security, Pension Plans, etc. Because government can't manage the economy effectively, their capacity for harm may outweigh any capacity for good. Let's face facts, only Government can cause war, depression, inflation, political instability and force the citizens to pay for it in taxes, devalued savings, and repressed freedom.
Now's a good time to seek stability. Part of your assets should be invested safely in CASH or inflation hedged liquid assets such as 91 day T-Bills, Government-only Money Market Funds, widely held and traded securities. Bonds, long term mortgages, and non-indexed leases would be wiped out by high inflation. Short term investments offer the best defense against inflation. Unless they're HELPED by inflation, long term assets with non-indexed income streams are hazardous. Houses become less liquid, the higher the inflation rate rises. Rents can be increased to capture cheaper dollars. Lenders won't be willing to make the long term loans as before, so it's wise not to depend upon favorable refinancing rates during any period of inflation. If you have balloon notes falling due, consider SELLING into an inflationary market and using the cash to buy other hedges.
I'm assuming that you already hold leveraged SFH when you take this newsletter. Inflation can aid your pyramiding PROVIDING THEY DON'T INDEX MORTGAGES TOO. If this does happen, negative cash-flaw properties will probably be dumped on the markets, depressing prices. The same thing could happen if the IRS changes the rules. A Congress committed to short term solutions is considering elimination of many tax advantages in real estate. Suppose you lost either interest or depreciation deductions, would you keep your houses? It's becoming more critical that you avoid high interest rates in financing houses. In our February 1981 letter we devoted the entire issue to ways in which you could both buy and free your properties of debt without cash by using EQUITY rather than DEBT financing.
That's particularly crucial during any period of general depression or if the impending CREDIT CRUNCH should catch you unaware. OPEC is currently in disarray. Oil prices are falling. That means that funds on demand deposit in our banking system could be called. The FED would probably support larger banks as they did Chase Manhattan, but smaller banks will certainly fail without support. Thus we'd have rampant INFLATION due to increases in the money in circulation at a time when lenders would be sorely pressed. Without operating funds, business and investment, housing, economic expansion would be sharply curtailed. We'd have even more unemployment than now, while paying more for it. And this scenario is outside the control of Washington. It can happen without warning. All Western nations would be affected. Better get rid of your short term financing!
I'm NOT PREDICTING ANY OF THE ABOVE. But I'm advising you to position your assets to ride out this uncertain year in a fully hedged stance. After you put away some liquid reserves, concentrate on increasing your indexed, steady income from rents – and indexed mortgages and trust deeds. In prior letters we've discussed using Gold clauses and indexing to protect against inflation in long term mortgages. These call for equivalent ounces of Gold at your option at time of payment. They're a good hedge. Be critical of prospective tenants' skills and employment stability to tide you over if employment conditions worsen. Use Options and Lease/Options to make inflation work for you. They'll work to build your estate through risk-free leveraging if things go up, and offer no threat to your assets if things go down. Be sure they're long term. I think inflation is much more probable than depression this year, but it will roll across the country in stages. As areas begin to recover, you'll see a variety of opportunities. You might buy back your own loans at discount if you have cash.
As the newly created money filters into the mortgage system, we may see short periods of relatively low mortgage rates. Your best choice is to SELL your property and to repurchase replacement properties once interest rates go up again. You can hedge your transaction by buying an OPTION on the replacement property, or by buying it with “soft“ terms on seller carry back paper. Don't forget lease/option techniques to control property until good terms can be negotiated. If you close your sale in January, you'll have a year to buy replacement shelter to offset your taxes. And you'll have a stepped-up tax basis upon which to base subsequent depreciation.
There are a couple of other inflation-hedged ways to sell. You can offer to buy a repurchase OPTION from your buyer at point of sale and pay with a Note or with Cash. If you pay with a Note, you can put below market interest rats and re-payment terms which would none-the-less be attractive to the buyer to help him meet his new loan payments on the house you sold him. Your Option would hedge the inflationary rise if it were at his purchase price, or at some price which would share future appreciation based on inflation. In the meantime, all the cash sale proceeds would be available for the future.
