Times Are Changing

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          Ultimately, one of the greatest hazards an entrepreneur faces is change, yet, in recent years, the changes that have taken place have benefited entrepreneurs to an unprecedented degree.  A case in point is the events that have transpired over the past decade or so.  In 1995, interest rates for owner-occupied houses hovered around 7%.  In recent months, they have been at least 1% lower.  Where credit was based upon a loan officer’s judgment, now, applications can be done from a personal computer, and approval is based on FICO scores.  Where mortgage loans required 5% down payment, today, 125% of fair market value can be borrowed on Home Equity Loans.  In the mid-90s, house prices rose slowly from their slump that was caused by Reaganomics and Clinton’s cut-back in defense spending; and the aftermath of skirmishes in the Iraq, Somalia and Haiti.  Despite the 9/11 attack that changed the way we lived, the housing market remained strong in most areas.  Fortunes were made as house prices exploded.  The boom is now described as a “housing bubble” by those who had sold too soon or who had failed to buy and had been left behind.

 

          As people made more money, income, capital gains, and estate taxes were being lowered.  There have been a plethora of changes which benefit the real estate entrepreneur.  Income tax brackets range from 10% to 35%.  Capital gains taxes range from as low as 5% for the bottom two income tax bracket taxpayers (which will fall to zero in 2006 and 2007) and top out at 15%.  Corporate dividends, instead of being taxed at ordinary income tax rates, are now only taxed at 15%. 

 

          In 1995, Limited Liability Companies were being held back because of the uncertainty as to how their earnings would be taxed at federal levels.  They were just coming into their own when the final regulations were issued.  These made it possible to have one-person LLCs taxed as individuals or corporations; and two-or-more person LLC‘s taxed either as partnerships or corporations. 

 

          Where ten years ago S-corporations were severely restricted as to how they could be owned, they can now be owned by Trusts as well as people, and can also own other S-corporations, C-corporations, Trusts, and Limited Liability Companies.  Under current law, using multiple entities, it is possible, with some effort, to be able to operate a thriving business and to only pay employment taxes on a fraction of the income earned

 

          Entrepreneurs operate their business as one or more of the above entities  are especially favored in the current environment.  Their estates can be discounted by as much as 40%, and estate taxes can be deferred for years.  They have a broad array of tax deductions and benefits that passive investors can’t avail themselves of.  Using these, they can operate from a number of low-taxed States and/or protect accumulated earnings by holding them in corporations formed in States that respect private property rights, and whose laws afford a high degree of asset protection. 

 

          Even more has been done in the area of Estate and Gift Tax exemptions.  A few years ago, the maximum that a person could leave or gift to someone other than a spouse was $600,000.  Today, unlimited assets can be bequeathed or gifted between spouses; moreover, $1,500,000 can be left by each spouse to anyone.  This will gradually rise to the point in 2009 at which there will be no estate tax at all.  Up to $11,000 per year, plus $1,000,000 in a lifetime exemption can be gifted by anyone to anyone tax free. 

 

          In spite of all the talk about how the tax laws now benefit the wealthy, the little guy has never had it so good.  In 1997, we saw the introduction of the Roth IRA which made it possible to accumulate massive amounts of money tax-free that can be passed on to the next generation.  Most people can now sell their homes every two years and pay no tax at all on their profits.  Who needs to work?   

 

THE MORE THINGS CHANGE, THE MORE THE STAY THE SAME . . .

 

          The good news is that there is more opportunity to make a lot of money in the housing market, but the bad news is that there is lot’s more competition.  Franchises are springing up everywhere to lure unsuspecting newbies into spending huge sums of money just to have someone find leads for them.  Thousands of derelict inner city houses are being recycled back into the market by re-habbers.  Their profits are being spread through the housing market by a food chain made up of bird-dogs who find houses; lenders who finance acquisition, fix-up, and sale; multiple levels of wholesalers who create a ready quick-cash market for houses that can’t be financed; retail buyers who are financed with the easiest mortgage loans in history.  

