November 1981
Vol 4 No 2
WHEN THINGS GET TOUGH, GET BACK TO BASICS.
In this period of extraordinarily high interest rates, good buys abound, but many still are unable to buy with positive cash flow. Still, nearly every day, a past student calls me with reports of triumph where he has purchased property well below market value with positive cash flow from day one. How can some be so lucky while others miss these good deals. It‘s not luck, let‘s review the basics of buying positive cash flow properties.
There are four basic factors that contribute to whether or not a property will have positive cash flow. Keep in mind that we should examine cash flows on an annual period, or even for the entire projected holding period, but not on a monthly basis. A cash basis tax payer will project a distorted cash flow in the event that he uses a monthly system because he will overlook large maintenance items, and other balloon payments which may occur during the holding period. The factors to consider when projecting cash flow are 1) the down payment, 2) the monthly payment or annual payment to service the debt, 3) the monthly or annual income you can reasonable expect a property to produce, and 4) an annual figure which will adequately cover taxes, insurance, and maintenance items.
Often, too much emphasis is placed on minimizing the down payment with little consideration given to the amount of the monthly payments. Let‘s take an example to illustrate this point. Two houses which are identical in construction and in value and for purposes of the example, will have zero maintenance and vacancy cost for the first year. One house can be purchased with $5,000 down and will then have a break even cash flow for the first two year period. The other property can be purchased with $2,000 down and will then have a negative cash flow to service the debt of $100 per month. Disregarding income tax ramifications, which house has the largest negative cash flow over the two year period?
At first blush, many people jump on the first house which obviously has a break even cash flow. However, they overlook including the down payment in their cash flow calculations. When you write a check for $5,000 down payment, that is negative cash flow, and because it occurs early in the investment, it has a more detrimental effect on your cash flows than the $100 a month negative spread over a period of two years.
The next factor you should project is major maintenance items which you will have to pay for during the holding period. Large items like roofs, new heating and cooling systems, etc., can be financed using home improvement loans, and if this is your intention then the monthly cost of those loans should be projected. The third item is balloon notes or lump sum payments you negotiated into your purchase price. Ideally, you will never have a large lump sum payment due while you still own the property. However, if your like me, you never sell a property, always negotiate a clause into any balloon note or lump sum payment that would allow you to extend that payment by paying an amount equal to 10% of the amount due as a prepayment of principal.
The next item, rents to be collected, should be projected on the low side. My long term game plan is to keep the same tenant in one property during the entire holding period. This eliminates vacancies and vacant days and minimizes the maintenance especially interior maintenance, which has to be performed on the property. As a much larger percentage of our long term profits will come from appreciation in property values than rents collected, I can own many more properties when I do not have to worry about the month to
month maintenance problems which long-term tenants eliminate.
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The largest expense in a poor management program is typically vacancy. Amateur landlords make many critical mistakes. First, they charge more than a property is really worth which generally results in more vacant days before the property is rented. It’s easy to see that you’re much better off full at $550 a month than empty at $600 a month. The second and more critical problem with charging rent that is too high, is that you attract people who will not stay for the long period of time that a good tenant would at perhaps 5% lower rental.
Watch those balloon notes! Thousands of poor planning buyers have a multitude of balloon notes coming due during the next year. Many of these investors will forfeit the profits which they have accumulated to lenders when they refinance their properties to pay off these balloons. Last weekend, I had the pleasure of attending one of Jimmy Napier’s “HEP“ days in Tampa, Florida. Jimmy admonishes his listeners never to sign a balloon note, but if they do by mistake then they should actually blow up a balloon, write on it the amount of the note and the date it is due and then tie it in some prominent place so it will always be a reminder of the ominous date.
