September 1993
Vol 15 No 13
People go broke because of a common error. They think in terms of GROSS profit instead of NET profit. They consume their capital without realizing it. Let me tell you about Granny's Attic. Granny's Attic was the name of a little shop that specialized in antiques and art objects reminiscent of the late 1800s. From the start it did a booming business, even being written up in the local Sunday supplement. The owners were four young college students who signed a 5 year lease with me to rent their retail space. Despite record sales, they were broke within a year and had to borrow money from their parents to buy their way out of the lease. Why? Because they thought each dollar of sales was a dollar of profit, so they divided up the receipts and spent them on the good life.
There are several lessons to be learned here. First of all, the landlord got paid! I wasn't a co-venturer in their store. I wouldn't have been paid extra if they'd made a million dollars. Correspondingly, I didn't get paid less because they failed. The parents paid off the lease because they'd guaranteed it. And my rental income went on regardless of their lack of business acumen. If landlords would just remember to write enforceable leases with cancellation penalties, they'd avoid spending their own capital and sharing the same fate as Granny's Attic.
Another lesson is that you can't determine NET spendable profit until you set aside the fair wages of capital as well as other costs of doing business. In order to do this, it requires the ability to maintain financial records which incorporate both direct and indirect costs of making the gross profit. We can further divide these costs into those attributable to the business itself, those attributable to financing the business, and those attributable to government. Let's see if we can be more specific.
PAY YOURSELF FIRST . . .
Since this is a real estate letter, we'll use an investment house for our pro forma examination of the subject at hand. In the typical operating statements I've seen, gross income usually includes rents, forfeited deposits, bad check and collection charges, late fees, extra visitor and pet fees. In some instances these might also include laundry, cleaning charges, security, parking, insurance, maintenance deductibles, pay telephones, and utilities. Ponder these a little and you might find a way to find ways to increase your own gross income. Remember GROSS pays your costs. NET pays YOU!
Operating expenses can be sub-categorized ad nauseum, but they can be broken down into vacancy, bad check and credit losses; exterior maintenance, which usually includes lawns, security, parking areas, pools, patios, landscaping, exterior painting, roofs, general repairs, lighting, signs, etc. Interior maintenance includes doors and windows, heating, cooling, plumbing, electrical, mechanical systems, appliances, cleaning, etc. Next come utilities. Electricity, gas, oil, garbage and trash removal, water, sewer, cable TV, etc. are included in this. What's missing? Where have owners begun to consume capital without realizing it?
WHERE ARE MANAGEMENT COSTS?
We've plugged everything in except PEOPLE. Most readers will be performing as many of the management and maintenance costs as they can without accounting for it on their operating statements and without placing a proper value on it. Early on, I did the same. I 'moonlighted' as a landlord. I reasoned that my time was worth nothing when I wasn't 'on the clock' at my regular job, so all I was investing was my 'spare' time. Now that I'm successful, I don't even know what 'spare' time is anymore. A 40 hour work week is a dim memory. 60 hours is an average week around our house. And so it was then too. My 'spare' time had an economic value equal at least to what my wages, including overtime and holiday pay, would have been if I'd hired myself out as an all around 'man Friday', doing all the things for another owner that I was doing for myself.
To the extent that you fail to include in your operating statement the value of your own work, you understate expenses, overstate taxable profit and consume your capital. Here's why. When you work for yourself, you probably don't subtract expenses for the value of your labor from operating statements. Suppose you were worth $15 per hour and worked 20 hours per week doing maintenance/management on your own properties. 52 weeks per year at $300 per week adds up to $15,600. That can distort the true property value.
When your management expenses aren't deducted from gross profit, it means you're paying taxes on profits calculated as if your labor had no value. This leads you to many errors in valuing your property based on the capitalized value of its income stream. Let's make it easy. Suppose you bought a property at 10 times net annual earnings where the value of the owner's labor was understated by $15,600. You'd be paying $156,000 too much. That's a meaningful transfer of capital that few people comprehend. They go broke!
CREDIT CAN BE A NARCOTIC . . .
'Nothing Down' has almost become a religion with many who buy houses. Somehow they feel as if they've got nothing invested in the property other than their effort. And as seen above, they place little value on their time or the work they do. Everyone needs credit to buy something as big as a house. Credit costs can't be overlooked. There's no such thing as a nothing down house! Before you start writing letters, give it some thought. When you buy 'nothing down' you pay more than you think. First of all, the number of sellers who'll sell with 100% owner financing is extremely limited.
