July 1990
TAKE THE MONEY AND RUN . . .
In last month's letter my emphasis was on my forecast for the next few years and ways the market would change. Going way out on a limb, I predicted that the coming near term might include tough times for real estate investors with indexed loans, marginal cash flows, management problems, burnt-out tax shelters and limited cash reserves. On the other hand, I also predicted that there would be dazzling opportunities for most of this decade. What's going on? Am I talking out of both sides of my mouth? No! The paradox is that, people with highly liquid positions will be able to jump either way to the side of profit as it's perceived. People who are locked into marginal investments will have to bite the bullet until things improve. So it boils down to how deep your pockets are.
George Plimpton's book 'PAPER LION' deals with football. In it a character says, 'We never lost a game. We just ran out of time.' That's true of many investors too. All they needed was another month or two of cash flow in order to hold on. Alas, it wasn't forthcoming and the ax fell along with their financial security. In the coming decade, it will be critical to survival to establish 'staying power' – even to be able to buy into the major distress opportunities that will be presented by those without staying power – so as to reap the fortune awaiting in the last two thirds of the twentieth century. In this Letter, we'll try to focus on ways to liquidate, hold the cash safely and to reinvest it wisely at the right time.
One of the criticisms leveled at this letter is that it seems to deal more with those who already have assets, rather than with those just starting out. From time to time we do publish issues focusing on the basics, and we make all previous issues available at pennies per page together with a comprehensive index especially for those who'd like to be able to study wealth-building techniques over the years. Furthermore, we also do seminars dealing with the fundamentals at very low prices to help get newcomers up to speed. In this issue, we should start with the basics of establishing a cash reserve – just for the beginners.
CREDIT IS FOR GENERATING PROFIT AND SAFETY – NOT FOR CONSUMPTION
Rule #1: Don't Borrow Short and Lend/Invest Long! Look around you at all those Banks, Insurance Companies, S&Ls, your Government, wiped-out investors. Possibly 90% of them fell victim to violation of this rule. Here's how it happens. You find the perfect deal, but the seller has to have cash. So you rush down and sign personally on a short term or demand note and buy real estate. ILLIQUID REAL ESTATE. You anticipate being able to refinance it long term to pay off the note, but fail to get the loan because:(a) With the new acquisition indebtedness plus your short term obligation, you're no longer a good credit risk and can't qualify. (b) Lenders are 'loaned out' as a result of heavy loan demand or lending restrictions indirectly applied by FED policy. (c) Interest rates pop up and the feasibility of your acquisition falls off. (d) They discover asbestos, formaldehyde, boll weavels, the snail darter or old Indian bones in your property so it can't qualify. Whatever the reason, you're stuck. Government is in exactly the same position when it borrows money on 90 day T-Bills and uses it to build dams. But it can print more money. You can't.
Rule #2: Don't Borrow Money at a Cost Which Exceeds the AFTER-TAX Yield the Borrowed Funds Can Produce. Here's the trap. You borrow on an adjustable rate mortgage against the equity on your residence (deductible sometimes) and invest in real estate with a negative cash flow after depreciation (non-deductible sometimes). Even at a bargain
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price, you can still lose money because the NET ?RESENT VALUE OF THE MONEY SPENT IS MORE THAN THE DISCOUNTED FUTURE VALUE OF THE MONEY RECEIVED. Remember, each dollar of negative cash flow increases your investment and lowers your yield. Each dollar of positive cash flow only increases your yield to the extent that you use it to obtain a higher yield or to nay down debt. If you spend it as profit, you're actually moving backwards toward destruction. Which brings us to rule #3:
Rule #3: Never Use Borrowed Money as if It Were Earned Income or Capital Gain while you're building your estate. Of course there are exceptions, but they should be rare. If you learn to borrow money to live on, you'll wind up like the tiger who started eating cows instead of hunting antelope. Like him, you'll lose your hunting skills and become dependent on easy kills. And like him, you'll begin to pick up some enemies. His in the form of irate herdsmen. Yours in the form of irate creditors, should you not pay them back. Exceptions: LIFE-THREATENING EMERGENCIES (you know, like failure to pay rent on time). As a part of an arrangement in which you borrow the money WITHOUT RECOURSE and someone else pays it back. (I've bought houses by getting the seller to borrow the cash he needs from his bank, then wrapping the loan in my payments back to him each month. This way he can spend his borrowings and let me pay it back out of the proceeds of the rents I collect. But in last month's letter, we pointed out this could be ruinous.) Possibly at the time you start to harvest your real estate wealth, you might decide to refinance to generate cash which the rental will repay comfortably, and thus keep the property in your estate for your kids.
