March 1995
Vol 18 No 7
I don’t know about you, but I was inundated with advertising brochures the first week of 1995. It was caused by the 10%+ hike in U.S. postal rates effective in 1995. An avalanche of mail flooded in from direct mailers who were intent on beating the cost increase by mailing their 1995 promotional material in 1994. There are several morals to this story. This price increase was possible only because of a monopoly.
Government’s monopoly over regular mail delivery allowed it to increase prices by 10% with no corresponding increase in productivity. This is a clear sign that inflation is alive and well in America today. Sooner or later, increased mailing costs will be passed on to their customers by businesses all across the land, and everyone will pay more. Note that the same government maintains we’ve had less than 3% inflation, even though a 10% boost in postal rates is required by the Post Office to offset it. Is somebody stretching the truth a little?
To offset government’s inefficient and inflationary policies, the producers are going to have to increase their own efficiency. They’ll have to knuckle down and find ways to squeeze their own profit margins a little more to pay for them. The lesson here is that in order to stay profitable, successful businesses must find ways to overcome cost increases, rather than merely passing them along to their customers.
Business’ inter-relationship with government has a direct application to making money with real estate. One of the fundamentals of real estate investment and speculation is first to understand and anticipate changes in costs and opportunities, then to adapt to these successfully. Let’s see if we can put this into a single illustration.
Think of real estate profits as a ship on a large sea which plies the profitable trade routes of real estate markets. Inflation and deflation, expansion and recession are economic tides which cause our ships to rise and fall with the economic business cycle. Government policies, actions, regulations, subsidies, taxation, restrictions are super-cargo which must be carried by our ships before we can load on profitable items for trade and commerce. Politics are storms which change the tides, the courses we must follow, the amount of trade goods we can carry, and the maximum amount of profits we can ultimately realize. Political change can make our ships founder or go faster, be more or less profitable. We must always be aware of which party is in power, and what their avowed policies are in order to anticipate ways to make money.
To illustrate this; generally, rent controls, rising prices, regulations, high taxes and government intrusion into private affairs accompany liberal takeover of political power. We’ve observed this in the proliferation of regulations and regulators, more concerned with the rights of spotted owls, woodpeckers, and politically correct segments of our population than with private property rights. In 1981, Republicans passed ERTA which was good for real estate, but followed up with tax bills in 1982, ’84, ’86, ’87, ’88, and 90 which did real estate little good. Nonetheless, in the next two years, we can reasonably expect some tax relief, less regulation, more respect for private property rights. This isn’t necessarily all good. There’s a fair chance that a lot of ‘social’ spending programs together with HUD programs could bite the dust. Section 8 landlords might want to watch this closely.
DO THE BEST YOU CAN WITH WHAT YOU’VE GOT
Those who have profited from real estate owe their successes to changes they made in the products of change that took place in the market, or both. Las Vegas land development is a case in point. Suppose government had restricted business and residential housing growth in Las Vegas to the original downtown area. What do you think desert land where the casinos now stand would have been worth? Suppose that taxes consumed 75% of the profits of the owners; would Nevada desert land have ever been bought or sold or developed? If government had determined that the rights of the kangaroo rat or the tumbleweed exceeded the rights of the taxpaying land owners, would there even be a Las Vegas? Probably not.
There’s another chapter to the Nevada story. About 35 miles from Las Vegas is Boulder Dam. It was built by government to protect farmers from ruinous Colorado River floods. Started in the depths of the great depression, it provided employment for thousands and generated millions of dollars of profit for the various contractors engaged in its construction. Once completed, it enabled millions of square miles of land in Nevada, Arizona, and California to be cultivated and developed profitably while generating billions of watts of electricity for sale in the Southwestern corner of the U.S.A. Without this dam, there would have been no Las Vegas. Los Angeles and much of Southern California would be unpopulated desert. The Imperial Valley’s rich farms would be mere extensions of the Yuma Desert. Who can say how many billions of dollars have been created for entrepreneurs and investors because of government capital investments throughout the region?
Let’s scale things down to small real estate investments. If you’re going to make money in land, you’ve got to be able to develop it. Depending upon where it is, obtaining government approvals is going to be the key to how much money you make. If you buy land with improvements already on it, for the most part, you’re still going to have to depend upon government for water and sewers, highways and transportation systems, occupancy licenses and permits, subsidized utilities and bank financing. In some instances, without government subsidized leases and/or tenants, even improved properties don’t make money. But along with government aid comes government controls and political liabilities.
MULTIPLE TENANTS MULTIPLY PROFITS AND LIABILITIES!
Multi-family dwellings carry the greatest political risks. Mobile Home parks fall into this category too. Why? The higher the concentration of tenants, the more likelihood they’ll band together to wrest concessions from the owner through the political process. Despite the fact that an owner may pay more taxes than all the tenants combined, his ability to influence political power is inherently much weaker.
Lead paint is going to become a major problem for many landlords in 1995. We’re researching the problem now, and expect to have a full review of the law and possible remedies shortly. In a multi-family setting, rigorous enforcement of the environmental regulations will garner a higher percentage of favorable tenants to unhappy landlords than will a single family rental house. One tenant vs. one taxpaying landlord doesn’t add up to as much political leverage as 100 tenants vs. one taxpaying landlord. And when these tenants are in favored political class (subsidized government dependents), the political advantages in enforcing regulations are going to cause both financial and social problems for multi-family and government subsidized rentals.
