October 1990
Vol. 13 No. 12
In his play, Julius Caesar, Shakespeare goes on to say, '. . which, taken at the flood, leads on to fortune.' Apparently he knew quite a bit about real estate investment. Come to think of it, so did Caesar, considering that at one point he owned and operated most of the civilized world. Implicit in this quote is the recognition of the EBB TIDE, which taken at the flood can have the opposite effect. Or as Kenny Rogers expressed it, you've got to know when to hold 'em and when to 'fold em. In this letter, we'll try to summarize the various currents and cross currents that are present in any tide, and some of the things we should be considering as we confront them in our investment lives.
If you're going to build a fortune, you've got to start with a firm foundation. You can't rely upon luck – although it certainly helps to have plenty of it. You have to have a real command of the fundamentals. In the house business, this centers around being able to establish a true market value on property you buy. Armed with this, you can then concentrate on negotiation, discounting, creative financing approaches, and the ways in which you expect to make a profit – whether as an investor, manager or speculator. If you have access to the GRADUATE REALTORS INSTITUTE courses as a Broker or Salesperson, you can get some real insights into appraisal theory there among other things. If you want to take on a more challenging approach, there are several courses which lead to formal appraisal. and professional Appraiser designations. In these days of RTC's control over billions of dollars worth of real estate, Appraisers are reaping windfall profits, Even determining the value of a simple tract single family house for purposes of FHA or VA financing costs $200.
It's pretty hard to make a profit if you pay too much. But, until you learn to price a property through your own experience, I found another way to handle value vs cost negotiations with sellers. There's usually a record of recent sales available in most areas either through the Multiple Listing Service (normally open only to members whom you may have to compensate with finder's fees in order to review) or through local Appraisers and printed summaries of the property transaction records available in the public records. Armed with the MLS book, I'd hand it to the owner and let him/her do a competitive market analysis for me. They'd select 5 houses from recent sales in the price range and area of their house. We'd agree that the RETAIL VALUE of their house would be the average of these 5 houses. This represented the highest price they could expect to get in the market place.
The negotiation would establish the WHOLESALE PRICE I'd eventually pay. Note that we make a distinction between VALUE and PRICE. The difference we call PROFIT. I'd use a SELLERS WORKSHEET to do the negotiation for me. On it I'd first enter the normal CLOSING COSTS of any FHA sale. You can obtain these items from mortgage brokers or bankers in your area. Don't overlook POINTS TO THE MORTGAGE. These can run as high as 5% or more when credit is tight. I've seen them as high as 11% (1970). Also, plug in ESTIMATED COSTS to bring the property up to prime market sale and FHA standards. Remember, as the next owner, YOU'LL HAVE TO PAY THESE WHEN YOU SELL. You'll probably also have to pay commissions, so these should be included too. If there's any question as to the justification of these deductions from retail value, let the seller call any lender, appraiser, closing company to verify that they are true costs of doing business. Having a printed summary doesn't hurt.
Finally, you should plug in a fair profit for yourself on the transaction. I try to wind up with a price about 80% of RETAIL VALUE. Here might be some numbers. On a house valued at $100,000., you might expect 6% commissions, 4% points, 3% closing costs, 7% profit for yourself. Remember, repairs and preparing the property for sale should be costs to the
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seller over and above these costs. Justify your profit by saying you're taking all the MARKET RISK. You'll be making payments while you await a sale. You'll have to negotiate with your buyer – and he/she may knock the price down. Some of your closing costs may be higher at the time you close. Appraisal could be lower. Loans may not be available at all. ALL THESE ARE ACTUAL RISKS EVERY BUYER TAKES ON EVERY HOUSE. This isn't some kind of flim flam. If you don't factor these into your transaction, extra costs will come out of your pocket. You very well may need to pay full commissions in order to get Brokers to help you.
Having concluded your negotiations, you'll have to reduce your final agreement to writing in a binding legal contract. In it you should specify the precise terms you've agreed to including closing time, kind of deed, Note and Mortgage (or Deed of Trust) language, proration of rents, taxes, insurance, interest; occupancy, warranties, condition of title, maximum amount of mortgage you'll be taking title subject to, etc. Knowing how to do these things on the spot is the real key to being able to buy your profit 'going in'. It's what sets real estate apart from other investments. You can change the yield dramatically by virtue of the price and terms you're able to negotiate. My short course called MILLER TIME details how you do all these things. We'll be doing it at Orlando at the Investors Clinic.
BUY WHEN THE OTHERS ARE SELLING!
