June 1985
Vol 7 No 9
TACTICS WIN THE BATTLES, STRATEGY WINS THE WAR . . . AND THE PEACE
Over the past 6 issues or so we've been taking hard looks at ways to increase cash flows and to capture profits in our investment houses. Cash flow comes from rents and/or paper. To the extent that we can learn to manage income property, we can increase income from rents. And as we gain skill in negotiating for and discounting 'paper', we can garner more cash flow and higher yields. With profit, we combine negotiating skill with our knowledge of 'paper' and income property management so that we are able to buy at a profit. Then we use marketing skills to convert real estate into profitable cash flows or cash. These are all tactical approaches to the subject of income and gain. If we expect to prosper over the long term, we have to be concerned with financial strategy.
When I write this newsletter, I try to offer advice which is oriented toward the 'real world' for most of my readers. Actually, what may be real world for some might be unrealistic for others, depending upon the reader's specific financial capacity and experience with single family houses as investments. First and foremost, I'm defensive! If you were to sit down and read every issue of the CommonWealth Letters you'd see that there's a balance between aggressive acquisition and finance in contrast to conservative asset protection when the market seems hazardous. It would be a mistake to always view the real estate market as one in which profit is automatic and loss a faint possibility. So we've tried to deal with both offensive and defensive techniques for acquiring assets and safeguarding them with as little risk as possible. That's our subject for June.
THE BALANCE OF THIS DECADE WILL BE A TIME FOR STRATEGY . . .
Things are changing faster than most of us realize! Look at how things have changed over the past decade. Ten years ago NO ONE WANTED TO INVEST IN SINGLE FAMILY HOUSES! Now, every traveling road show features 'experts' who've made millions in their spare time investing in houses. For the first few years – up to 1982 – it was possible for even the least experienced neophyte investor to buy a house with a minimum down payment and get both positive cash flow and high appreciation. Then the world turned and assumable loans started to dry up at about the same time that house appreciation started to slow down dramatically. The name of the game changed from APPRECIATION to INCOME and the players who continued to win had to learn a whole new ball game.
Where before, interest-only financing at 9% produced cash flow and balloon notes could be paid off out of the inflationary growth of housing, now, 13½% variable rate loans rob the owners of both cash flow and appreciation – especially where reverse amortization is involved. And it's questionable whether or not there will be any loans available with which to pay off the balloon notes when they do fall due. At these rates, meaningful loan amortization is virtually a phenomenon of the past. Investment in single family houses has become much more speculative and risky for those without experience and knowledge of the markets. Amazingly, thousands of people still cling to techniques of super-leverage and marginal prices as if houses are continuing to appreciate at 1977 rates. They aren't!
Houses aren't the only things undergoing change. Syndication of apartments and office buildings has driven prices skyward, reaping millions of dollars for the promoters . The 'promotees' are already seeing their pie in the sky crumble as Congress threatens to deprive them of tax write-toffs on overpriced properties with record vacancy rates and interest costs. The stock market ran to record levels in 1982, making millions for many only to lose them for others in 1983 and '84. Gold and Silver – a disaster for people who failed to understand that what goes up fast comes down fast in a speculative market. Ditto for investment grade diamonds and colored gem stones, collectables, etc. As a matter of fact, it's possible that the best investment these past 5 years for the small investor might have been cash – dollars invested in T-Bills, Cash Management accounts, money market funds. But not necessarily banks and savings and loan associations. Many of these supposedly safe institutions have gone broke, or are on the endangered list. Their depositors haven't all been saved by FDIC and FSLIC. Ask folks in Ohio.
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SHORT TERM GAINS CAN BE WIPED OUT BY LONG TERM CHANGES!
