August 1987
Vol 10 No 10
Depending upon whose point of view you're reading, things are either looking up or looking bleak for investors. The stock market is either ready for a 15% – 30% drop, or a spurt ahead to 3000 on the Dow. Real estate is either poised for new growth or ready for a crash. Banks are either going to finally admit that they are no longer solvent or they're going to 'book keep' their bad loans off the books. Foreign balance of payments and trade deficits are either turning around or the dollar must continue to drop another 15%. Every time I get ready to plunge into the fray and invest some money in something a little voice stops me. Maybe its the voice of reason. Maybe fear.
One of the maxims in my Winning booklet reads, 'Anytime that logic has to compete with greed, greed usually wins.' They say that every successful species has to cultivate a sound fight-or-flight syndrome. The same is true of investors. You've got to decide quickly whether to jump into the fray and ride the surge in silver, gold shares, options, commodities or whether to stand aside. Whether to buy distressed real estate in the oil patch or rust belt or not. Whether to start up a business or buy into one in hopes the recovery will continue, or whether to keep your money in cash. Whether to buy real estate 'paper' at fixed rates and with high taxes or to use it to buy houses in anticipation of coming inflation. Now's the time to get down to specifics.
After a remarkable first quarter, the stock market has been moving sideways, jittering between 2200 and 2400 with every headline. That's about a 10% range. For the speculator who can time those moves, a 10% move in the Dow can mean 100% when highly leveraged options are being used. And each move in and out of the market to catch these excursions makes the Broker and the Tax Collector a little richer. The trouble with being a market speculator is that leverage works against you too. And no one really controls the market. It's too big. It goes where it goes based upon the fight-or-flight of over a hundred million shares a day, bought by speculators all over the world. The investor's only choice is to get in or get out or adopt a hedging strategy. He doesn't get to steer the roller coaster, only to ride it or get off. And roller coaster rides can be scary.
On the other hand, by comparison, single family houses can be downright boring. First of all, they're income producers when leveraged at the same level as stocks one might buy Let's say that you buy stocks-on 50% margin. In terms of a rental house that costs $75,000, you'd have to spend $37,500 in cash down payment. And let's say you have a 10% loan with payments of $400 PITI. You're probably getting $600 per month rent, so you'd have about $2400 return (assuming that your tax benefits pretty much offset other expenses of ownership) on your invested cash – or about 6.4%. That's easily twice what you'd get in the form of dividends in the stock market today. But there's much more.
Suppose the market went to 3000. It will only do that if there's improvement in the economic picture or a speculative fever. On the one hand, economic improvement means consumers will have more after tax dollars to spend, and they'll spend them buying houses or up-grading their rental life-style. On the other hand, any rush into dollar denominated stocks will be triggered by a reduction in inflationary anticipation. That means that we'll probably see a corresponding reduction in interest rates which always bode well for house prices. They'll continue to move upward as they have been doing. Any inflation would drive cash into tangible assets, out of the market, right into real estate. So Billions of dollars would compound inflation's effects on real estate prices.
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FORTUNES HAVE BEEN MADE WITH 10% RETURNS . . .
Every day my mail is crammed with letters extolling the virtues of assorted soothsayers who claim anywhere between 207 and 11007 profit to the lucky entrepreneur who buys their investment advice. I always wonder why they have to work so hard when they're able to earn so much on their investments. The paradox is that, in studying the lives of truly successful people – the moguls of the investment world – it seems they achieved a remarkable degree of success just trying to obtain investment yields at about 3% over the inflation rate. There's a rational explanation for this. It's called CAPITAL.
We have a tendency to focus on the spectacular rather than the mundane. We see a $25,000,000 purse at a boxing match and forget all those preliminary bouts where the winner received $1000 for getting his head beat in. And we'll gladly pay $395 for a set of tapes promising millions without effort rather than to take a $100 course at the local college in investment or economics. When we hear that someone doubled his/her money on a lucky stock pick, we're impressed more than when we hear that housing prices rose by 7% in most areas in 1986 – more in others. What we forget to do is to look at the dollars.
It really does take money to make money! Doubling $1000 in the stock market results in less wealth than making 10% on a $100,000 house. And a speculator might have only paid $1000 for an option on the $100,000 house. Or an investor might have bought it when it could be purchased with $1000 down and when it only cost $15,000. When we use leverage – such as that produced by an option – we are effectively employing another's capital to make money. The trick here is to avoid having to pay for the use of that equity represented by the $100,000 house above. We can also do this by using a single payment note – one which draws no interest and which is only payable upon sale of the house. The market that is developing with double digit interest rates will permit the fledgling buyer in the market to structure this type of transaction under certain circumstances.