 

          Despite all of the changes that have taken place in the real estate, finance and tax arenas, money continues to be made with houses about the same way it has always been made.  When I hark back to the things I did to make money thirty years ago, the wealth-building process boiled down to buying or renting something at a bargain price or on bargain terms that were below fair market values, financing it so it produced income, then selling or leasing it to a “user” at full retail value.  The same fundamental approach is the key to making money today, but successful people have refined basic methods to take advantage of modern technology.

 

FINDING HOUSES:  Jack Griffin of Tampa maintains that “Real estate is the highest paying hard work and the lowest paying easy work you can do.”  The most difficult part of the process has always been, and still is, being able to find a house that can be bought or leased from a motivated owner.  Before proceeding further, when I say “houses” I also include double-wide and single-wide mobile homes on their own lot.  I’ve found them to be even more profitable than houses whether being held as rentals or being flipped for a quick profit. 

 

          In the good old days, my sole technique was to go door-to-door and ask people if they wanted to sell or lease their house.  This is still one of the best, and cheapest ways to find houses to buy, but now we also:

 

1.  Buy CD lists from the county tax-collector of out-of-town and single property owners in selected areas and mail out hundreds of post cards and letters to them each week. 

 

2.  Place flyers on derelict houses, and on cars in mall parking lots on the weekends, offering quick cash for houses in any condition, occupied or not. 

 

3.  Offer a $1000 bounty “dead or alive” to “bird-dogs”, if a deal can be made. 

 

4.  Run several continuing ads in weekly shoppers guides, in the “apartments and houses for rent“, “houses and mobile homes for sale“, and “money to lend” columns.  Keep them running month after month, and they’ll pay off big eventually

 

5.  Attend foreclosure sales and contact lenders to find delinquent loan payers and/or foreclosed inventory that they are willing to sell at discount

 

6.  Contact landlords who are running “For Rent” or “Vacancy” ads and try to buy or lease their houses for cash flow with a rental credit toward an Option to buy.

  

7.  Avail yourself of the new cell phones that take pictures that can be downloaded to wireless computers in which you can access credit data bases.  Store blank Notes, contracts, disclosure/disclaimer forms, deeds, loan documents, bills of sale, appraisals and comparative sales data so you can make quick, accurate offers.

 

8.  Keep up-do-date summaries of your financial obligations and cash reserves that you can use to buy with.  Don’t over-extend yourself.  For financial emergencies, cultivate multiple sources of private long and short-term loan money and venture capital to augment your own cash when you need it to make a quick purchase. 

 

YOU CAN’T BUY WHAT YOU CAN’T PAY FOR . . .

 

           Even cheap houses are expensive.  Berkshire Hathaway “A” stock is the highest priced stock on the market, yet it is less expensive than all but mobile homes and a perhaps a few older houses in need of repair.  Because only a relatively small minority are able to buy a house without first obtaining a new loan or taking over existing financing, the second priority for the entrepreneur is to find ways to buy houses using “credit”.  Even at today’s low interest rates, few houses would generate positive cash flow if they were financed at a point much higher than 90% of fair market value. 

 

          To put numbers to this, a $100,000 30-year, level payment, fully amortizing loan  at 6% annual interest would require monthly payments of $600.  When you add $80 per month in property taxes and $100 per month for liability, flood, hail, windstorm, sink hole, earthquake, etc. insurance, that brings payments up to $780.  Assuming average vacancy, advertising, management, and repairs to cost about 2 month’s rent per year, the house would have to rent for $935 per month just to break even.  In my area, this is $100 or so above market rents for this kind of house.  The answer is to either buy houses for quick re-sale, or to buy them for the long term using some form of creative financing.  This can be divided into two forms, “debt” financing, and “equity financing”. 

 

DEBT FINANCING:  With “debt” financing, the buyer gets a loan from the seller, or any third party, and makes payments as agreed.  Here are some variations:

 

1.  The easiest, and most expensive debt financing is to borrow the money you need on conventional terms from an institutional lender.

 

2.  After a reasonable down payment, you take over payments on any existing loans and the seller takes back a 2nd mortgage or a “wrap around” loan for the balance. 

 

3.  A cash-poor buyer could buy from a cash-poor seller by first getting the seller to borrow the money he needs, then the buyer could pay it back as in #2 above.

