January 1990
Vol 13 No 3
It's the last second of the ball game. Only time enough for a field goal attempt. The snap. Placement. The kick goes wide of the goal and the game is lost. But wait! Flag on the play. Defensive penalty. The down goes over. This time the kick is good. We win! If the 80s attempt at success went wide for you, the 90s offer a second chance.
This letter is addressed to all those people who've been frustrated in their quest for success. Those who've been misled by false prophets/profits, empty promises, elusive opportunity. Those who've learned that there's no such thing as a free lunch. Those who've paid their dues with negative cash flow, management stress, rapacious tenants and indifferent courts, confiscatory taxation and seductive financing. Bankruptcies. Forced liquidations. Fraud. The coming decade offers redemption for those who've become lean and mean, and who are ready to charge into this final decade of the 20th century with the will to win.
I think a repeat of the 70's is a distinct possibility for single family houses. Remember, we started with 7.5% mortgage rates, these rose to 11% during the OPEC crisis, then fell back to 8.5% by late 1975. The Jimmy Carter inflation drove them back up as high as 22.5 percent in some areas by 1980, and along with them, the rate of house appreciation which reached 3% per month in several areas, But it will be a different ball game this time around. Both the financial playing field and the tax environment are radically different. We'll need to adapt our techniques to accomodate these changes.
EDUCATION + EXPERIENCE + COMMONSENSE = SUCCESS . . .
By now most readers realize that some of the catch phrases like 'NOTHING DOWN', EQUITY SHARING', 'PULLING EQUITY OUT TAX FREE', 'TAX SHELTER' and 'SUPER LEVERAGE' aren't going to create real wealth. They've learned this through bitter experience which cost them years of sacrifice and effort. Someone once said that education is what you get by reading the fine print. Experience is what you get by NOT reading it. There's another maxim worth repeating: 'Never ask your barber whether or not you need a haircut'. It's pretty hard to gain any worthwhile education from someone who's trying to sell you something in the process. And it's equally difficult to gain any true insights into the world of real estate solely by attending classes and reading books. How would you like to take an airplane ride with a pilot who'd learned to fly through home study?
Yet another cliche: If it looks too good to be true, it probably is. Very few rental properties can be operated profitably with less than 50% of the gross scheduled rent being allocated to operating expenses, vacancy, management and credit losses, repairs and reserves for replacement of capital items, yet how often do you see them presented as break even when rents just equal loan payments? Single family houses and mobile homes are an exception because of favorable tax, financing and management savings, but some apartment complexes can be even more expensive to operate. For the 90's, we've got to be brutally realistic about listening to our own intuition before blindly accepting the word of expert appraisers, lenders, management firms and brokers as to the merits of a particular property.
We're going to have to un-learn some things and to re-learn others. During that runaway real estate market of the 70's, we could assume fixed rate low interest loans without any personal liability. We rarely encountered rent controls. FHA and VA loans were fully assumable without limitation. EPA clean-up liability was unheard of. So were tenant claims amounting to million dollar law suits. We didn't have Section 8, but we did have HUD 235 houses. We had 70% tax brackets, but unlimited real estate deductions to offset them. Now we have 33% brackets with very limited real estate deductions for non-active owners. Back
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then we had favorable capital gains rates and unlimited use of installment sales to spread them out over several years. Today, we've lost those favorable rates and Dealers are denied access to installment sales for tax purposes. We're going to have to face life with 27½ and 31½ year depreciable lives, Alternate Minimum Tax and special audits of 'tax shelters'. We will start using Corporations and Trusts to hold title more and more in our strategies. So we'll have to become involved more deeply in our own tax planning, tactics and documentation.
As owners of property, we'll have to become professionally qualified as managers simply because it will be more and more difficult to find others to do this for us. In 1990, only 10% of excess passive losses will be deductible against other income. Getting property on a paying basis will be the only way to fly. We'll find computers becoming indispensable tools both in property management and tax management. We'll use them for analysis of older properties to determine when to sell them or to raise the rents. We'll use them for instant access to prospective tenant credit reports. We'll analyze property performance before we decide to buy it to make certain we're not paying too much. We'll prepare tax reports on it.
As buyers of property, we'll reap a cornucopia in distress-sale offerings as RTC (Resolution Trust Corp.) begins to unload over $200 BILLION in properties held by them as a result of the bank bailout. The Federal government is the world's largest seller of property in distress. They've only just scratched the surface. Bank and S&L failures in the Northeast and Sunbelt could double the cost of the bailout. Insurance company real estate defaults will create a competitive distress sale environment in which both small and large investors will be able to participate at pennies on the dollar. Even now, in parts of the energy belt, much of the bail out money is going to property management and security firms who charge high fees. Over a Trillion dollars held in pension funds is available for financing purchases at bargain rates for those who can find ways to create joint ventures with fund managers and trustees.
