January 1989
Vol 12 No 3
With the election over, I can start picking on a new Administration. It's getting easier and easier as candidates promise themselves into a box, then try to cover up. We have to give Reagan credit. The voters never caught on to just how serious things are for the economy. Unfortunately, American jobs and standard of living are influenced to a great degree by perceptions of the international community. Look at what foreigners did when it became clear that Bush had won. They began dumping dollars, stocks and started to buy gold. Only through the heroic efforts of the Japanese central bank to shore up the dollar by purchasing billions of dollars worth of them in just a couple of days was a real crisis averted. A full 60 days ahead of inauguration, the new Administration is being challenged to come up with workable solutions to American deficits and balance of payments problems which have grown to crisis proportions. Bush will have to hit the ground running.
Put Yourself into Bush's position as the incoming President. You've promised unequivocally NOT TO RAISE TAXES. You're hemmed in by promises made in prior administrations to pay Veteran's pensions, cover farm and bank/S&L financial failures, maintain indexed Social Security pensions; insure corporate, union and institutional pension plans. You're locked into multi-year procurement contracts in Defense. Congress won't permit you to cut social spending programs. You're faced with ever mounting costs of our foreign policy for maintenance of huge military forces abroad and shoring up of anti-communist governments. We're entering the 7th year of the longest economic recovery in our history with no hope of balancing the budget, let alone reducing our accumulated deficit. AND YOU CAN'T RAISE TAXES!
Despite the relatively low value of the dollar, Americans are still buying more merchandise from abroad than we're selling. Dollars are piling up overseas. Suppose YOU were a Japanese exporter with a hoard of dollars. You've been able to sell everything you can produce to Americans, but you have to pay your labor and material costs with Yen. Where do you get the Yen? You trade in dollars for it. As American deficits rise, you find that you have to trade in more and more dollars for the same amount of Yen. This cuts into your profits. The same thing is happening to the dollar that you re-invest in the American stock market or in T-Bills. The interest/dividends/profits your dollars earn are all reduced by the falling dollar. You've really only got two choices. Either invest in American real estate which typically holds its value against a falling dollar and is a great inflation hedge, or buy American companies so you can use your dollars to manufacture your products in America and thereby avoid having to convert them back into Yen at low prices.
Doing either of the above deprives Japan of the capital investment and jobs that funds invested in Japan would generate. It creates fortunes for those Americans lucky enough to be bought out by Japanese investors. It creates jobs for American workers and a higher standard of living. The dollars that the Japanese spend in America create fantastic bank reserves which can be used to expand credit in mortgage and equity markets. This little scenario is recreated in countries everywhere with large dollar reserves. Americans are being subsidized by foreign investment not only in T-Bills and T-Bonds, but throughout the economy. But remember, this is a strictly financial arrangement. What foreigners can give, they can take away. And they will anytime it's not to their advantage to continue to invest in us.
So Bush has to either turn the dollar around or raise interest rates if he wants to keep foreign investment up. And he has to reduce the deficit by expanding the economy unless he increases tax revenues or reduces spending. But a stronger dollar makes our products more expensive overseas, increasing trade imbalances. I think we're in for exciting times in 1989!
Copyright Sunjon Trust All Rights Reserved
Quotation not permitted. Material may not be reproduced in whole or in part in any form whatsoever.
1-888-282-1882 www.CashFlowDepot.com
WHO'S AFRAID OF THE BIG BAD WOLF?
Most of us don't like change! We tend to view the unknown as the enemy. And we're fearful of the unknown future that change produces. So we do nothing, and hence, lose out on ground floor opportunities that the change has brought about. If you remember the story of the 3 little pigs that the title phrase was taken from, the little pig who built his house out of brick survived. The key to meeting the uncertain future on solid ground lies in getting your house in order NOW and maintaining a position of financial security until the future opportunities begin to emerge. This way you'll be in position to act quickly regardless of what the economic changes bring.
