August 1980
Vol 2 No 11
The Nitty-Gritty Clinics held in various locations these past few months have been an excellent source of feedback on problems being encountered by our readers. More and more Investor difficulties appear to stem from loss of control over the details of execution of the transaction. Unprofessional workmanship in structuring and documenting acquisition of properties can result in loss of prodigious amounts of profits over the holding period. Often, the difference between success and failure boils down to minute overlooked details which change the complexion of a transaction when considered by others (i.e. the IRS). This issue will review some of the various items of “paper work” commonly used to control and to document SFH transactions in hopes of preventing future problems.
Let’s start with the CONTRACT – the basis for almost all real estate investment activities. The purchase contract should spell out in specific detail just exactly what the transaction intends to accomplish and the means by which each party is going to attain his or her particular objectives. Fundamentally, in most jurisdictions, a contract must contain an OFFER and ACCEPTANCE between parties COMPETENT TO ACT who have had a MEETING OF THE MINDS as to their agreement, which agreement shall not be for ILLEGAL PURPOSES or inimical to the PUBLIC INTEREST and shall be bound by passing of CONSIDERATION between the parties. Licensed real estate professionals are obligated to disclose their special expertise PRIOR to the contract being signed in order to be enforceable in most areas.
There are other practical considerations which must also be observed if future problems are to be minimized. First, if you don’t know how to draft a contract, hire the necessary expertise to have it done properly. This includes getting it signed, witnessed, Notarized (if it is to be recorded later), and recorded if you intent to cloud title. By becoming actively involved in the drafting of legal documents, one forces oneself to come to grips fully with the securing of the desired objectives in the transaction. It’s a mistake to assume automatically that an Attorney or other specialist will be qualified to draft a document which meets your needs without your input. How many times has litigation ensued a result of obscurely phrased points in a legal document? Express yours clearly!
We are accustomed to thinking of purchase and sale agreements as contracts. We should understand that the same considerations also apply to successfully implemented Notes, Trust Deeds, Mortgages, Options, Escrow Instructions, Trust Agreements, and Leases. It is crucial that we understand the practical and legal ramifications of these documents in order to enhance the prospects of our investment decisions and portfolio management.
What about LEASES? They constitute a contract between Owner and Tenant which transfers an interest in the property between the parties. To the extent that property rights are conveyed in the Lease, the owner’s equity is also conveyed over its term, so they should be drafted carefully to secure the desired result. Of course, we need to keep a weather eye cocked at the various State and local laws to know what other transfers of equity are being done in the name of social progress. We must choose our roles cautiously.
As an OWNER I would use only a month-to-month tenancy documented in a Rental Agreement. It would employ a discount feature to provide for prompt payment and maintenance incentives on the parts of the tenants. It would provide for automatic escalation to keep pace with inflation. I would use every strategy to avoid rent controls and the effects of Tenant oriented legislation. I would not use a Lease in my SFH rental program nor succumb to the temptation of government subsidy programs which employ Leases.
What about my approach as a Tenant? Since my position has been reversed, it is only natural that my methods of acquiring benefits would also be reversed. I would seek a “level” long term lease which allowed me to sub-lease or to assign my rights in the property. I would not want any clause which cancelled my lease in the event of any suit for condemnation. I would want an Option to Purchase at a price to be established NOW. I would want a portion of my rent payments to be applied toward the down payment. I would want the Owner to pay for all maintenance, utilities, taxes, and insurance during the term of my tenancy. I would ask for several Options to renew my lease, with my purchase option to run concurrently with the renewals. I would be aggressive in ensuring that the Owner complied with all rules and regulations including any rent control statutes. Obviously, I would draft a lease which conveyed as many benefits as possible to me. And I would ensure that the lease was recorded in order to establish my claim on the title.
It becomes apparent that a Lease can be a valuable tool for controlling profits. It should also be clear that knowledge of the applicable “rules of the road” is crucial. Part of our emphasis on detail work is to stress the importance of KNOWING the legal environment within which your investment must function. As an adjunct to the professional advice you employ, you need to acquire copies of the Health and Maintenance Ordinances, Minimum Housing Regulations, Landlord and Tenant Acts, Rent Control Statutes which affect your portfolio. Based upon these you can choose which role is best for you, Owner or Tenant. You might contact your local legislative delegation or Apartment Owners Association to acquire the copies of ordinances you will need. They are usually quite cooperative.