A student from San Diego called me last week to get my opinion on the following investment. A San Diego broker had offered to sell him a house located in Phoenix for a price of $54,000, which would require $15,000 down payment, and the cash flow before taxes would be approximately $50 a month negative. When I asked him what the house was really worth, he told me about $53,000. Therefore, the broker was trying to sell him a house at retail prices with a negative cash flow, and a 30% down payment in a town far away from the investors home town. There was no guaranteed management, and in fact a stiff commission would come out of any rent collected for this investor. The investor was seriously considering the deal and had already put up the deposit although he had not signed any type of contract. Let‘s analyze the return on our investment if we would purchase the suggested house on the terms and condition the broker offered.
|
Purchase Price |
$53,000 |
|
|
Cash Down Payment |
115,000 |
|
|
First Mortgage (T.D.) |
333,000 |
(11% V.A. Loan, $314 per month) |
|
Purchase Money 2nd |
55,000 |
(11% $46 per month with 3 year balloon) |
|
|
Speculator‘s Five Year Sale Projection
|
Sale Price |
$106,000 |
|
Net Proceeds |
999,000 |
| Net Profit after provision for Taxes | 335,400
|
Return on original $15,000 investment for five years 17+%.
From the above example, you should be able to spot many mistakes that a novice investor may make. He is paying a retail price with about 30% cash down payment for a house which does have 11% mortgage financing on it but also has a negative cash flow. A VA loan with an interest rate of 11% is probably no more than two years old. One can draw a conclusion, therefore, that a previous owner paid about $33,000 dollars for the house about two years ago. Either the house has enjoyed phenomenal appreciation during the past two years, or it is priced a little above the current market.
There are two lessons to be learned from this real life story. First, some people live in areas such as San Diego where they have been brainwashed into believing that any property that approaches break even or positive cash flow is worth its weight in gold. We‘ve discussed earlier in this letter what causes negative cash flow and a way to avoid it by structuring your debt payments so that the income from the rents will cover them. Secondly, here is an example of an “investment broker“ who’s selling a property at a price equal to or greater than fair market value on terms that most first time buyers would shudder at. Even if this house doubled in value during the next five years, and the rents increased sufficiently so that the property would show a break even cash flow for the five year period, the overall net return after paying the sales commission on an ultimate sales price of $106,000 at capital gains taxes of 20% would be just over 17% on the $15,000 invested Now 17% isn’t a terrible return, however, I think most can do far better with less risk.
All you hard working buyers who continue to find great deals and can‘t raise the cash for down payments should take heart from the above example. There are thousands of investors, just like our friend above, who are dying to get into real estate and will pay a premium to learn. This fellow explained to me that he knew that this was not a great investment, but he felt that he would learn enough from this experience to do better next time. By comparison, a learning adventure like this would make any seminar in the country seem very inexpensive.
Keep in mind that when you buy a property based only on the proposition that it will increase in value due to inflation, you are playing in a sucker game. You should only be acquiring properties at below market values and/or on better than market terms, which you can immediately resell at a profit on any given day. Even negative cash flows are not had, as long as the cash flow is negative at your discretion. It may make sense to finance a property with very high leverage and payments which will be greater than the income for a period of time in order to give you maximum leverage, and maximum tax advantages. In the event that you at your whim change this cash flow position by either prepaying the loan, or easily disposing of the property to one of several willing buyers, then you are in a no risk negative cash flow position. Many buyers structure at-risk negative cash flow positions, i.e., losing situations which they cannot reverse and for which there is little or no market. Take the two below houses for an example.
Offer A Offer B
Market Value $80,000 Market Rent: $550. $80,000 Market Rent $550.00
Purchase Price 70,000 80,000
Cash Down 5,000 2,000
1st 50,000 ($475PITI) 9% 78,000 (Wrap $1000 PITI/mo,
2nd 15,000 ($125 mthly 9% ( 15%, Bal due 3 yrs)
Bal due 8 yrs)
In house A above a recent Miller/Schaub graduate has negotiated a buy using $5,000 cash at $10,000 below market value. He has negotiated to take subject to an existing 9% loan payable at $475 PITI and has agreed to pay the seller $125 per month on an interest-only note which balloons in eight years. As this house will only rent for $550 per month, it will have a $50 a month negative cash flow. House B was acquired by a less educated investor who was intent on getting in the highest leverage and sacrificed price and terms for that benefit. He paid a retail price with a relatively nominal down payment. However, he has obligated himself to a payment that will cost him $450 a month out of pocket for three years. He then faces a substantial balloon which he might not be able to pay off.