Fairly modern single family houses in non-rent-controlled areas are going to be the overwhelming choice over smaller, older, subsidized apartments for those who want to avoid political problems. They’re a lot more resistant to economic problems as well. While inflation’s rising tide floats all boats, it doesn’t raise net operating income or cash flow for multi-family dwellings as much as it does with singles. Here’s why:
In a subsidized rent program, politics, not the markets, will control how much the rent can be increased. With single family rentals – except in liberal strongholds such as Cambridge, Berkeley and Santa Monica – rent controls are usually not applied to single family rental houses. Thus, as the tide of inflation raises costs, single family landlords can swiftly offset with increased rents or sell their rentals to capture the price increases. Owners of multi-family units usually find it much more difficult to liquidate properties. When they try to raise rents to keep pace with rising costs, they often must await government approvals. This brings into play the effects of inflation on property valuation.
FINANCING, NET INCOME, SUPPLY AND DEMAND, CONTROL PROFITS
The effects of politics and economics on profits are reflected in financing, occupancy and net operating income. Let’s begin with which to buy an apartment. My credit is perfect, but approval of my application for a $500,000 loan with which to buy a small apartment property must look beyond my personal resources to the collateral itself. The value of the collateral must support the loan amount. Furthermore, the loan yield must compete with other yields of comparable risk in the money markets. Thus, for 30-year, non-owner-occupied real estate loans, I’ve got to expect to pay a higher interest rate than a bank would get risk-free by investing its money in 30-year U.S. government bonds.
Government borrowing can thus influence my loan costs by changing the rate it will pay for its loans. Throughout 1994, as the Federal Reserve has raised interest rates, mortgage rates have risen. Appraised apartment values are reduced by net operating income yield as compared to long term mortgage rates. Thus, inflation can cause some properties to lose value when rates rise. Here’s an example: Recently mortgage interest rates fell to about 8%. Using the ERV formula, an apartment which yielded $40,000 net operating income might have been valued by dividing $40,000 by .08 to arrive at $500,000 for loan purposes. When inflation fears drive interest rates to 10%, without a corresponding increase of net operating income, the appraised property value might be reduced from $500,000 to $400,000 ($40,000 divided by .10). Houses are affected differently by inflation. Here’s why:
When income properties are most often valued in investment markets by comparing their net incomes to long term money market rates and applying various risks, management, and physical factors; single family houses are most often valued according to comparable sales figures developed in the user markets without regard to the economics of any use as rentals. Thus, their appraised values for loan purposes rise much more readily as inflation sweeps in. You might say that they are much more buoyant in a rising tide. What about a falling tide – deflation?
It’s a mistake to think of houses as speculative commodities to be traded willy nilly by speculators. They aren’t. Everyone needs housing. They’re either going to buy it, rent it, or steal it regardless of its price. During inflationary periods, the tax and economic benefits to owning one’s home rather than renting it are compelling. As prices rise, so do wages and rents. So do tax brackets. Back in the ‘70s, when John Q. Renter saw how much apparent wealth was being created by rising inflation for homeowners, he couldn’t wait to buy a house. Lenders were eager to grant mortgages because of the historically low foreclosure rates for single family home loans – even at real interest rates which were below the inflation rate. Leveraging a rising market pays off.
With Jimmy Carter’s inflation (politics) running at 15%, a loan pegged to 14% actually paid the borrower one percent per year in terms of price appreciation. Homeowner deductions put net, after-tax cash into former tenant’s pockets when they bought a house with high leverage. And each month, these new homeowners saw their net assets leap upward. Demand for single family houses skyrocketed driving prices upward. Every buyer was making money over fist. What happens when prices fall?
Many people who borrowed at high rates later refinanced or sold their homes, reinvesting the proceeds in replacement homes, often obtaining new loans at much lower rates. When prices fell, they fell from what were effectively much higher levels than when the properties were originally purchased. Prudent owners continued to live in the properties with monthly payments considerably below prevailing rents. Others got greedy. And foolish. They refinanced their homes with much higher mortgages in order to ‘borrow out their equity tax free’. When prices fell, borrowers couldn’t comprehend that they’d already been paid their profit via the borrowed funds. They felt somehow robbed. Many of them surrendered their homes to lenders via foreclosure or bankruptcy. There’s a wide perception that they lost money in real estate despite the fact that they took out far more than most of them had ever put in.
SINGLE FAMILY HOUSES YIELD PROFITS IN MANY WAYS
Thus far, we’ve been talking about houses from the viewpoint of the consumer. What can they do for the entrepreneur? All single family house profits boil down to a spread between the purchase power value that is invested and that which is returned. You have to make your profit when you buy them for the most part, whether you intend to hold them long term for income and appreciation, or to ‘flip’ them for a quick profit.
When house prices are falling, they can be bought more readily on ‘creative terms from motivated sellers and later sold when markets turn more favorable. When buyer demand is down, renter demand is usually up. Rising rents can contribute significant cash flow to support the financing while you wait for higher prices. Another way to make money with houses for those who don’t want to manage is with ‘fixers’.
A few hardy souls do just fine in good times and bad buying the ugly ducklings and turning them into swans. One person we know earns around $100,000 per year fixing up properties. (Call us at 800-889-2020 to order his $39.95 video tape and instruction book.) Another person sells fixed up houses at top appraised market price quickly by carrying back the financing himself. He then sells his fresh first mortgage ‘paper’ to investors at discount for cash which he uses for more acquisitions.
Selling mortgage notes is a business unto itself. Mortgages can be custom designed to provide high market demand for the ‘paper’. A recent issue of Howard Cook’s outstanding Mortgage Report (P.O. Box 647, Elfers, Florida 34680, (813) 845-4590) explains using two Notes, both at top market rates. One would call for all payments to be applied to it to amortize it swiftly. The other would call for no payments. It would accrue and compound interest until the first was completely amortized. At that point all payments would be applied to the second note. The 1st note could be easily sold at a high percentage of its face value. The second note would contain most of the profit and be held for the long term. Compounding interest on the 2nd would multiply ultimate profits.
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My God that Howard Cook is a Genius! Where does he write now?