Once the total legal framework becomes integrated into your decision-making process, you can take a hard look at the financial aspects of any proposition. One of the most popular investor refrains centers on NEGATIVE CASH-FLOW. It should be clear by now that when local property values outrun rents the appropriate role to play is that of the Tenant. This way the current owner is actually subsidizing the Tenant. When a purchase Option is incorporated in the Lease, it has the effect of gradually transferring ownership of the property. During this time, the Tenant (you) may well be enjoying a positive cash flow as you increase your sub-lease revenues periodically. (Remember, you only use a short term rental agreement with YOUR tenants, so you can increase cash-flows periodically.)
This brings us to the OPTION. This is possibly the most misunderstood tool in the SFH field. It is simply an offer which one party has made another. For a consideration the other party has purchased the right to keep the offer open, deferring a decision until a future date. It must contain all the provisions of any contract including various terms and conditions of sale. Because it deals with the uncertain future, special steps should be taken to ensure the protection of all parties. It should be recorded. All documents needed to convey title are best held in Trust by a competent “Third Party” (who indeed might even be holding Title in Trust also) under specific Escrow Instructions or a Trust Agreement. Once the Option is exercised, title may be transferred. In the event it is not exercised, the title must be cleared by recording of a Quit Claim Deed. Unfortunately many Options are haphazardly drafted with unclear terms. Or they are not recorded. Or they are not valid because of a failure to have a “meeting of the minds”. Or vitally important conveyances have not been executed and placed into escrow. Failure to observe the niceties too often results in complete loss of profit and expensive litigation.
Critically important to the viability of any investment are the financial terms! These are contained in the Notes, Mortgages, Trust Deeds, and Installment Sales Contracts. They document the obligations between parties to implement the overall agreement on the applicable purchase or Option contracts. Like any other contractual arrangement, they must be drafted to express the understandings of each party in order to be enforceable. Over a period of years we have seen some fairly “creative” instruments which contain many ancillary provisions relating to built in discounts, Gold Clauses, variable interest rates or indexed principal amounts. Many of these instruments will not stand legal testing in the courts because they don’t meet the fundamental tests of contract law, as several S&L’s are now finding out with their tricky “due on sale” clauses.
Providing that all parties to the transaction agree, there are several protective terms which one or the other might want to insert into the various instruments. These include provisions for substitution of collateral, performance payments, and deferred payments. When one is structuring financing it is critical that the end is an economically viable investment property. This means that the property is producing the specific benefits required for the owner at a price he or she is able and willing to pay. It doesn’t always mean there will be a positive cash flow; however financial terms should be such as to allow the purchaser reasonable safety and flexibility.
Insertion of a “Substitution of Collateral” clause permits the borrower freedom to manipulate his encumbered properties in the event he has a need to sell, exchange, or borrow additional sums against them. He merely pledges other properties acceptable to the lender, removing any outstanding liens against his own property. On the other hand drafting “Performance Note and Mortgage” terms provides the borrower a margin of safety because they relieve him of his obligation to make payments when the property itself doesn’t generate sufficient cash-flows out of its own income stream. An “Exculpability Clause” simply states that the Lender will look only to the property as collateral and security for his loan. In this way, the borrower need not fear attachment of a deficiency judgment against his other assets in the event of default.
The “BALLOON NOTE” is extremely useful in evening out potential negative cash flow problems, however, it can be hazardous to one’s health on the date it falls due. When the usual self-amortizing level payment terms would generate menacing cash flow deficiencies, it is quite common for the Lender to call for payments of lesser amounts, then to have all the back payments and accrued interest brought current in a single periodic payment. The borrower assumes the availability of financing, planning to borrow the needed funds when the note falls due. In recent months many of these borrowers have fallen prey to the tight money market. They’ve lost their investments via foreclosures. By structuring a deferred payment schedule into Balloon Notes, they can be put off until the properties can be sold or refinanced.
One way of getting a deferred payment schedule accepted is to offer the Lender a set penalty payment for a specific payment deferral period. For example, an additional 10% might be paid on the principal of the amount owed in return for a year’s grace period. Of course these terms should be made on the original agreement when the loan is generated.
