April 2008
Vol 31 No 7
Every kid knows how seesaws work. One end goes down when the other goes up. When a heftier kid gets on one end, it doesn’t work as well until another kid who weighs as much gets on the other end, or two kids get on the other end, or the heavier kid moves up toward the center, or the lighter kid moves backward to equalize the weight differential. If adjustments aren’t made, nobody has much fun. The housing market works like a seesaw, but in a more complex manner.
When prices are rising swiftly and thousands of dollars of equity are being created each year, there are plenty of buyers to buy existing and new housing with the easily obtained credit. When interest rates go down and credit is easy to qualify for, demand for houses continues to drive up prices. Speculators enter the market in the form of aggressive lenders, rehabbers, buy/sell dealers who compete to get their share of quick and easy profits. This drives the prices up even further.
Sooner or later, somebody notices that houses are overpriced and they rush to sell out at the top. A stampede to get out ensues as others follow suit. Unsold inventory grows. Time intervals between purchase and sale stretch from weeks to months to years. Speculators, who counted on quick, easy, effortless profits, can’t afford the holding costs. They begin defaulting on purchase contracts. Lenders cut back on loans to all but the best qualified mortgage applicants. This leaves the market largely comprised of buyers who will be owner/occupants rather than investors or speculators. Today, we need to find a way to get on the high end of the seesaw.
With slowing sales, builders start cutting back on new construction, laying off workers, and disposing of existing inventory at deeply discounted prices. This further depresses the housing market. Sales in many related industries fall along with profits. Many are caught with high expenses and loan carrying costs. Those most affected are real estate Brokers, Speculators, Mortgage Lenders, Mortgage Investors, land developers, builders, and companies that are heavily committed to this segment of the market. They begin to lay off workers. As workers are laid off, wages and disposable income also falls. This combination of events causes the market to continue its downward spiral; but a few entrepreneurs benefit from this.
As the supply of “for sale” housing goes down, demand for quality rentals in good neighborhoods goes up. In addition to those who have traditionally rented their housing, the rental market is expanded by prior home owners who have been foreclosed and residents of multi-family units who now have an opportunity to move into better single family rentals. Capable landlords with attractive houses in decent areas are able to increase rents and occupancy rates. In contrast, landlords with little training, experience and ability such as builders, speculators, and lenders make things worse. Finding themselves with unsold inventory, they offer houses for rent at low prices to help them survive. This creates price competition that drives rents down while further squeezing landlords with marginal rentals.
Even with low interest rates, with the press full of stories of rising home foreclosures and impending recession, buyers are less prone to borrow, and lenders are less prone to lend. At the same time as the housing industry is beset by a sea of troubles, local areas, municipalities, cities, counties, States also see sales and income tax revenues fall off and demand for social services brought on by the general financial distress rising. Property taxes are increased to make up budget shortfalls. After a devastating sequence of hurricanes, earthquakes, fires, and tornados that create billions of dollars in insurance claims, insurance companies double and triple their premiums. As property taxes and property insurance shrink net cash flow, landlords’ ability to make mortgage payments falls. Their loan defaults also begin to rise. This creates a unique opportunity for opportunists.
CAST YOUR NETS ON THE OTHER SIDE OF THE BOAT . . .
What do those who are negatively affected by the slumping housing market all have in common? Short time horizons! Buying for the short term made a lot of sense when a person could borrow almost all the money needed to buy a house and get it ready for sale, then sell it within just a few months. Today, in this new housing market, that strategy is no longer viable. In the short term, the market promises to be very volatile, but when a house is bought for to hold for several years, all the short term excursions in price disappear. The key to being able to buy houses that can produce net cash flow as rentals is to buy at very deep discounts to reproduction costs, and to finance them with low payments.
One factor has remained constant in the changing markets: Thirty year, fixed rate, fully amortizing, low mortgage interest rates have remained available to qualified home buyers; including investors and owner-occupants. Despite all the turmoil in the mortgage markets, under Congressional pressure, these mortgage loans are still being offered by lenders. They’ve even started aggressively advertising low interest rates to qualified borrowers. This bodes well for those who buy homes to rent out at the current deep price discounts and easy payment terms. Now is a good time for investors to shift their focus from short term to long term holdings.