Here are some of the fundamentals in preparing for the future as I see it:
a. Beware of variable rate mortgage loans! The key to using inflation as a generator of profits lies in having FIXED EXPENSES with VARIABLE (higher and higher) INCOME. By definition, inflation – or the falling dollar – increases operating expenses on any real estate. Taxes, Insurance, capital investment, replacements, repairs will all be increasing. Hopefully, so will your rents. But when you add escalating interest and mortgage payments, you can still be wiped out even as your equity grows by leaps and bounds unless you can continue to meet your loan payments on time. Look at this:
Suppose your interest rates rose from 9% to 12% on an $80,000 house. Sure, you'd also be seeing an increase in its value – possibly as much as $10,000 per year. But your payments of principal and interest alone on 580K would rise from $643.70 to $822.89. If your rents were at $650 and could be increased to $700, you'd have gone from a very slight positive to a large negative cash flow very swiftly. And remember, insurance and taxes plus operating expenses would make you fall even farther behind. This isn't such a big deal with one house. But suppose you had 10 like this? It could be fatal.
b. Don't use financing which requires your personal guarantee! Using INFLATION to pyramid a real estate fortune is a tried and true practice – but it's still highly SPECULATIVE! You don't control the rate of inflation, interest rates, market demand, tax rates and a host of other things that could affect the outcome of your inflation bet. Things can (and do) go wrong frequently in the life of a real estate speculator. When that happens, about the best you can do is to slink away and wait for another opportunity. But when you PERSONALLY GUARANTEE A LOAN WITH FULL RECOURSE, you're not allowed to slip away into the night. You have to stand and face the music – quite often at the cost of all your personal assets and possibly future earnings as well.
There's another less tangible reason to avoid unnecessary risk taking (i.e. personal liability on loans). As you leverage into more and more real estate, you compound the risk! Eventually, the burden of this risk will limit your desire to leverage further, and you'll fail to acquire as much real estate as you might otherwise have done. On the other hand, when you make each acquisition stand on its own without reference to any other acquisition, then its failure as an investment doesn't affect your other property. Hence, risk DOESN'T COMPOUND. You don't risk EVERYTHING with each added acquisition. You DON'T LOSE financially healthy properties because of the failure of one sick house. Consequently, you don't suffer psychological malaise because of the build up of risk which would have happened had you personally guaranteed the loans on houses you leverage.
c. Don't take 'Experts' opinions as to whether property is appreciating in your area. In many instances, we see people relying on NATIONAL news and financial data as the source of their buying and selling decisions. Rarely will your personal experience exactly match the opinion of someone speaking to a national audience. (That's why I present a lot of regional seminars around the country which address your local situation). Use your own good sense and judgement before you jump in. Today, you could go to Washington, DC, Southern California, Seattle, New Jersey/New York areas and see rampant appreciation. Or you could go to Dallas, Denver, Oklahoma City, New Orleans and see what amounts to a real estate crash. Obviously, the same advice doesn't work for both up and down areas.
d. Get your personal finances in order! The easiest way to fail in this world is to make the assumption that your present financial position will endure forever. From my own personal experience, it's possible to lose property because there aren't any renters to help make payments. It's possible for your friendly banker to file bankruptcy and for you NOT to get your funds back (in my own case, it was an S&L). It's possible that full recourse loans on property you've SOLD could go into default or foreclosure and for judgements to attach without your ever having been informed. Some states don't require your notification when notices are published according to state law. It's also possible for your banker to call your short term line of credit and business loans when there's a change in management, ownership or when FDIC/FSLIC takes the lender over. Even when there seems no threat of surprise layoff (I got 15 minutes notice), debilitating illness or accident (How's your insurance coverage? How vulnerable is your insurance UNDERWRITER to financial upheaval?), marital problems; you should maintain a CASH BUFFER which is easily accessible 24 hours a day and 7 days a week. You never know when you'll need it to make the once-in-a-lifetime deal – or to leave town in a hurry.
e. Cull your properties to eliminate all but the best. Don't fall in love with your houses Remember, they're there to create financial independence for you. If they aren't doing this, SELL THEM AND REPLACE THEM. You can do this tax-free via Section 1031 Exchanges with the result that you'll not only be eliminating potential financial problems, but also increasing your net worth. For instance, assuming that you can sell in a RETAIL market and buy in a WHOLESALE market with about 20% difference between the two, can you see that by selling for $50K and replacing the property for $40K, you've made $10K. Your increased equity would be un-taxable in a properly constructed exchange. Actually, you'd probably be able to do much better than this as a cash buyer in the distress market And you'd be doing this to upgrade the QUALITY of property in your portfolio to better withstand any upheaval in the real estate and/or financial markets.
YOU CAN'T OWN WHAT YOU CAN'T MANAGE . . . FOR LONG!
The key to INCOME PROPERTY is INCOME! If you're going to leverage real estate, the only way you can build a significant portfolio is by getting renters to pay for it on a monthly basis at a rate which will provide the funds with which to reduce debt. That's a fundamental that's usually overlooked. For some reason or other, people like to ACQUIRE lots of real estate, but they avoid the challenge of managing it to produce income. When they can get others to do the management job for them, they even refuse to supervise the managers to insure they are doing a good job. They act much more like VICTIMS than OWNERS. Consequently, few investors last in real estate. They're driven out by the lack of ability to manage their own property. In any kind of future scenario, the person who can manage a real estate portfolio profitably and efficiently will be able to write his/her own ticket. And the person who can't or won't manage will pay whatever it takes to that manager OR FAIL!