Long time readers of this letter have heard me harping on the evils of bad loans and excess leverage for years. The main thing wrong with INSTITUTIONAL FINANCING is that it places you in the MOST COMPETITIVE MARKET SECTOR. Think with me a moment. As someone acquiring a real estate portfolio, you've got to use credit. With each additional property you buy, your ability to get financing decreases. Lenders start to view you as more risk than opportunity. They never have any confidence in PROJECTED INCOME from rents or sales. So, about the only time you can get bank financing is when banks are awash with cash. It's at this precise time that most houses can be bought/sold for all cash via refinancing, so sellers don't have to negotiate price and terms. They only have to put 'For Sale by Owner' signs in their front lawns and let pent up demand from the tight credit era create sales.
Conversely, because you had to take the loan terms the lender was willing to offer, you'll be the first to suffer when that old ebb tide starts going out. As vacancies build, you'll be squeezed into selling at any price you can get just to stay alive. Thus, by using institutional financing, you'll be condemned to buying at high prices and selling at low prices. You can't self-destruct any faster than this. Look at how I do things.
I only accept properties with seller financing. When are sellers most susceptible to my 'innovative' offers? When there are no other buyers in the market! Say, during any period where credit is tight, where there is a local recession, where lenders are taking properties back. And when do I sell? When credit is easy. When buyers are flooding into the housing market, driving prices up, multiplying my profits. Ask anyone who caught the flood in California, Massachusetts, New Jersey – and a lot of other places. You'll hear stories of unbelievable fortunes created virtually overnight with highly leveraged houses. By buying in the 'distress' markets using private financing, you're always buying low and selling high. Old Bill Shakespeare knew what he was talking about. Buy low, sell high.
Eventually, I learned that the various flood and ebb tides were OCCURRING ALL THE TIME SOMEWHERE in real estate just as they are in the ocean. In the securities markets, there's too much organization and information. All over the world, investors can buy and sell at the same price, or engage in arbitrage to the extent they're able to discern an opportunity early on. The law prohibits them from using INSIDER INFORMATION. But in real estate, use of insider information is EXPECTED. There is no national real estate market. There are no market 'tip sheets'. Geographic areas differ markedly in terms of what the market is doing. By moving my buying and selling efforts into different areas, I managed to catch the flood tide and the ebb tide AT THE SAME TIME, but in different markets. That's why all the 'predictions' made in the press about real estate are nonsense most of the time.
CAST YOUR NETS ON THE OPPOSITE SIDE OF THE MARKET . . .
I was the first person to extoll the virtues of single family house investing in a national seminar based upon my own experience. Several years ago I started doing the same thing with MANUFACTURED HOUSING. I bought my first mobile home in 1954. By August 1982, I was advising you to consider mobile homes and factory-built housing in this letter. There have been many references since that time. For you who've bought all the back issues ($174) with the comprehensive index, take the time to read up on this emerging major opportunity. There's still plenty of time to get into the swim.
Terry Strine – a long time subscriber and personal friend – has been a featured speaker at a couple of our conventions on the subject of syndication, financing, acquisition and management of mobile home parks. He's a real pro. So much so that he sees no reason to enter the seminar business when it could interfere with his chosen field – mobile homes. At a completely different level, I've been doing one-day seminars from the perspective of an occupant (11 years), speculator, small park owner, and landlord. It's a fascinating arena for the beginning investor who is looking for high yields, low risk, terrific tax benefits. There's room in this broad field for the smallest and the largest investor.
Look at this range of opportunities. Individual lots zoned for mobile homes can often be bought for about $5000. With minimal amenities: water, sewer/septic, concrete pad for the unit and for a patio, a fence (optional), easy access; rents in my area run $165/mo. Consider that the tenant owns the unit. There's nothing to break (with the exception of a well and septic if they're used). And the mobile home owner/tenant doesn't have a tenant mentality. He/she thinks of himself/herself as a HOME OWNER. Really effortless management. NET RENTS ALMOST EQUAL GROSS RENTS because there is little expense. Yields run from 30%-40%.
If you're greedy, you can buy a repo mobile home for between $1000 and $2000 and put it on your lot. Prices can be considerably more and a lot less. we've bought a solid rental unit from an estate for as little as $800 and paid as much as $4000 for a double wide unit with full amenities, furnished. Rents run about $350 in our area, but I've seen them in the $700 range in average parks/condition in California. Your cash flow and yield can increase with rental units, but so does your management intensity. And your liability. In many areas, mobile home parks have their own section of the landlord/tenant laws too. You have to be a lot more selective (I like young retiree tenants, hence avoid the problems with kids and itinerant tenants who can create large turn-over and vacancy problems).
One of the things I'm most interested in is the Mobile Home Condominium Subdivision. One fellow I met has a real money machine. First of all, he's a new mobile home DEALER. He puts a new unit on one of his lots in his condominium park and rents it with ANNUAL RENTS to only retired, financially able people. After 3 years, he sells them the unit (after he's written it down for a time, but before any maintenance problems crop up). Since it's on a lot which is included in the sale, he's able to completely recover his costs. But he keeps a right of first refusal on the sale of the LOT in the future. Thus, when the unit is placed on the market, he buys the lot back, and rents it to the person who buys the unit. After a time, he takes the old unit in trade for a new unit, and repeats the process. Fascinating.
