January 2006

Vol 29 No 4

WELCOME TO 2006; WHAT WILL YOU DO WITH IT?

Each year at this time I set out for myself some of the things that I want to work for during the following year. The process is about the same every year. I measure my achievements of the preceding year against my prior list, and, if they're still relevant, I start a new list with the “leftovers”; then, I add any new objectives for the new year. You'll notice that these are things that I picked out for myself that I intend to work for. I don't just “hope” they'll come to pass.

I don't like “New Year's Resolutions” because they have the seeds of failure built into them. These are “soft ball” lists that include things like “losing weight”, “getting in shape”, “moving up in a career”, “improving family relationships”, “improving oneself”, etc. These are more honored as broken promises that never quite attain the status of real goals; and the breaking of them is swiftly forgiven and forgotten. Each time you break a promise to yourself, it diminishes you a little in your own eyes. Conversely, each time you attain a goal you've set for yourself, you gain a little more self-respect and confidence. So, where going through the motions of setting New Year's Resolutions that you don't really expect to follow takes a little of your confidence away, making a habit of setting specific goals and time schedules that you can – and will – meet increases your probability of success.

My style is to list things that I expect to accomplish in specific, measurable terms; then to lay out ways to accomplish them. To do this, I first look to the resources I'll need: Do I have enough money? If not, where will I get it? What about professional help and labor needed to do the job? Who will I use, or where will I find new people? When can I reasonably expect to complete each task? What must I do to get things started and to keep them on track? Do I have a “Plan B” in the event something untoward happens that makes it impossible to complete my initial plans? By making a serious effort to lay out a path to success, then diligently following it, you can set yourself apart from all the “wantabes” who settle for mere dreams of rising to the top of the heap and who spend their lives wondering why they don't seem to get anywhere.

A logical place to start is with the net income you expect to produce by 12/31/06. A lot of people get hung up on their grosses without focusing on net income after all expenses and taxes. They feel successful, but often aren't. One of the major influences that enabled me to break away from real estate brokerage and to begin buying, fixing, selling, and investing for myself was the realization that, even though I was a one-man brokerage, I was really sharing my time and profit with a lot of people who weren't helping generate any of them. These were time wasters, tax collectors, lenders, insurance companies, other brokers, bookkeepers, accountants, assorted maintenance people, and those I hired to help me enforce my rights as a landlord. In the early 1970s I decided to do something about it.

I began to set goals to eliminate as many of these “negative income” factors as possible. I worked out ways to find motivated sellers before they listed their houses and either bought, rented, or Optioned them. I learned something about keeping books and reducing taxes. I learned how to manage and maintain property more effectively. I learned how to avoid banks by using private financing for the properties I bought in my name. By learning how to use short-term Options rather than listings, I stopped being a broker who split commissions. I became a principal who sold them for much larger profits. To limit idle callers, I shut off all but two telephone lines; one for prospects and one for all others rather than tying up my phone with non-productive calls. If cell phones had been available, I would have used one exclusively to field prospects, and let all others FAX me. All of this took several years, but once I set my mind to seriously do better, like magic, it all happened. In only five years at the age of 45, I was able to quit active brokerage and to retire to a life of travel, excitement, and adventure.

A YEAR OF CHANGE . . .

Even for those who are already doing well and meeting their objectives, in 2006 there are still compelling reasons for honing skills and staying on top of things. Why? A number of economic factors are in play that we can't control. We can only try to react intelligently to them to find ways to use them to our advantage while others slink to the sidelines lamenting their ill fortune. Here are some of them:

The housing market is driven by new first-time home-buyers. I remember that I could only afford a mobile home as my first house. I paid it off and moved up to a better one, which I paid off, then sold for cash. This gave me enough money to buy a house. After selling and trading up three more times, I now live in a nice house on the water; but I couldn't have done any of this without that first mobile home. Back then, financing was difficult to obtain except via FHA and VA loans, but houses didn't cost much; nor did insurance and property taxes.