 

4.  Buyers might pay “interest only” with a balloon at the end to increase income.

 

5.  To increase income, you could pay less than monthly interest, adding unpaid interest to the balloon payment when the loan came due, or when the house is sold. 

 

EQUITY FINANCING:  With “equity” financing, the buyer usually takes over an existing loan and shares costs and profits with one or more other investors.  In so many words, you swap future profit for cash flow today, and the investors do vice versa.

Note that equity financing seeks to avoid any negative cash flow problems.

 

1.  You might enter into a joint venture with one or more people by taking title as Tenants-in-Common, then splitting profits according to your percent of ownership.

 

2.  You could “syndicate“ a property by forming an LLC or Limited Partnership with several investors, then taking title in its name.  You’d contribute an Option or Purchase contract for a portion of the tax benefits and profits.  The LLC might buy for cash, or pay “cash-to-the-loan” and take title subject to existing loans; or put new financing on the property.  Equity partners would contribute any needed funding.

 

3.  You might “rent a signature” by giving away a piece of the action to anyone who would guarantee your loan at a bank.

 

4.  You could lease/Option an over-financed appreciating property, then share the profits with anyone who would pay any negative cash flow as needed until the debt was paid off.

 

5.  You could joint venture fixer-uppers with investors who would buy them, and contractors who would wait to be paid out of sale proceeds.

EQUITY IS FANTASY UNTIL IT IS CONVERTED TO CASH OR INCOME . . .

     

          The ultimate task for the entrepreneur is to market property so that equity can be converted to income or cash, or both.  Equity is defined as the difference between the current loan payoff and net after-tax sale proceeds.  It can be generated in several ways: 

 

A.  It can be manufactured during the re-hab process. 

 

B.  It can be created automatically when prices rise faster than the inflation rate.

 

C.  It can be slowly accrued as loans are paid off.

 

D.  It can be factored into price and terms via negotiation.

 

E.  It can be created at foreclosure when there is little competition.

 

F.  It can be generated when a property is sold in the retail market, and the cash is then reinvested tax free in a replacement property bought at a wholesale price.

 

         Regardless how it comes about, equity has no real value to the holder until it is converted to cash with which goods and services can be purchased.  There are only a limited number of ways this can be done with real estate:

 

A.  It can be sold for cash, or on terms, with capital gains taxes paid.

 

B.  It can be Exchanged tax free; with your cash loaned back by the last seller.

 

C.  It can be leased, with your investment paid off by tax-sheltered rents

 

D.  It can be mortgaged, and the loans can be re-paid with rents.

 

E.  It can be mortgaged as above at a low interest rate, then sold on “wrap-around” terms at a higher rate to create a spread in both the yield and the interest income.

 

F.  Renewable resources from timber land, farms, mines, and bodies of water can be “harvested”, and their proceeds sold for cash that’s tax-sheltered by depletion.

 

          The key to accomplishing any or all of the foregoing is to be an effective marketer.  There are two main goals marketing attempts to achieve.  (1)  To attract qualified buyers and/or lessees as the case may be.  (2) To motivate them to buy or rent what you own at a fair price at the time when you’re selling.  Finding and “closing” buyers or lessees is like fishing with a net.  You try to reach the largest number of potential customers as possible, then sort through them to select only those with the greatest promise.  With marketing, your “net” is advertising.  The better and more effective it is, the more profit you’ll make; sooner.

 

          Finding buyers mirrors the process for finding sellers.  A long kept secret of mine is that, when I went door to door canvassing for sellers, I also asked about potential buyers owners might know.  It’s not much of a reach to see that any seller I found would eventually have to buy a house.  I made it a practice to help them find it starting with the moment they signed a contract to sell their home.   As often as not, they didn’t really become motivated sellers until they had found a house that they really wanted to move into.  Making both a buyer’s and a seller’s profit with each home owner, I multiplied my cash flow and reduced my cost.

 

          Markets switch back and forth between sellers’ and buyers’.  Credit goes from easy, driving prices up, to tight, stagnating values.  Politics create both fear and hope depending upon whose running things.  Technology continues to change how we do things, but by sticking to fundamentals, houses will still make you rich.

         

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