Or you might sell on a “CONVERTIBLE NOTE AND MORTGAGE“. In effect, this would provide for interest-only payments by the buyer, but would give you the option to regain title to the property by means of the convertible feature which would enable you to convert the loan into the equity of the house. Here again the precise terms would have to be a matter of negotiation. Both of the above techniques are viable defenses against rent controls in the event they should be imposed in your area. And they'd both work if the IRS rules that either your depreciation or investment interest were to be eliminated in any period in which U.S. Treasury tax policy should be turned against entrepreneurs.
CREDIT AND LIQUIDITY HEDGES ARE A MUST!
Inflation eventually makes houses illiquid. At first, with easy money, you can sell or buy anything. Then you notice that the money you get from a house won't buy a replacement house. From that point on, you'll be reluctant to sell at all for fear you'll be caught off base without any tangible assets. You'll notice that other seller's share a similar attitude. If interest rates are still low, you'll be able to borrow to raise cash, but as people rush to acquire tangible assets, bank reserves will dry up, and credit will be in short supply except at high prices. That's what has been happening the past two years or so. It will certainly happen again before the year is out. Be prepared.
Liquid funds in banks are always in jeopardy when banks are undergoing change. That's happening now. Put your funds into T-Bills, Gold or Silver Bullion which you can take delivery on and store, into the securities markets in widely traded growth stocks or those associated with the real estate industry. This way, you can convert to cash in order to take advantage of special buying opportunities. On the other hand, your liquid reserves will be safely earning an inflation hedged yield even though T-Bills may rise a little more slowly than the inflation rate or the precious metals.
More money is earned as an economy cools down than when it heats up because of the lack of competition. Ready cash makes the difference. That's why you should retain some liquidity when things are uncertain. In 1979 I started advising liquidity. Those who took this advice were positioned to make fortunes in the past 2 years or so. Cash lets you be a buyer in a buyer's market and a seller in a seller's market. Conversely, when you're forced to depend upon credit to buy, you're locked into the credit cycle in the most competitive market cycles. You rarely have a chance to reap the harvest. If you don't have assets to liquidate to raise cash, ally yourself with someone who does.
I once optioned three houses advantageously merely by offering free management during summer vacation periods when the owner wanted to travel. I now own them all. I also co-ventured investments with high bracket wage earners who had neither the skills or time to invest wisely and who shared profits that I could generate. As you might expect, these same people had the ability to command credit limits beyond my own abilities. They could be counted on for cash when I found bargains, so I didn't have to have my own cash.
Mortgage Bankers will permit investors to purchase future loan commitments for about 1% of the amount to be borrowed. It works like any other futures contract. The conditions of the loan, interest rate, re-payment period, amount of money promised and pro-forma qualifications of the borrower will be specified. Interest rate and loan commitments are usually arranged through Mortgage Brokers listed in the yellow pages. An investment of $10,000 will tie up $1,000,000. That kind of credit insurance is a good idea for those engaged in construction or development where permanent financing is a do or die proposition. And where uncertain conditions make it desirable to be able to sell property quickly to raise cash when markets are changing.
The ideal hedge position will enable you to jump quickly when you can see which way the economy is moving. For instance, currently in many parts of the country it's still a buyer's market. Creative financing can still be employed to buy houses. But it could turn around over night into a seller's market if interest drops much more. Then prices might experience as much as a 25% jump due to pent up demand which has been estimated at 7 million households. At an average price of $68,000 this would consume almost half a TRILLION dollars in credit. It's not hard to see that the credit crunch will return in only a few months. Being poised to sell quickly, remain liquid, and re-enter the market with cash in late summer might be an extremely profitable strategy – especially with your short term loans eliminated. FNMA is preparing for this market with plans for putting $1.3 Trillion into the secondary mortgage market in the next 7 years.
If a true down-turn does occur through miscalculation of the FED, having cash can mean the difference between survival and elimination. Changes in the tax laws, rent controls, vacancies, regulatory controls can be weathered with cash. Without it, one could lose everything. And in the event of a chaotic investment climate in which the rules are changed several times a year, short term profit opportunities will present themselves to the informed, liquid investor who is patient enough to await them. Like we said, the turtle won the race, and he'll continue to do so in most instances. A balanced portfolio, hedged between cash, paper, and single family houses will weather most storms.
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