Before one can devise a long term strategy, one has to develop a premise. That's where the crystal ball comes into play. Anytime you try to forecast the future, you have to make some educated guesses. And guesses are just that – mystical excursions into the land of what COULD be, not necessarily what WILL be. So, in that context, let's consider some of the things that might affect our portfolio of single family houses and real estate 'paper'. We have to include things which affect our investment environment such as GOVERNMENT, DEMOGRAPHICS, INTERNATIONAL INFLUENCES, ECONOMIC CYCLES. And we can't leave out some of the more mundane scenarios like personal problems, natural disasters, man-made disasters. Before you automatically discount these, take a look at some of their recent consequences- such as love canal, three-mile island, polluted beaches. There's more: Let's say that you saved your money and bought some 'fixer-uppers' in a low income neighborhood. You rent them out under SECTION 8 and start getting cash flow. Then you syndicate them, bringing small investors in from the high tax bracket ranks who pay you a profit in return for your leasing the properties back at a specified yield after taxes. You're sitting on top of the world, and you've already used the cash to buy in to an even bigger deal which you hope to roll out of the same way. Enter the government. Over night Section 8 is wiped out in favor of a different program, leaving you with loads of tenants who have been counting on government assistance to pay for their housing.
It couldn't happen to you, right? Once upon a time there was a HUD 235 program which encouraged builders to build houses for subsidized buyers. It was wiped out in an afternoon without any warning whatsoever. A lot of builders bit the dust on that one. So, bear with me a moment and let's say Section 8 could meet the same fate. Hundreds of properties would be affected. Thousands of tenants! Eviction would be nearly impossible as local housing authorities contemplated ways to house all those VOTERS. Courts would be jammed. You'd have a bunch of surly tenants who might retaliate by trashing your houses. But that's not the worst of it. Think of your investors; many of them more or less influential members of your community. Remember, you've guaranteed them cash flow.
Let's really get you into hot water. Perhaps you've heard rumors about a new tax bill which is going to radically change the tax deductions investors can take on real estate. Suppose depreciation and interest deductions were reduced by 25%. That's a reasonable possibility. On the one hand you'd be losing income from rents and on the other hand, you'd be forced to dip into savings to augment cash flow promised to your formerly friendly investors. One false move and someone might accuse you of selling a SECURITY. When you sell a property, promoting the sale by promising profits from the efforts of a third party it could be construed that the limited partnership interest in real estate was also a security, subject to regulations of the SEC.
All of this conjecture is to point up the fact that your financial position is always subject to government policy whether because of subsidies and regulations, interest rates, inflation, rent controls, property taxes, zoning, occupational licenses, health regulations, depreciation schedules, building codes or whatever. And let's not forget condemnation, inclusionary zoning, impact fees, assessments, etc. These can destroy the equity in free and clear properties which might seem to be impregnable. No investor dares ignore government in his or her forecasting if he or she is going to prosper long term.
What are some of the other factors that will. influence the outcome of an investor? What about the people? Don't they pay the rent? Taxes? Vote? The science of studying vital and social statistics is called Demography. Demographics play a critical role when it comes to real estate investment. Consider the 'SUNBELT' phenomenon. As millions of people moved out of the Northeast and Midwest into the Southwest and Southeast, political and economic power went with them. Those areas which gained people also gained economic benefits. Markets improved. Construction boomed, furnishing jobs for hundreds of thousands of newcomers. Districts were re-defined to provide for more Congressional Representatives. More Federal and State money was attracted – even international money.
What about land values? Yon can buy raw acreage in many parts of the country for under. $500 per acre. Not in Orange County, CA, Sarasota, FL, Phoenix, AZ, Boston, MA, Dallas, TX. The difference is people – and their earning power. Conversely, in Akron, OH and many other towns in farm belt areas or where smokestack industries have laid off large numbers of workers, incomes have dropped along with the population. Real estate doesn't command a very big price where people don't need it. The same goes for rents when there'-plenty of space to go around. This can happen even when the population is growing if too many rental units are being constructed. Houston is a prime example of this. Tampa e be too in a couple of years. Knowing WHERE and WHEN as well as HOW to buy is critical.