IT'S TIME TO IMPLEMENT THE BLASH STRATEGY . . . BUT IN REVERSE!
Don't BUY LOW AND SELL HIGH! Instead, SELL HIGH AND BUY LOW. Or SELL LOW FAST AND BUY LOWER. With literally millions of properties coming on the market in the biggest fire sale in history, the market price of all non-user real estate will be driven down. In good neighborhoods near attractive amenities, good jobs and schools, transportation, etc., single family houses will retain their value because of personal preferences of their owners. But in the world of investment, there's going to be some turmoil. And turmoil creates lots of opportunity for the person who can bring CASH or who can use PAPER effectively. In 1986, we advised you to sell out ahead of the new tax act and buy back in when prices dropped. We sacrificed houses at 75% of value in order to get cash. We bought back in at 25% of original price in the Texas market within 2 years, using the cash we'd raised. That's not a had plan today. We've already started by soliciting our tenants with offers to sell at bargain prices.
Whether you're selling out in order to position yourself for the new opportunities or whether you're merely retiring to the sidelines by 'harvesting' your equity crop, your best prospect is that tenant whom you've carefully qualified and selected as a potential buyer of your property. Over and over we've stressed that you should be investing in houses that would attract decent people. And we've followed that up by emphasizing the urgency of carefully screening tenant applicants as to their incomes and credit qualifications so that they would be able to qualify for a new loan and buy your house should you decide to sell. Those are the people we're now approaching.
Here are some steps you should take in the selling process. First, spend some money to give your house real curb anneal. Sod. Paint. Repair of broken walks and drives. Shrubbery, fences, stucco, trim all are highly cost effective. Inside, upgrade carpets and replace shabby vinyl in baths and kitchens. Re-glaze or use the new coating techniques to make bath tubs appealing. Re-tile and/or re-grout showers and back splashes. Re-paint or up-grade appliances. Put on a new front door and shutters, light fixtures, cabinets and/or counter tops where needed. Get the tenant to help and pay him/her with the understanding that the money paid will be used as the down payment on the property. Make certain that you don't run afoul of HUD and VA regulations in the process. Then locate a good MORTGAGE BROKER.
GOOD MORTGAGE BROKERS ARE HARD TO FIND
Let's say that you've done all of the above. Now you want to get your buyer to qualify for a maximum loan at the maximum price. You want to explore ways to 'buy down' interest rates, lower down payments and closing costs, close as quickly as possible with the minimum hassle and frustration to either yourself or your tenant. The Mortgage Broker that you choose will be the key to all of these objectives. The one I use has been in the business for 20 years. He's specialized in FHA and VA loans – which cover the price range of the houses I'm selling. If you're selling different priced properties, find a broker who specializes in the kind of properties you're trying to sell. The point is, that you want to locate a CAN-DO broker who has many sources of funds, both institutional and private. If you're lucky, he'll also have entred into some of that PRIVATE pension fund money. And he'll know where you can convert any 'paper' you carry on a sale into cash at reasonable rates. He'll be able to SERVICE any paper you decide to carry yourself in a sale. He'll be able to find 2nd mortgage money when it's needed. And he'll be able to give you 'drive by' appraisal estimates to help you plan your sale. He can be invaluable to you. Don't abuse him/her.
Suppose you don't want to encounter the extra expense and/or delay of institutional financing and decide to carry back the loan on a property sale yourself. First, decide what your objectives really are. Do you intend to hold the paper yourself? Then you'd be certain to INDEX it someway so that inflation wouldn't wipe you out. We've discussed the mechanics of this in prior letters many times. You can refresh your memory by re-reading the back issues. ($174 for a complete set through 12/89) But, suppose you just want to induce a sale with the most attractive terms to the buyer. Then you'd concentrate on payments that he/she could afford. I once sold a house on an installment sale (land) contract under which the buyer signed a note for $3000 payable at 12% interest only for 5 years and balance due ($30 per month) with full personal recourse. Using that as the down-payment, I sold the house at only $75 more per month than he'd been paying for rent, and secured the $3000 note with the contract, holding both the contract and the note in escrow pending full payment. The contract called for refinance and full payoff in 5 years or at any time the buyer failed to occupy the premises or conveyed any interest in it. I put in a 10% discount for early payoff within the first 2 years to give him the incentive to refinance it. This would enable him to find a 90% loan. And I gave his name to my mortgage broker who regularly solicited him to refinance the property. But how would I arrange the loan if I were looking for CASH?