Rule #4: Borrowed Money Isn't Tax-Free! Let's make this one easy. Suppose you inherited a property at market value, then borrowed against it on a 30 year loan. Income from the property comfortably repays the loan WITH TAXABLE FUNDS to the extent they aren't deductible. And principal payments can't be expensed against income. If you borrow against property where the term of the loan is greater than the term of the depreciable life – or place secondary financing on the property, or refinance it – you'll wind up with MORTGAGE IN EXCESS OF BASIS. You'll get to repay that at the time you sell. Proposed legislation would make all depreciation RECAPTURABLE IN CASH IN THE YEAR OF SALE. Wonderful. How do you pay for taxes due on an installment sale when your buyer buys with a small down payment?
Rule #5: Borrow Ahead of Actual Need, Safely and Prudently. Let's say that you agree with my forecast of a tough credit market looming just ahead. Prepare a financial statement based upon CURRENT INCOME which you can reflect as extrapolated on a trend line into the future. Obtain a line of credit and negotiate a roll-over at the same time into a long term mortgage at your option anytime it's called in. Identify the specific collateral and get the lender to accept it provisionally against that contingency. REMOVE THE FUNDS FROM THE LENDING INSTITUTION as soon as you can do it without exciting anyone – along with any other funds held in your name – and buy T-Bills or short term CDs in a sound bank. Borrowing from a weak lender can be as bad as putting your money into a weak bank. If either fails, you're in trouble when RTC steps in. They can modify commitments and Bankruptcy cancels contracts. By removing the funds, your cash reserves will be safely out of harms way for YOUR SECURITY, not the lender's.
YOUR TENANTS ARE YOUR BEST PROSPECTS . . .
Every December I review my rental properties. We look at the new property taxes, insurance costs, general condition, tenant performance, and anticipated costs/revenues for the next year. I TRY TO ELIMINATE MY LOWEST 10% OF PROPERTIES. I construct a HIT-LIST. When the overall picture indicates that values are peaking out, or that major overhaul is needed, or that desirability is marginal, or that cash flow yields don't measure up to my overall averages; the house is a candidate for liquidation. From a business standpoint, I can plan whether or not to use tax-free Exchange techniques; generate capital gains to add to my passive activity income which my passive losses will offset; use installment sales to spread my taxable event, or to take the money to build liquidity and pay taxes.
My next move, while working out possible rent increases versus improvements I intend to make is to write the tenant a letter offering to sell the property. Ideally I'd like to go to contract in December, close shortly after the start of the new year so that the taxable event will be counted in the next following year. On the other hand, I can also trigger the tax in the current year simply by selling on a short term contract. Say the property is 575,000. I can offer it to the Tenant with a low down payment. In some cases he can use his deposit plus a Note. Then I can elect OUT OF INSTALLMENT SALE REPORTING for that year. In the next year, the contract can call for his refinancing the property and paying off the contract. Thus, I can use the positive income to cover any negative cash flow write-offs that I might otherwise not have been able to use in the current year.
Let's take a closer look at that contract. First of all, FEE TITLE DOESN'T TRANSFER to the tenant/buyer, only EQUITABLE TITLE. That means that any problems that might be associated with property ownership remain with me. On the other hand, if I were nervous about a particular tenant's activities – say he's storing radioactive waste on the premises – I might be much happier selling to him on a short term Note and Mortgage or Deed of Trust with the same terms. This way, the EPA can go talk to him. My position would be that of an innocent mortgagee. Furthermore, a Note/Mortgage would be easier to sell to raise cash if that were to be my intent. Again, there's a timing advantage to consider. I might choose NOT to elect out of installment treatment in the year of sale, but want to trigger the tax in a subsequent year. I can do this by selling the Note at a market rate discount through a Broker or use it to buy more property. It's as if I'd received cash, and the taxable event is triggered. Knowing timing strategies can be quite valuable in structuring transactions to produce the maximum after-tax cash.
If my aim is to create liquidity, then I can either take my buyer into the FHA or VA Loan market, Farm Home, Conventional Loan markets or private loan arena. In either case, I'll have to meet the underwriting standards of the SECONDARY MARKET into which my buyer's loan will later have to be sold. My first move is to contact a professional MORTGAGE LOAN BROKER. He gets paid on commission of CLOSED LOANS. Unlike the institutional loan officer who works on salary, my broker has a vested interest in helping my buyer get a loan which will yield me the most cash. I count on this and rely heavily on his advice. If he has a source for private financing, we structure the loan terms to give it the highest value when sold to that source. For example, a 3 year loan, 13% interest only with a balloon might yield a lot more cash than a 15 year loan, fully amortized at 14%. He'll know. In like fashion, he knows who the wholesale buyers of private paper are.