It's like buying at a real estate garage sale. You can find bargains, but you have to make compromises regarding condition, location, function, marketing, etc. You're probably buying an older property in a neighborhood that's past its prime where you're not going to attract many who'll be able to pay market rents. If you don't believe me, see how many 'nothing down' deals are made viable only because of government subsidies in the form of rents, interest rates or tax credits. Added to this is the lack of liquidity.
In general, the only reason you're getting your 'nothing down' terms is because the owner can't find anyone who'll buy the house who can qualify for a loan. Nor will you be able to do it either. In all probability, you'll only be able to dispose of the property by carrying third rate 'paper' yourself from another 'nothing down' buyer or exchanging the property for another and adding cash or more credit at that time. The older the property gets, the less likely conventional lenders will advance mortgage money to a subsequent purchaser. In order to liquidate, you'll be forced into the discount paper market or the distressed property market. Both will discount the value of your property heavily. You might even find yourself having to add cash just to get someone to take the property off your hands. I know. I've done it!
There are other less obvious costs. Second rate properties with third rate tenants are usually accompanied by low gross incomes and high operating costs. Add the costs of 100% financing to this, and the results add up to negative cash flow. So that 'nothing down' deal is merely a technique which stretches out the down payment over a period in which the 'interest' cost on the stretched out payments are in the form of unpaid labor. I can't seem to find anybody who has accumulated much money with this type of transaction outside of the distress markets.
The problem with all types of credit is that it obscures the true costs of holding property from the entrepreneur. I recently was negotiating with a developer who'd placed 3 mortgages on his project, then pawned his corporate shares for another loan, then optioned the completed property for yet another 'loan'. And he still needed more money to finish the project. Only by revising his sale prices upward continuously could he delude himself that he would make a profit. He couldn't comprehend that the credit he'd been so successful at negotiating had already consumed the profit in his property.
Suppose an income property is only worth 10 times its net income stream, you can see that each dollar of interest costs $10 of value, assuming that there's no inflation. When there's real price inflation in a market ready, willing and able to pay, it's possible that high leverage at fixed rate interest will enable the owner to make a profit which will overcome the costs of financing. But inflation is a fickle mistress. While it robs lenders of profit when fixed rate loans can be paid back with cheaper dollars, it also robs those who operate income property. Let me explain a little further.
Suppose you owned a property that produced $10,000 per year of net operating income before financing. At ten times earnings, it would be worth $100,000. Now, let's say that we're enjoying 10% real inflation. Next year the property would be worth $110,000 right? Not always! Here's why. The same inflation that drove up the value by 10% would also be driving up expenses. Suppose operating expenses were to be half of the gross rental income. That would mean it would take $20,000 of gross income to produce $10,000 of net income. The other $10,000 would consist of operating expenses. Let's say these go up also by 10%. This would reduce the net income by $1000 leaving $9000. At ten times earnings, inflation would have driven the building value down rather than up in value. Only by increasing rents MORE THAN 10% can an owner break even on inflation. But there are wild cards which can really mix things up.
First of all, if we're talking about a property that is rented to people who are seeing an increase in their own net incomes, we can raise rents to match inflation. Even though we've arranged financing that is fixed rate and which enables us to capture extra cash flow which keeps net operating revenues above the inflation rate, any buyer who tries to buy our property will have to pay higher interest in order for the lender to offset the costs of inflation against his own profits. In 1979 and again in 1980 we saw quantum leaps in mortgage interest rates which ranged from 8% to 22%. Imagine how this would affect the value of the property to another buyer.
By now you're asking yourself how in the world you can make a rational judgment about investing in real estate. Single family houses defy all of the above rationalization for the simple reason that most people buy houses for irrational reasons. They want to USE a house, not INVEST in one. So they buy the one that best meets their needs at a price they can afford to pay. So did I. So did you. For that reason, single family houses lead inflation upward and trail deflation downward. Prices aren't set by multiples of income streams, but by emotional appeal. All the more reason to buy houses in decent neighborhoods where decent, solvent people will either buy or rent them. I'm content to let the real swingers invest in leveraged apartments and commercial property.