First, I'd check with the mortgage broker to see what the market for new mortgage paper required. Then I'd get him to assist me in structuring the paper so that it would be either tailored to a specific investor client of his, or so it would have the widest possible market appeal yet still be attractive to my buyer. In general, the market likes SHORT TERM, WELL SECURED, HIGH QUALITY paper. That means that the buyer's credit rating should be tops. Having additional collateral added to the mortgage, or co-signers or a buy-back guarantee by the note seller might add several thousand dollars to the sale price and cash proceeds. The advantages to selling property on paper, then selling the paper are that the house might sell AND CLOSE faster, more easily, at a higher price to more potential buyers. The downside is that there will be generally LESS CASH proceeds because of extra layers of profit being used up by both the broker and the ultimate taker of the paper, there could be the risk of any buy-back guarantee too in the event the property buyer were to default.
MOST TRIPS START IN REVERSE GEAR . . .
Almost any trip begins when you back out of the garage. The same holds true when you start raising cash by selling. For a while it seems all you do is spend money and equity. Then, having raised cash or created paper in a prior sale, you start re-acquiring more than you spent. How? Through NEGOTIATION and by working areas in which there are more properties for sale than there are buyers. A real pro can sell and buy at a profit in the same market. How? Simply by negotiating a profit every time he BUYS, not when he sells. Buying is the only time that you totally control what happens. When you sell, the market controls things. As a Buyer, when things don't go your way, you can always withdraw and save your money for another day. As a Seller, you may not have the time to wait for your money before foreclosure.
Negotiating skills are far and away the highest paid of any that a person can master. Anyone who's ever bought anything has undergone a negotiating experience whether perceived or not. When you buy something with a price tag on it, the seller has merely only presented you with his offer which you've accepted without question. In our NEGOTIATION SEMINAR, you learn to question every price and premise before you pay your money or sign on the dotted line. This can translate into THOUSANDS of dollars in savings both in property purchases and in family budgeting every year. We'll be presenting it twice in 1990.
For the next 2 or 3 years, DISTRESS BUYING IS THE NAME OF THE GAME! If you're in an area in which S&Ls and Banks are failing, bank officers being jailed, FDIC and FSLIC are selling lending institutions, then these offer the best prospects for the cash you've raised by selling your property earlier, or in another market area. We were extremely active in Texas a couple of years ago – even did a special seminar in Houston which we hope to be able to offer again, but in DENVER or PHOENIX next time. We found it best to hire our own BUYER'S BROKER. He worked, uncovered and negotiated with lenders for us. We were able to buy at about 18% of loan value by first buying the mortgage then negotiating with the owner. But dealing with individual distressed owners should be done one-on-one so transactions can generate the most incentive for both parties to make a deal. Here's one approach to use.
Instead of BUYING a property, MORTGAGE it! Case #1: OWNER just can't keep up with his payments because of undisciplined credit card spending, but has a stable job, family and payment record verified by credit report. He can come within $100 of meeting his mortgage payments. HOUSE is worth $100,000 in the normal retail market with a $60,000 mortgage left on it at 9%. It's non-assumable without liability. His $600 monthly payments are $4000 in arrears. He can't afford a conventional loan to make them up. You LEND the owner $4000 and agree to extend a PRIVATE LINE OF CREDIT secured by a $100,000 wrap-around mortgage lien on the property at 14%. Under the terms of this line of credit, the owner makes you a monthly payment of $500. You lend him $100 and send in $600 to the underlying 1st lien holder. The $100 is added to the $4000 previously advanced and to the existing $60,000 PLUS the monthly interest of $47.83 is added to the balance due you by him. So the next month, the 100 you pay is added and also draws interest at 14%. This is a REVERSE ANNUITY MORTGAGE under which the owner draws down cash and the investor allows interest to accrue without any cash flow. Doing business this way eliminates due-on-sale clause problems. You should have the owner's insurance policy amended to reflect your interest as a MORTGAGEE to protect your investment.
Use a standard FNMA mortgage or deed of trust to record the lien on the property. The note is a little more complicated. In it, have the owner give you an Option to secure the loan under terms which allow you to take a .5 undivided interest in the property in lieu of payment at anytime he fails to occupy the property as his principal residence or conveys any interest to any other person. Make the entire loan due and payable within 5 years. Of course, should the owner fail to make his monthly payments, the entire equity would be lost by him. But, by dealing only with good credit risks, this is a remote possibility. Now, look at the incentives each party has to motivate them to enter into this transaction.
The Seller: retains his home and ½ his equity, clean credit rating, previously paid for amortization of his loan, home owner tax benefits, $100 per month additional cash flow, $4000 in interim financing without the need to make payments out of his household income. Instead, he gives up appreciated equity at time of sale to pay for it painlessly.
The Buyer: Invests a relatively small sum safely at a decent rate of interest. He has a management-free Option on .5 of any appreciated equity in the property. His wrap loan gives him control over payments, foreclosures, payment of taxes and insurance. He doesn't worry about repairs, vacancies, landlord liability. He has relatively low exposure to risk. By having the owner place the property into a Title Holding Trust, it becomes even more secure.