Let me make my case for creating wealth buying houses for the long term:
1. Despite the fact that house prices in some areas have always come back after a drop, because the extent and degree of the most recent housing boom was unprecedented, nobody really knows how high these prices will come back in the near term future; or when they’ll start up. Speculating in today’s market that you’ll be able to sell at a profit in a few months is a gamble that could wipe out any savings and credit you might have left as a result of the current housing price collapse.
2. Of the benefits of income, depreciation, equity build-up, appreciation, and liquidity that single family house ownership provides; short term appreciation and liquidity are uncertain at best except for those who are able to buy far below even today’s market values. Even then, dealers can only earn profit by selling at prices and/or on terms that are far below the current market. Tax-sheltered loan pay-down offers the most certain way to create equity with the least effort and risk.
3. In the midst of a very political year, promulgation of false hopes based upon false promises of politicians who haven’t yet gained office make speculation even more risky. Today, the economy resembles that of the Johnson Administration that tried to pay for a war and social programs by increasing debt. This led to “stagflation”, which is a combination of stagnation that costs jobs and growth and inflation that wipes out the purchasing power of money; causing all prices to rise. Johnson was followed by Jimmy Carter who tried to jump-start the economy by printing money and giving it away in his own version of today’s economic stimulus package. That drove FHA interest rates to 17.5% and wiped out what was left of the housing market. Capital gains rates rose to 50%. Ordinary income was taxed as high as 70%. As a long term investor, I saw my equities driven up by thousands of dollars a week, but buyers couldn’t qualify for high interest rate loans so I could cash out.
4. For 20 years following the Carter years, prices in my area only rose about 3% per year. Nonetheless, rents soared over 300%, and cash flow rose accordingly.
5. In one area where I held houses rents remained weak and prices stayed flat for two decades. Despite this, equity continued to grow because of mortgage pay down. Despite having miniscule appreciation and having virtually no net cash flow after paying for management, when I finally sold these houses, in addition to tax write offs, I netted over $300,000 with very little personal effort or risk.
6. As an investor rather than a dealer, I was able to exchange the profit I made tax free into another, more dynamic, investment market where it continued to grow.
LONG TERM INVESTING CAN CREATE CASH FLOW AND BUILD EQUITY . . .
Despite the current housing slump I don’t see anybody earnestly trying to exploit this market except investment banks and institutional investors. One school of thought is that it’s better to sit on the sidelines and wait until prices start up. This isn’t a bad strategy if safety is your primary concern over potential profit; but sitting on the sidelines waiting for the recovery could cause you to miss one of the best markets for long term investors in twenty years.
Put yourself into the position of a frustrated seller who can’t find a buyer; would you be more willing to sell when you perceived that house prices were going to fall further, or when you saw a price recovery start back up? My point is that, if you started buying at deep discounts today, prices might indeed fall further, but you could be able to make a better deal today from motivated sellers.
Let me give you an example: As a long term investor, while price is certainly important, payment terms have a much more profound impact on cash flow from rents. Without regard to the costs of taxes and insurance, a 30-year loan to buy a free and clear $300,000 house for $270,000 would cost you about $1425 per year if rented for $1500 per month. At the end of five years, if the price returned to $400,000, you’d net about $123,000 profit once negative cash flow had been deducted. This isn’t a bad return on your investment if you can afford the negative cash flow.
On the other hand, suppose you paid $330,000 for the same house with zero interest rate seller financing, $1000 per month payments, and a balloon payment for the balance in 60 months? This could create $500/month, or $6000 per year positive cash flow. Now, if you negotiated a $1000 credit against the $330,000 price for 60 months, when you added this to your $500 per month in net cash flow, you’d wind up $160,000 richer when you sold in five years; and you’d have been much safer. More importantly, you could buy many more houses safely when you motivated owners to give you the terms you needed in return for paying a much higher price.
This was just an illustration. Few houses will be free and clear. Few owners will be willing to make a deal this way. On the other hand, in this short lived buyers’ market, you need to stop thinking that you have to pander to sellers who don’t understand their situation. When a seller won’t negotiate, move on to another house. You won’t have any trouble finding lots of owners willing to make a deal if you begin a methodical system of direct mail, bird dogs, leads from lenders, and legal notices, etc.; rather than merely relying on Brokers and signs for leads.