One of the murkiest areas in which Investors find themselves is Management of the SFH portfolio. In spite of bargain prices, easy terms, market demand, or other favorable factors; on-site Management can still make or break your investment. Most management costs can be traced to the owner’s cutting corners in this most critical area. Very little cheap management is good, yet the best management is cheap! By choosing your Manager carefully, seeking those with experience IN THEIR OWN SFH PORTFOLIOS, the Investor can solve problems related to vacancy, turn over, maintenance, and cash flows. We consider this so crucial that we offer our Managers ½ of the profits generated by his or her efforts over the full holding period. When this is accepted, we don’t pay any management fees. This is another way to solve negative cash flow problems and to acquire a motivated manager as well.
Here again, the Management Agreement should be carefully worded to achieve the desired results. The Manager’s interest might well be contained in an Option to Purchase of an interest in the property only upon sale, with the Owner’s having the right to set the sale date at some point in the future. The Manager might even Lease with an Option. In this way the Owner would KNOW what the future cash flows would be from his property. Too often we have heard tales of woe from Owners who have failed to protect themselves against indifferent Managers AFTER they have given away an interest in their properties. A well drafted contractual agreement in any of the forms mentioned above can save many dollars.
There is a direct connection between one’s ability to control details of investment transactions and profits from them. Often, I’ve heard “I’m just not a detail person”, uttered by the same person whose portfolio is plagued with problems, inadequate cash flows, lawsuits, misunderstandings, and general lack of performance. Maintenance of control over one’s portfolio through thoroughly documented performance records, acquisition contracts, leases, options, and debt instruments helps both the Owner and his manager achieve more consistently better results. If you need professional help, it will cost far less to hire it than not.
WHY RENT WHEN YOU CAN BUY?
With interest rates once again turning toward reasonable levels and a Buyer’s market in many areas of the country, there are situations in which it might be better to be a Tenant than an Owner. In the June issue we discussed the merits of Leasing with an Option from a third party. What about selling our personal residence and using the money for SFH?
What does it cost to hold a high equity in our own home if we are in the 50% tax bracket? Say we have a house which has rapidly appreciated to $150,000. We owe $50,000 on a 4 year old 8% loan. Our payments are $500 per month including taxes and insurance, right? Wrong! To arrive at the true costs of owning our own residence we have to look at the “opportunity costs” of leaving our equity “un-invested”. Oh it’s invested, but not at an aggressive rate. How much can our equity earn if we convert it to additional investments?
Let’s face it, the tax laws discriminate against home ownership except when we sell. As owner/occupants we don’t get to take depreciation, maintenance, or insurance deductions that we would be able to take if we owned the same house as Investors. Just for a moment come fantasize with me. You’re over 55 and can qualify for a one-time $100,000 tax exemption of profits on sale of your personal residence, which just equals your net gain if you sell. You sell it to an investor and lease it back for 5 years break even to him. You take your $100,000 and use it to purchase $1,000,000 worth of replacement SFH investments (which for the sake of this example are breaking even on the loans you have been able to assume). What might the results be?
Since this is merely a fantasy, we won’t be too precise, but if you depreciated $800,000 over 20 years that would give you $20,000 in AFTER TAX CASH each year in your bracket assuming that the operating expenses and interest payments just offset the income. If the SFH met National norms and appreciated at 15%, you would have an additional million dollars in equity in 5 years when you might feel like retiring. Since you leased your old house back from the Investor, you never gave up any of the comfortable surroundings you had been accustomed to while you created your estate. Your tax savings can help pay your rent payments. Why would any investor cooperate? Suppose he put up $20,000 and you carried back $10,000 interest only and balance due in 5 years. His depreciation would be $6,000 or $3,000 cash flow in 50% bracket. That amounts to a 15% AFTER TAX return from a passive investment based upon the cash he put down. In addition, his SFH is appreciating at about the same rate as yours, so he will have an extra $150,000 too in 5 years.
Oh sure, you don’t live in that house. You aren’t in that bracket. You don’t know anyone like that. But maybe there is something you can do in your own situation. I did a variation on this theme 2 years ago and believe me it works quite well in Florida.
IN THE POTPOURRI DEPARTMENT:
Here are a couple of good books to read: “All You Need to Know about the I.R.S.” Paul N. Strassels, Random House. Very readable and informative about Audit proceedings. Also, “Inflation Tax Planning”, B. Ray Anderson, Target Publications, San Ramon, Calif. Really a terrific compilation of a range of subject matter relating to estate building and planning, Corporations, Trusts, Gold Clauses, etc.
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