Like it or not, you'll eventually have to acquire management skills AND be able to supervise the management activities of those you may hire in order to get all property benefits. Not the least of these is the $25,000 in write-offs against all other types of income available to the owner-manager. And there are all those profits which managers can produce via the LEASE/OPTION route. Lease and Option techniques, used separately and in concert can produce some of the most spectacular profits and yields in the entire industry. But to use them, a person has to be able to manage effectively. Then there are management profits derived from the offering of Management Services to the public. With the growth of REO (Real Estate Owned) properties held by lenders and government agencies, demand for pro managers has grown geometrically. One of our readers, a HUD property manager reports:
HUD management contracts are competitively bid. He both manages and sells for a flat fee per foreclosed house that's in the HUD inventory in his area. He reports that 99% of these are VACANT and they number in the hundreds. Between management and sales, he is grossing between $8,000 and $16,000 PER MONTH. Because he FARMS OUT ALL THE ACTUAL WORK, he pays out about half this amount to sub-contractors. I've agreed to respect his privacy as to his identity, but you should check into this opportunity in your own area – especially where there are lots of foreclosed properties sitting vacant. Don't go off half-cocked expecting a big government or lender contract unless you have a track record as a manager. In order to capitalize on the real opportunities you have to pay your dues and gain experience. This is no exception. But it's just another one of the cash flow sources real managers can have.
When you regard the management function, it's interesting that it is a double edged hedge against either depression or inflation. When the economy turns down, there are many more properties in the hands of the government, financial institutions and others who don't know how to manage. And there are many more people who can't afford to pay rent. So the efficient and capable manager becomes indispensable, able to command fees greater than one might expect – and from a much broader and deeper market of helpless owners. You can visit Houston today and see management costs that are astronomical as a percentage of the total NET property operating income. There you'll find even MARGINAL management companies doing a land office business.
On the other hand, when inflation starts to run, many more 'amateurs' buy into income producing real estate without the management skills they need. So they're FORCED to hire those who can do the job. Because Managers typically are paid on GROSS RENTS collected, they're unaffected by escalating costs that squeeze NET PROFITS to the owner. Management income rises with inflation-driven rent increases. It's inflation indexed.
YOU HAVE TO UNDERSTAND BOTH THE LAW AND THE PROFITS . . .
As government housing policy fails, more and more people compete for fewer and fewer rental dwellings. Politicians seeking short term advantage institute rent controls. Landlords react by (a) converting apartments to condos, (b) taking rental houses off the market and selling them to escape controls, (c) abandoning properties that aren't profitable, (d) settling for lesser profits in order to stay in business, (e) letting properties accrue deferred maintenance and taxes until they become slums. (a) and (b) above can be quite profitable as a result of housing shortages caused by rent controls. But the the other options can be ruinous. One slumlord in LA sold his apartment, but was required to pay $800,000 of the proceeds to repair it to city standards AFTER the sale. The presence of rent controls can reduce apartment values by 50%. Even more in cities like New York.
Another case has been settled in California where the court decided that a lease option effectively transferred EQUITABLE TITLE to the tenant. Because there was no Deed of Trust which would have provided for non-judicial power of sale, the tenant had to be foreclosed, This left the tenant with a 3 year Right of Redemption during which time he can re-initiate his contract. It's critical that you fully understand the legal effects of the methods that you use in the jurisdiction they're being employed in BEFORE YOU USE THEM. States can pass laws which by-pass your rental contracts. Florida has statutes which bar escalation clauses in condominium leases that are pegged to an inflation index – these are leases on the land under the condominium. U.S. 5th Circuit ruled the State is right.
Bob Bruss' excellent California Real Estate Newsletter ($48, 251 Park Rd, Ste 200, Burlingame, CA 94010) reports a ruling in Mughrabi v. Suzuki (243 Cal. Rptr. 438) that a person who fails to make good a bad check within 30 days following demand for payment will be liable for MANDATORY TREBLE DAMAGES (i.e. Rent Checks). Check Calif Civ Code Sec 1719.
Copyright Sunjon Trust All Rights Reserved
Quotation not permitted. Material may not be reproduced in whole or in part in any form whatsoever.
1-888-282-1882 www.CashFlowDepot.com