Investors can't ignore the BIG PICTURE ever! Economic cycles control interest rates and inflation as well as the numbers of people who have jobs and who can afford to buy houses or rent them. For several years I've been warning of the hazards of variable interest rate loans and balloon payments. So long as there's plenty of money, you can always either sell your way out of a hole, or borrow your way out – even at a high cost. But what happens when there's no money to borrow? Neither you nor the person to whom you might sill your house will be able to complete the transaction without credit. The house business is a great consumer of credit. Leverage is what makes real estate possible No leverage, no housing market! So one has to learn ways to predict what interest rates will he long before credit is needed – or learn how to get along without using bank loans at all.
As soon as you start boning up on the economy you'll find out that fortress America has been pretty effectively invaded by foreign money and products. For the past 5 years or so we've been sending jobs and dollars overseas and foreigners have been buying T-Bills and corporate stock. Their factories are here and ours are over there. We're linked economically if not politically. Anytime we can run fiscal deficits and pay for them with foreign dollars which we borrow, we can hold both inflation and interest down. On the other hand, THEY CONTROL BOTH OF THESE indirectly. Should they withdraw their money, we'll either have to inflate or increase taxes and interest rates – or do some of. all three – just to run our country. This brings us full circle to government policy. You can see that the best laid plans, the best properties, the best financing may still not he safe when such powerful economic forces might be arrayed against the investor.
THE PRUDENT INVESTOR DARES NOT OVERLOOK PERSONAL FACTORS.
From time to time I counsel for a fee. The people I talk to usually have financing problems, but more and more I'm encountering personal problems. Troubled marriages, law suits, tax problems, estates, senility, sudden death, loss of job and/or income – these can all be devastating when one isn't prepared. Whether or not you're a student of the big picture, making lots of money in real estate isn't much fun if you have a lousy family life. The sooner you can get your spouse and adult dependents – even your involved as active participants in estate building, the better. I don't know of many truly successful people who didn't have the full support of their families. There's very little joy in this life to compare with the feeling one gets from having the entire family involved from start to finish in successful entrepreneurial enterprises. And it
makes a lot of sense from both an estate planning and a tax strategy point of view. The best joint venturer you can do business with is your spouse and/or offspring IF you've given them a chance to grow with you, participating in the rewards as well as the effort.
THE HIGHER YOU RISE, THE FARTHER YOU HAVE TO FALL – AND THE EASIER IT IS!
If you think making money is challenging, wait until you have to start KEEPING it. We've covered some of the more obvious threats to your well being and keys to success as an investor and entrepreneur. There are others which are more insidious. They can be invisible. They're based on ENVY. As you move ahead of your peer group, your relative progress toward financial security will be resented by some who can't keep up. You've got to be prepared to defend your position against the raids of those who would deprive you of your hard earned gains. The simplest way to do this is to maintain a low profile.
Take a look at all the 'junk mail' you receive. Think of all those strangers whose lists you're on. How do they get your name and address? From the start, I've made it a policy not to sell names of my subscribers and students in order to protect their financial privacy. But selling of lists is big business. When you fill out a credit application in a bank, when you use your credit cards, when you make long distance calls, when you cash checks and send in warranty cards, when you buy airplane tickets, you leave a record of your transactions which virtually anyone can have access to. Is that wise?
In the past year here's what has happened to several of our subscribers. In one case, a tenant got a class action suit filed on behalf of all other tenants against the landlords. They lost all their property and now face criminal charges. In another case, a subscriber's child injured a playmate accidentally. A million dollar law suit was avoided because he'd taken the precautions of keeping his portfolio private. Success has always used privacy as a cornerstone in it's foundation. For that reason, we've been recommending the use of Trusts and Corporations for holding title to real estate. Family strategies work particularly well as a device for protecting ownership. This is an area which you shouldn't overlook, and one which can combine effective estate planning as well.
One of the really interesting things you should be learning to do is to make forecasts of your income and expenses, plugging in special events like balloon notes you might be having paid off or which might be falling due When you receive those payments it could trigger large taxes. When you have to pay them, it could trigger something worse. You could default and lose your property. If you can't pay your taxes you could still be in trouble. An IRS jeopardy assessment lien could wipe out your liquidity and equity. So financial management is a critical aspect of successful portfolio strategy too.
