In the race between the tortoise and the hare, if the hares are wheeler-dealers, managers are the turtles. Over the years I’ve noticed that the high-flyers of yesterday never seem to get to the finish line. Bill Zeckendorf and Bill Levitt were two of the giants who went broke after making billions of dollars. Why? There’s a simple reason for this; those who buy and sell make a lot of money while they’re doing it, but they have four adversaries that rob them of success.
The first adversary is Market Risk. The real estate market is totally dependent upon the availability of reasonably priced mortgage credit. Without it, buyers can’t buy, and sellers can’t sell. Today’s historically low interest rates have spawned a lot of success stories among the wheeler-dealers, but when interest rates rise, they die like flies. Wheeler-dealers put their cash and credit on the line today in hope that they will make a profit tomorrow. Anything that changes the markets to dry up demand can cost them everything they have accumulated.
The second adversary is physical and mental strain. Virtually all aspects of the wheeler-dealer business is intensely competitive and stressful. Sooner or later stress manifests itself in frequent or serious illness that removes even the best from the field. What illness doesn’t take away, advancing age does. To retain a competitive edge, a person must maintain high levels of energy and continue to perform at high levels over his or her entire career. Few are able to do this.
The third adversary is taxation and mandated expenses. Wheeler-dealers are the highest taxed of all real estate operators. They are denied capital gain tax rates and installment sale treatment. They can’t exchange what they build, buy, or improve tax-free. State and federal taxation are only the tip of the iceberg. When other mandated fees, carrying costs, interest, workmen’s comp insurance, pension plan expenses, permits, etc. are added to the mix, gross revenues can turn into negative cash flow without careful planning and a lot of luck.
The fourth adversary is government interference in markets. How many thousands of builders and developers have been chased out of the business by EPA, OSHA, Planning Boards, Impact studies, manipulation of interest rates and loan underwriting criteria, inclusionary zoning, and down zoning? When Clinton closed most of the military bases in Southern California, it set house prices back by 20% in some areas. When Reagan changed real estate write-offs, real estate speculaors failed by the thousands.
So much for the rabbits; how have the turtles faired? Those who buy and hold reasonably leveraged houses for the long term enjoy several significant advantages. Once they’ve bought a house, there’s little to do other than to keep it rented. Rental houses are counter-cyclical. Rents go up when prices go down for a number of reasons. When profit margins shrink, builders stop building and speculators stop buying. The more the buy/sell market is forced down the more demand for rentals goes up, and the higher the market drives up rents; so landlords still make money in bad times. When inflation drives up house prices, being leveraged with long term fixed rate mortgage financing insulates landlords from rising rates. When they sell, the can avoid all taxation through Tax-Free exchanging, or stretch out taxes via installment sales, or simply pay capital gains taxes at the 15% rate.
Management is the key to long-term rental profits. Ideally, it not only increases cash flow every year, but more importantly, the value of the property too. I’ve been fortunate to have found several good managers. What attracted them was that I was willing to divide the profits that they created rather than to simply hire them just like everyone else. When they saw that the better they managed, the richer they got, all I had to do was to sit back and watch the process. I more than made up their share of profits by being able to hold more rental property long term.