Over the past few years, wages and house prices have risen, but interest rates and income taxes have gone down. It is still possible for the first time buyer to start the process of building equity in a house in order to move up. Interest rates are still below 7% in most markets, but the costs of energy, interest, insurance, and property taxes are rising. In the process, these rising costs are robbing the house market of potential buyers; here's why:

In most areas of the country, Johnny Paycheck and his wife average about $50,000 gross income per year. HUD statistics have shown that people who pay more than about 30% or so of their gross income for housing have a much higher incidence of loan default than those who pay less. Using this as a benchmark, Johnny's house payments shouldn't exceed $15,000 per year — or $1250 per month — including impounds for taxes and insurance. Ordinarily, he might expect to pay about $200 per month for these, so the mortgage payment should be in the range of $1,050. If he can get a loan with an interest rate of 6.75%, he can afford a mortgage of $185,000 and change. Depending upon his down payment, this could put him into an average priced house, which the latest figures peg at around $216,000 in America today.

What about his “take home pay”; how is it being spent? He'll pay around $10,000 in federal income taxes, plus state income taxes. After making his house payments, that will leave him $25,000 to pay for food, clothing, medical insurance, a couple cars, interest on personal debt, and expenses related to his kids education. Despite his earnings, his disposable income is near the poverty line.

For the past few years, Johnny has been living on his credit cards. When he reaches his limit, he sells or refinances his home to pay them off, and resumes the cycle. With low home interest rates and rapid appreciation, this has worked out fairly well, but each year he has to make higher mortgage payments. This increases the need to go deeper into debt. Is it any wonder that Americans are mired in a sea of debt today, and getting further behind every day and that we are among the lowest “savers” in the world?

Now, let's introduce a few bumps in the road that will probably have an effect on Johnny's disposable income and the overall housing market. Both credit card and home mortgage interest rates are on the rise. In areas affected by natural disasters, insurance costs are doubling. Cash-strapped municipalities are raising real estate taxes. The costs of medical care, prescriptions, and education are rising faster than the rate of inflation — even though inflation is also on the rise. We seem to be getting more than our share of natural disasters that create disruptions in the employment market. Added to this, we are losing higher paying jobs to foreign competition and “smart” machines. Laid off workers are having a hard time finding jobs that pay as much as they earned before. Corporate America is reneging on their retirement plans, squeezing retirees even more than others. Can you see that Johnny Paycheck is in for a lot of trouble? So are the lenders he owes. Something's got to give; and pretty soon.

THE HOUSE MARKET HAS ALREADY STARTED ADAPTING

Land developers, builders, lenders, real estate and mortgage brokers, and marketing mavens are adjusting to the foregoing scenario, even if Johnny Paycheck is largely oblivious to it. The market has been adapting to these realities for some time. A concerted effort is being made by builders to exclude speculators (who may never complete their purchases) from buying into new projects. Appraisals are tightening. Down payments and interest rates are being increased for buyers with “bruised credit”.

A dramatic shift has taken place in the home mortgage market. Lenders are now writing loans with “interest-only” payments with the entire balance coming due in five years. This gives the recent home-buyer five more years to struggle before he has to confront financial reality. Some five-year balloons are already coming due already. Mortgage lenders have been granting lavish “home equity loans” to be used to pay off credit card debt. At least, this way, they'll be “secured lenders” in the event borrowers declare bankruptcy. Speaking of which, on October 17th, the new bankruptcy law made it more difficult for people to simply walk away from debt.

The result of all this is a slowing market for housing; whether used or new. The market seems to be dying from the top down. The most dramatic price reductions on listed property seem to be on the more expensive houses for which the market has dried up in many areas. At the same time, people who live in houses with comfortable mortgage payments are less willing to sell out in this period of uncertainty. They aren't offering putting their houses up for sale as readily. As land-use restrictions limit available development land, it becomes more expensive. This limits new construction to houses that are beyond the reach of first-time house buyers. These changes create opportunities for entrepreneurs who can exploit them.

Foreclosure sales are coming alive again. Following the passage of the new bankruptcy act, lenders are finding it easer to get courts permission to foreclose. That's the good news. The bad news is that few bidders are willing to pay as much as the defaulted loan balances. As a result, as foreclosure sales climb, relatively fewer active bidders are interested in buying. This opens up several ways for distress-market buyers to earn profits even in a slow market:

1. Buy pre-foreclosures from distressed owners who want to avoid bankruptcy and still get relief from payments. With mature, financially responsible people who have become victims of rising payments, arranging to make up the payment shortfall each month for an equity interest in the property allows the entrepreneur to invest in good houses in good areas with little down payment and small negative cash flow.