Who would sell on such terms? The person who is being transferred and who needs someone to take over his low-leveraged property payments pending a subsequent sale. He's really just trading off interest & payments in return for management and marketing of his property when the transaction is reduced to its essentials. Real estate is unique in that it offers this type of personal problem which can yield a profitable solution to those who can recognize it and explain it to the 'capitalist' who owns a property. Thus, the would-be-entrepreneur who can undertake to manage and market a property at the expense of making payments and repairs out of collected rents is able to capitalize on investment of others without having to wait to build his/her own capital base. Of course, this is far different from rushing down to the bank and borrowing funds with which to speculate in real estate. As thousands have found out, including some of the foremost gurus of cable TV, a bank loan enables you to RENT CAPITAL. A lease, option, or single payment note has the effect of allowing you to trade on another's capital without renting it. That difference can mean the margin between success and failure. It requires no little skill to implement.
As you may surmise, wealth flows to those with the best understanding of it. In order to borrow the capital of another, you must be able to comprehend the motivation of the owner, structure a rational response to his/her particular needs, have the ability to implement your own strategy which might combine management/maintenance/marketing skills, and be able to await favorable events to enhance your profits. It requires patience. Or you can do what millions of other successful real estate investors have done. Just WAIT!
Despite all the hype about fancy financial structures, negotiation skills, bank sales, etc. The American homeowner who has held is home for 10 years or so has been the big winner overall everywhere. I've never seen a figure that reflected less than 50% of all homes being free and clear. That means that at least half of all homes have been paid off and are occupied by people who've enjoyed fantastic appreciation over the past decades while being able to enjoy the full use and occupancy of a home. And, even under the latest tax laws, they'll he able to sell tax free, take out $125,000 tax free, Or, they can just leave it to their heirs tax free. TIME is the key to their capital formation, not skill.
TENANT TURNOVER IS THE KEY TO CAPITAL FORMATION . . .
I just lost Helen. Helen was my longest-term tenant. She's a pretty fair case study to illustrate how the combination of TIME and SKILL can earn profits without risk. In I974 Nixon had just stepped down, Ford was President. Inflation and interest rates were high – about the same as today – but the massive inflation of housing prices was still ahead of us. I bought a 3/2 with a family room and central air for $19,000. The sellers were being divorced and leaving the area. She needed some cash, he needed shelter. I gave her $2000 cash to leave town with. I gave him a single payment note due 2 years after he left the house. In the meantime, he leased it from me for the payments NET after all taxes, insurance, maintenance. I was assigned $857 in impounded tax and insurance account funds as part of the down payment. I took title to a fully assumable VA loan at 7% with a balance of just over $15,000. Payments were $147 PITI.
In 6 months the seller moved out. Helen was pregnant with her first child and needed more space. I accepted her smaller 3/1 with an equity of $2000 over a $14,000, 8% loan as consideration for an OPTION to buy the first house. She agreed to pay $200 per month rent for 2 years, then to pay $250 for 5 years after which time she'd pay market price for the house, or would be able to continue to rent it at a market rent without an option. Over the ensuing years, she was divorced so didn't pick up her option. I put a roof on her house, replaced the appliances, and rebuilt the bath. I also exchanged the house she'd traded in for a larger house, using it as a down payment, and I exchanged that for an apartment house. Now Helen has moved out. Considerable work has to be done to the property after 13 years, but the replacement tenant has agreed to do that as an independent contractor for $400. His rent will be $450. Payments on the property have increased to $222. There's a $14,607 loan balance. The house is worth about $54,000.
The house Helen traded in was exchanged for a small apartment. After 9 years this was finally sold on an installment contract. After it finally paid off, I made $83,000 after taxes. I collected $17,400 in rents over the period in excess of my costs from Helen. And the house equity has increased by $35,000. Suppose I valued my management effort at 10% of the rents collected – which were $48,600 over the entire period – and subtracted that from my profits. That would leave me with $43,540 AFTER THE FULL RECOVERY OF MY INVESTED CAPITAL or a total of $130,540 return on a $4000 investment over 13 years. Of course, this doesn't take into consideration the tax benefits over the years. Plus, I can exchange this equity position into other income properties tax free under Sec 1031.