It seems to me that Mobile Homes and Manufactured Homes (built to a different code specification and usually more expensive) are viable alternatives to those in areas where housing prices make the rental investment house prohibitive. All those creative finance concepts that worked with single family houses work with mobile homes because they are relatively illiquid compared to houses. The market is smaller – but growing. Over one third of all housing in the United States that comes on the market is built in factories.
EVERYBODY KNOWS THE RIGHT TIME TO BUY. FEW KNOW WHEN THE TIDE'S ABOUT TO TURN .
Somewhere along the way you're going to decide that you've had it. You're either going to be ready for retirement, or for a new game; or may just decide to start partaking of the good life that you've worked so hard for. In other instances, you may perceive a new opportunity that will require cash. Or you may want to move up into larger properties that can afford professional management. Whether it's because you WANT the money and the LIQUIDITY it affords, or NEED the money to protect your assets by paying off balloon notes, knowing how to sell is a vital ingredient in the care and maintenance of your portfolio.
For those who've made a life's work out of buying below market, learning to sell ABOVE market is like flying upside down. All the controls are going to have to be reversed if you want to avoid crashing. You can no longer play hard to get. You're going to have to ATTRACT MOTIVATED BUYERS. You're going to look forward eagerly to INSTITUTIONAL loans. You won't be attracted to creative finance techniques. You'll want CASH. Lots of it. You'll want to sell in a sellers' market when credit is easy. If you have to take 'paper', you'll want it to be INDEXED so that any future inflation won't destroy it's purchasing power.
You may have bought without using a Broker, but you'll probably need the services of a good MLS broker when you're looking for a cash buyer. Hark back to the time when you negotiated your purchase and plugged in the costs of selling. Now, those negotiations will stand you in good stead when you have to pay them. You'll want to be conversant with any tax limiting strategies, the use of fiscal year corporations, bracket advantages, timing and Exchange techniques. You may even find that a CHARITABLE CONTRIBUTION will yield more after tax than a straight sale. Especially when it can be combined with estate planning. Many of your old attitudes will change at the prospect of paying out as much as one half of your lifetime accumulations in taxes just because you want cash liquidity. But read on.
SPLITS, GRITS, RITS, ITS . . .
Regardless how much tax strategy you employ today, the IRS bag man will be there at the end when your estate gets divvied up. Today's 33% max bracket is a lot less than the 50% estate tax bracket your estate could wind up being in. You may find it preferable to pay the tax today, then employ the money for the rest of your life to reduce taxes. Here's one way. Once you're liquid, you can enter into a purchase agreement for an ESTATE FOR YEARS in a property from a LEGITIMATE 3RD PARTY SELLER. Your HEIRS can independently buy a REMAINDER ESTATE in the same property. IRS tables will show the precise amount on a 20 year estate for years that each of you should pay based upon a 10% discounted present value. So we might assume this to be 14.864% of the total value allocatable to the REMAINDER INTEREST at the end of that time. You'd enter into a joint purchase agreement with them on a $100,000 property under which you paid $85,136 for your 20 year interest and they paid $14,864 for their remainder. AND YOU'D BE ABLE TO AMORTIZE YOUR PURCHASE OVER 20 YEARS TO SHELTER INCOME.
Suppose you died after 15 years? Then you could GIFT the odd 5 years to a charity to create a deduction against estate taxes of the value of the remaining estate, and your heirs would still get the property TAX FREE AT THE END OF THE 20 YEAR TERM. This is called a SPLIT. It has more advantages than a GRANTOR RETAINED INCOME TRUST (GRIT) in that there is no GIFT which would count against your $600,000 lifetime gift exclusion. It's better than a REMAINDER INTEREST TRUST (RIT) because it creates an AMORTIZABLE INTEREST even if the property is otherwise UNDEPRECIABLE. For example LAND, a VACATION HOME, even MUNICIPAL BONDS can be bought, and the amortization used to shelter other income.
OK, OK – you don't want to give anything to charity and you want maximum deducts now. Using Treasury Tables, you find that you have 20 years to live and the same math applies. Then you buy a special insurance policy (INSURANCE TRUSTS or ITS) to pay any taxes that may be incurred by your estate by virtue of an early demise. The shelter provided by the SPLIT INCREASES AFTER TAX SPENDABLE CASH FLOW in your declining years, REDUCES YOUR ESTATE and any estate taxes, INCREASES THE AMOUNT YOUR HEIRS GET, lowers overall taxes.