Owners who are making payments on empty houses are much more flexible than owners of empty free and clear houses, although both would welcome offers from a reliable person to lease their property with the right to sub-lease. This market includes lenders, private mortgage insurers, and HUD. Sandwich-leasing property on a performance lease with net cash flow is the fastest and easiest way to catapult your cash flow; but only if you know how to manage single family rentals. There’s a lot of room to trade off the “spread” in your rents to an owner for an Option to buy the property at a later date once the market resumes. Here’s how that might work:
Owners of houses with low payments might easily afford to allow you to earn a profit by paying them less than market rents. Owners with negative cash flow rentals might not be able to afford your lease, but they can afford to share the equity you are protecting. One person I know agreed to pay $300 more than market rents to a distressed owner in return for a credit of 100% of the $1800 monthly rents against the cost of an Option to Purchase the premises for the current discounted $360,000 price. In lieu of being paid to manage, he was paying $3600 each year to build an Option equity at the rate of $21,600 per year. How would you like to make 600% per year on your investment? So would other investors. If you can make this deal, you should have no trouble finding a Roth IRA or a high income bracket investor to put up all the negative cash flow in return for half of the Option equity. You’d still have enough profit left to induce a professional manager to do all the work for some of the eventual profit created by your rental credit.
CONVERT EQUITY TO LONG TERM INCOME!
If you ask any group of real estate entrepreneurs what they least want to do to make money, their universal reply will be “management”. I don’t know how management got such a bad reputation among those who don’t want to do it other than that, well, they’ve usually never done it; they’ve just heard others talk about it.
On the other hand, ask single family property managers how they feel about property management and they’ll almost always agree that, year in and year out, it’s the most fruitful part of the single family house business. Only by actually learning how to manage well, then applying the management insights gained, can a person really make a valid observation about whether management is good or bad. Having said that, this next portion is for those who absolutely refuse to manage. How can they make money?
When I first opened my Brokerage office, my next door neighbor had been buying and selling houses for three decades, in good times and bad. His cash flow had been in the top 1% of all Americans during the entire time. How had he been able to do this? He sold his houses at low prices on thirty year interest-only installment contracts with small down payments, low payments, and high interest. He built in severe pre-payment penalties for early loan payoff. The combination of a high interest rate and pre-payment penalty returned him any profit he had foregone when he sold a house for just a little more than the price he had paid for it.
Earlier, I mentioned some of the benefits of house ownership among which were appreciation and depreciation. When you sell a house, ordinarily you would lose these; but put things into perspective: Depreciation is merely a form of tax rebate to help keep a house repaired. When you sell a house, you no longer have any responsibility for maintenance, so the cash flow from interest is probably better than a rental could produce once depreciation had been deducted from actual operating expenses. What about appreciation? When pre-foreclosed houses are deeded back to the lender, all the equity over the loan is also surrendered; thus the lender gets the imbedded appreciation and can re-sell the house at the higher value.
What about other benefits. Absent of depreciation, interest income boils down to rent on money instead of on houses. Buy houses that are financed on terms that allow you to wrap existing loans; then sell them on unrecorded installment contracts. This way, you can create net income well in excess of the loan payments.
What about liquidity? Your contract should allow you to re-finance the house whenever you want to so long as the new debt doesn’t exceed the amount owed to you. In a pinch, you might also “pawn” your contracts at your bank for quick cash.
What about mortgage pay down. Remember, by selling on interest-only terms, the buyer’s mortgage is never paid down. On the other hand, out of the interest received, you’ll be paying down underlying loans and reducing the balance.
What about dealer taxes? A dealer pays ordinary tax on sale profits. If you bought and sold at cost, there would be very little tax owed at time of sale. As a result, you’ll be taxed on your high interest only as it is received.
Now and then I sell houses on contracts, but I add a few wrinkles. First of all, I don’t sell houses; I put houses into Land Trusts and sell the Beneficial Shares on installments. Under the Uniform Commercial Code, I can repossess a property without going to court rather than having to foreclose it. Moreover, by not selling the house itself, I don’t have to concern myself with property tax re-assessment, difficulty in obtaining new insurance, Due-on-Sale, recording and transfer costs. I obtain Title Insurance in the name of the Trustee of the Trust, and successor Trustees, so don’t have to buy extra insurance. I index both the interest rate and principal balance to the Consumer Price Index so that inflation can’t wipe out equity or the purchasing power of my income. Couldn’t you do this?
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