With $4000 invested and with $130,540 returned – and computed as a single sum reversion without regard to timing of the payment and/or receipt of funds – the yield on my investment is equivalent to over 30% compounded each year. But not everyone can do this. Nor can it be done anywhere or at any time. Unusual market circumstances made it possible. Let's forget all about the exchange and option and just look at rents. The return is still about 12%! If we just look at appreciation, the return is over 18%. In both instances, it was the long term holding period without any loss of rents that earned the return. And remember, each month I received a positive INCOME while I held the house. Had I had to pay for vacancies and extra refurbishing, my return would have been far less.
Tenants like Helen are hard to find, and harder to keep. But it pays to spend the effort. First, the house has to be attractive – to have curb appeal. It has to be located in a 'family' neighborhood, not in a 'rental ghetto'. It has to be contemporary. In the South, central air is a real PLUS. And the rent has to be attractive. You can only afford this if you've properly structured your terms upon purchase to allow for some give and take in the rents to match market conditions. Your landlord policies have to he equitable. It's O.K. to be a tough landlord, but only if you bend over backward to be reasonable about your demands and fair in your treatment of the tenant. Most of all, you've got to remove incentive on the tenant's part to leave! When they're involved in improvements, given incentives to renew with a nice home – they don't leave.
THE OUTLOOK FOR RENTAL INCOME CONTINUES UPWARD . . .
The government shot itself in the foot – again! When the bureaucrats passed the tax act, they forgot to ask the permission of the people who produce housing. As a result, builders and financiers all over the country have withdrawn services. You might say that we've got a general strike when it comes to building more rental housing and many communities are already beginning to feel the pinch in affordable housing.
In any supply/demand situation, responsible entrepreneurs will match prices to the levels the market will pay. As more taxes are collected to fund social programs, entrepreneurs see profit margins shrink. Builders don't have the incentives to take long term risks in an environment controlled by 2-year-term Congressmen. Nor do lenders. Nor do investors. Hence, those who flock into urban areas in the continuing quest for tax-payer dollars with which to fund their life styles are finding that there just isn't enough housing – particularly low cost housing. Landlords have discovered that they can earn higher profits by up-grading their rentals and appealing to middle-class tenants. This prices the lower income groups out of the market. And it gives even more incentive to investors to raise prices in order to offset the increased tax burdens of real estate.
The worm is turning with regard to tenant-power all over America. Newspapers now have display advertisement for TENANT EVICTION ATTORNEYS who specialize in LANDLORD RIGHTS at very competitive rates. More screening and collection services are doing well. In Kansas, effective July 1st, tenants who leave the property owing the landlord more than $150 face CRIMINAL penalties of up to 5 years. Lesser amounts lead to county jail. Zoning boards are becoming extremely lenient when it comes to tenants 'doubling up' in rentals. A short session with a calculator can show the effects on cash flow and yield.
One subscriber specializes only in houses which have floor plans amenable to splitting into multifamily occupancy – usually older/larger homes in conveniently located areas. He provides for separate entrances, bath and kitchen facilities. Often, basements and attics can be finished off as well as garages to create more rent-able space. Where tenants used to turn their noses up at these accommodations, the housing crunch is making them very attractive. A developer near a University is building student condos of 200 square feet with a sleeper loft at one end over the kitchen/bath unit. Think of a garage 10 X 20 with 5 feet of space used for the loft/kitchen/bath and 15 feet for living room. They sell for $22,500 like hot cakes. Similarly, we're seeing Mobile Home Quadraplexes consisting of a 70 X 14 Mobile home divided lengthwise and laterally to make 35 X 14 units. They rent for $200 each and cost about $16,000 to have built at the factory.
One would think that small apartments would be a drug on the market, but those with positive cash flow yields seem to be commanding high prices where they can be found in tight rental markets around New England, California, Washington D.C. and elsewhere. Here again, creative use of partitions creates high density living units. In a 12 X 12 bedroom, a free standing partition made of fabric-covered Masonite panels in the form of a 'Z' allows two twin beds to be placed in the center of the room for two teenagers while maintaining separation and a fair degree of privacy provided by the 6'8“ panels. This has the effect of adding another bedroom, making a 2 bedroom unit serve as a 3 bedroom.
Let's say that you can increase the gross rents by 50% using some method of doubling up. If you're in danger of having un-useable passive losses because of TRA 86, 1 S500/month rental will bring in $250 more which these losses can offset – or $500 for a $1000 per month rental. With only 5 of these, your annual income jumps $15 – $30,000. without a corresponding jump in operating costs.
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Quotation not permitted. Material may not be reproduced in whole or in part in any form whatsoever.
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