By doing all of the work and keeping things simple, my Tenant will only be involved to the extent that we have to gain access to the property to make improvements and for the Appraiser. As soon as we can, we ring the Title Company into the act. In many areas, people elect to use closing attorneys and escrow companies. Regardless how you do business, make sure that a true professional is handling things. Don't pay someone to tell you that you can't do something. Pay them to explain the problems and to tell you how to meet your goals despite them. Look for people with sufficient staff to complete the necessary documentation per your instructions as quickly and as accurately as possible so you can close the loan quickly. Delay can sometimes cost a sale, especially when points and interest rates are changing or loan money under the program you're using runs out. You want all members of your closing team to work smoothly together and to have a sense of urgency. This includes those who are making the improvements on the house.
If we can get top dollar on our price, we're willing to accept property from our buyer as part of the price and the down payment ONLY SO LONG AS THE LENDER ACCEPTS THIS AS MEETING HIS REQUIREMENTS. In some instance, we'll BUY something from the buyer, so long as he uses the funds to buy the house. We never lend him a down payment. Too risky.
DON'T SELL THE STEAK, SELL THE SIZZLE . .
People sell problems, they buy dreams and satisfaction. Unless you're trying to appeal to avarice with 'bargain sale' advertising, you'll do a lot better proclaiming the BENEFITS OF OWNERSHIP. These include UTILITY, CONTROL, SECURITY, PRIDE OF OWNERSHIP, INVESTMENT YIELD, STABILITY – maybe INCOME, PROFIT, TAX-BENEFITS. look through the acs in the paper. You'll see lead lines like 'Family Kitchen', 'Room for Kids', 'Nothing Down', 'Rent-to-Own', 'A 5 Iron from the Fairway', 'Fish from Your Own Dock' 'Private Retreat'. My all time best ad was generic. It applied to everything I had to sell, i.e.
NO CASH NEEDED – with good credit. Buy this family home and move in today. Use spare time work for a down payment. Payments like rent. Start building your future TODAY.
We sold on a lease/purchase plan under which they moved in (filling a vacancy) with rent the same as their projected payments. We let them sign a contract to paint and do enough cosmetic improvements to meet financing and appraisal requirements, paying them on a contract basis sufficient to meet the down payment needed. These payments were endorsed back into escrow with instructions that they'd be given to the seller (us) in the event the sale didn't close for any reason. The cosmetic improvements were added to the cost of the property, so we weren't really out of pocket at all. The buyer either got a house in excellent condition to buy, or to rent. In the event the sale fell through, the costs of the improvements were returned to us from escrow. We discovered that buyers who do their own cosmetic improvements rarely abuse them afterwards even as rental tenants.
To attract buyers, you can offer to GUARANTEE THE VALUE for as long as they live there in return for a share of the profits. After the closing, you give them an Option to sell the property to you for what they paid for it, with you taking title subject to the original loan balance remaining and paying them their principal payments (a PUT). And they give you an Option to buy the property for a price .5 way between their original cost and fair market value the day they move out for any reason (a CALL). This works well in the case of service personnel who are subject to transfer with short notice. If the loans are non-assumable, structure your Option as an Option to LEASE/PURCHASE.
Don't overlook EXCHANGING as a way to liquidate. Once I made an Exchange of a free and clear house for 15 houses with about $5000 equity in each. Then the other party sold the free and clear house, realizing about $60,000 NET on a quick bargain sale price. He went to cash. I acquired 15 appreciating (I hoped) properties with rental income. If you have too many highly leveraged properties to refinance for liquidity, try this yourself. From the other side of the deal, consider how efficiently I acquired 15 houses compared to actually going out and locating, negotiating for them and paying for them one at a time. Please note that I DIDN'T DRAW DOWN MY CASH RESERVES TO ACQUIRE THEM, I USED MY EQUITY.
Don't be afraid to AUCTION properties for a quick sale. Use a PRO! Someone who can attract a field of qualified buyers who are motivated to buy. On a gross level, it might look as if you're paying too high a price for liquidity, but when credit is tight, this might just save your life. In the FHA market, it could take 60 days to close a sale. Suppose you paid 6 points to the mortgage, 7% commission, 3% out-of-pocket closing costs, 5% fix-up to meet FHA specifications. You'd be dollars ahead to auction it for 75% of value. One fellow we knew had over a hundred properties being foreclosed. His auction terms were for the buyer to cure the default and assume the loan. He sold them out completely in 30 days and walked away with over $200,000. The regular sale market wouldn't have been able to respond with the speed he required and he'd have lost it all. Keep this in mind.
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