2. Short-Sales: When lenders are the only bidders at foreclosure sales, their troubles are only beginning. They must evict the occupants and bring the premises back up to salable condition. They have to insure it as a vacant house, and pay property taxes. They know all this, and are often motivated to allow a loan to be paid off at far less than it's stated value so long as the borrower is going to give up title to the house with no compensation. Scott Britton (601-977-0277 or [email protected])) offers an excellent home-study course on Short Sales.

3. Loan discounting: The same reasoning applies to obtaining large discounts on defaulted loans, but the difference between buying a loan at a discount and buying a house by paying less than the loan balance is profound. When you buy a discounted loan, you effectively become the lender responsible for foreclosing and doing all the things the former lender would have to do, or persuading the occupant to deed the property over by negotiating an acceptable arrangement with him/her.

You can do all of the above with mobile homes; and it's often much easier to negotiate both with the lender and the borrower. Used mobile homes come in all shapes and sizes, some on their own lots and some in rental parks. This opens up myriad possibilities for re-sellers and re-habbers alike with large profit margins.

WHERE WILL YOU FIT INTO THIS PICTURE?

Because of all the changes that are slated to take place in 2006, there will probably be many more loan defaults and foreclosures, higher inflation and interest rates. The housing market will turn from a seller's market to a buyer's market. Seller financing will come back. How will you continue to grow and prosper over the coming year? Harking back to page #1, this is where you've got to do some thinking about what you'll accomplish and how you'll go about doing it.

Your first task is going to be to round up money to work with. Mortgage lenders are going to be very reluctant to finance people in the “equity market” who fix and/or flip properties. As credit demand picks up, private money lenders are going to want much higher interest rates. My friend Jack Griffin coined a saying that “Three nickels are more than a dime.” In so many words you'll make a lot more money if you're willing to share profits with others who will provide the funds you need without the need to pay interest or make payments until a project reaches fruition. That gets around high interest rates and gives you a preferential place in the market by allowing you to buy quickly without needing to get loan approval.

A lot of money can be made by entering into equity-sharing arrangements whereby an investor shares the risk in return for a large share of the profits that an entrepreneur might generate. For several years I've been the “investor” in a number of different projects with the “entrepreneur” who found an opportunity and capitalized on it using my money. I think my money is entitled to half the net profits and his work is of equal value. There is something inherently appealing and fair in dividing profits 50/50. For the investor, it's a hands-off way to have idle funds earn much higher returns. When T-Bills are earning less than 5%, the annual yield from buying, fixing, and selling houses without using debt can be over 20%. For the entrepreneur, many opportunities that might not have been feasible with high interest rate loans work out well when bought with an investor's cash.

When institutional financing dries up, private investors can earn high yields buying “seller carry-back paper” generated in the market at discount. This is less speculative than participating in profits because the documentation, credit history, and collateral can be checked out in advance; and the discounted yield on investment can be fairly precisely calculated. Selling off inventory now, paying taxes, and using the money to buy discounted notes can make a lot of sense to those who don't live in areas where there's much real estate opportunity. But beware; the farther away you are from the borrower and the collateral, the more careful you have to be in deciding which notes to buy and at what market discount. You're going to be the new banker and you don't want to have to deal with loan defaults later on.

Landlords make out like bandits when the real estate market dries up. People form families and need housing whether or not any new houses are being built. This puts upward pressure on rents, which usually can be set at just below the level of payments on a comparable house. As interest rates drive these payments higher, rents can be raised too. There are two ways to play this market. If you've got inventory you can't sell, rent it out, or lease it to an entrepreneur who will rent it from you and sub-lease it to the occupants. Or you can switch places and lease or lease/Option properties you don't own at one price and lease them out at a higher price. Either way, rents can continually be adjusted upward to offset higher operating costs and inflation while equities grow.

Using the foregoing equity sharing approach, focus on elderly people on fixed incomes who are being forced out of their homes by the rising costs of interest, taxes, and/or insurance. Buy a “Remainder Estate” in their homes with payments that will augment their income and enable them to meet their rising costs. They'd retain a “Life Estate” and the house would revert to you once they go to the big escrow in the sky. This would give you a highly leveraged long term investment that would increase in value without the need for either maintenance or management.

Welcome To 2006; What Will You Do With It?

THE HOUSE MARKET HAS ALREADY STARTED ADAPTING

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