Of course, you could reap the wild wind of a financial panic which caused a flood of naive buyers willing to pay any price on any terms just to get their deteriorating cash into tangible real estate assets. Then you might cash out at a high price, but there's one more little card to play.
GOVERNMENT ALWAYS HAS THE LAST LAUGH . . .
Every time you buy or sell, or transfer real estate, or mortgage it, or collect rent, or improve the property, or raise rents; you pay a tax to someone at some level of government. One of the great myths is that real estate is somehow taxed less than other investments. Not necessarily so. Sometime, compare the total tax load imposed on real estate by AD VALOREM, SALES, TRANSFER, DOCUMENTARY, USAGE, IMPACT taxes and fees with a comparable investment in non-real estate. When I did this with my own portfolio, I discovered that the total tax load was higher with real estate than with stocks,bonds, and/or paper. Does that mean that I'm dumping real estate? No. It does mean that I'm paying a lot less for any new acquisitions until special tax incentives are re instituted for real estate rentals. In the meantime, it pays to find ways to reduce those taxes.
The first line of defense is in documenting your acquisition to allocate as much of the cost to items which will provide deductible EXPENSES rather than CAPITAL improvements. Once upon a time, I bought 10 houses at 80% of market value by leaving the seller in title to the land beneath the houses. Think of this like a 10 unit mobile home park, except the houses weren't mobile. The owner leased the land beneath the houses for 35 years at 3% of value (in contrast to 8% financing) to provide for a secure income stream, deeding me the houses, subject to his carrying 8% owner financing. Each month I paid deductible rents and interest to him, lowering my taxes. And I depreciated 100% of the improvements to further shelter the rents from income taxes. The allocation of land to improvements is usually negotiable at time of purchase. Show it on your contracts and if possible, on the closing statements as well as the county tax records if you can negotiate with the bureaucrats to adjust the tax records accordingly.
There are lots of rules concerning expensing repairs, but, when you spend money on something which won't wear out or be used up in a year, or which is being held as inventory for resale in the ordinary course of business, or which maintains the earning power of a property, you can expense it. That means, you can reduce your taxable income by the amount spent in the same year as the money or credit is used to pay for it. When you're making long term improvements to rental property such as adding pools, roofs, screen porches, patios, central heat & air, etc., you can't expense these in the year of the actual cost. Instead, costs must be deducted over 27.5 years on a house and 31.5 years on a commercial building. These periods may go up under Clinton's tax package.
There are several ways to mitigate these rules. One of them is to rent property to a tenant at fair market rents 'as is' and let the tenant make the improvements or not as he/she sees fit. When the rental market is tight, to turn the house over as quickly as possible, giving a qualified tenant a lower rent and yourself lower expenses. The question as to whether or not a tenant improvement is capitalized is moot since it's the tenants' cost, not yours. The rent you don't get because of the cost the tenant incurs has the same effect as actually receiving the rents and making repairs.
Check your state and local ordinances over carefully to see where you might be able to save on other taxes. For example, in Florida, residential rentals that are shorter than 6 months are subject to sales tax. By writing a lease for a period longer than 6 months, this tax can be avoided. When the tenant arbitrarily breaks the lease and disappears in a shorter period, the tax isn't due. The lease term as written is what counts. Saved sales taxes go straight to the bottom line.
In some states, transfer and/or documentary taxes must be paid on all property and mortgage transactions. But they often overlook long term leases. Does in make any difference whether you own a property or hold a 99 year lease on it? If this can be coupled with some right to buy at a future date, all the rights to income and depreciation can be transferred while taxes are saved. Let's turn this around a little.
Lease Options have always been a favorite way to control property. But suppose you leased a property as described above in need of extensive capital improvements. Your lease might be for 10 years with 3 extensions for a total of 40 years. In such case, you'd be able to AMORTIZE your improvements over the term of the lease at approximately the same rate as if they were being depreciated, but at the end of the lease period, all unamortized basis in the property could be expensed in the final year. Suppose you failed to renew the lease at the end of the first ten year period. You'd get a tax deduction windfall. Suppose, out of the blue, the owner paid you not to renew the lease. The tax deductions from amortization might easily offset the amount paid by the owner, giving you a reasonable after tax return over the period. All concepts and ideas aren't for all people. We'll be exploring many more of these in upcoming seminars on both coasts.
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