True, Offer B is more likely to be accepted than Offer A by a seller, but he who makes Offer B is speculating, not investing. The buyer with Offer B is projecting a large increase in value for the house during the three year period of time. He rationalizes that the negative cash flow can be expensed and will save him many dollars on his next year‘s tax return. He doesn‘t realize that the only real tax shelter one realizes from real estate is depreciation and that benefit will be nearly equal with either offer.
Those who make offers like Offer A on the other hand, buy only about one out of 20 properties offered on. However, the ones they do purchase, in addition to giving tax benefits, can certainly be sold for an immediate profit at any time during the holding period. Therefore, the buyer of properties using Offer A will always have the choice of whether or not to have continued negative cash flow. The buyer under Offer B may well be trapped with that negative cash flow whether or not he can afford it.
In the September 14 issue of Forbes, Ashbee Bladen adds his warning about the coming crash in house prices to the dozens of other forecasters of doom in the housing market. Toward the end of his article, Bladen admits that in his opinion the Government will control whether or not we have this crash which would rank in popularity according to Mr. Bladen somewhere between the Mediterranean Fruit Fly and the Bubonic plague.
I‘ve been collecting articles dating back from as early as four years ago which predicted a crash in SFH prices. I’m continually amazed by statistics sent in from all areas by subscribers that indicate that prices of single family houses are INCREASING rather than dropping. Reports in the past week from Chicago, Washington D.C. and the New England region relate instances in which subscribers have been able to acquire SFH on very favorable terms. This is the result of panic among sellers who rely on “crash“ rumors to dump their property. As in any irrational financial decision, the profits are accruing to those who take the time to inform themselves about the true situation and being lost by those who fail to resist market speculation and the advice of so called “experts“ who’ve had little first hand experience either as landlords or investors in single family houses. Thus, buyers in today‘s market place are able to pick up houses at attractive prices and on favorable terms which will continue to increase in value despite contrary predictions.
In the event you are nervous about the immediate future, now is an excellent time in light of the 1981 tax bill to sell a one-half interest in several of your properties to an investor to raise needed cash at reasonable cost. The new tax law which now allows an audit-proof 15 year write down at 175% declining balance per year makes managed single family houses an attractive alternative to anyone in higher tax brackets. Why go to the bank and borrow at today‘s ruinous interest rates when you could sell a partial interest in your portfolio to a cash investor? You’ll both benefit. He’ll get an appreciating, easy, management-free investment from which tax benefits can be gleaned which will serve as an outstanding inflation hedge. On the other hand, you’ll get financial backing to hedge your own position against any economic downturn, you’ll avoid risky, expensive financing.
The key is to avoid being greedy when dealing with an investor. If you‘ll provide a better-than-market deal, the investor might just be willing to play again. Suppose you had a balloon note coming due. You might offer an undivided interest in your property to someone if they’d be willing to pay it off. A cash investor might be able to discount it for cash today; or merely endorse your note, thereby extending the due date. Or, if the balloon is not due for five or six months yet, he would be able to pick up some tax goodies this year with nothing down, and the tax savings could be used to pay off the balloon when it came due next year. Of course, this “nothing down“ purchase by the investor, with the payment being delayed for several months would be extremely attractive.
Naturally, there would be some tax consequences to you as a result of this sale, but under the new tax rules, the cost of taxes is often lower than the cost of borrowed money! Furthermore, you would avoid the usual expenses of selling or of refinancing by adopting this approach. Not the least of your considerations might be the fact that, in the case of a rental property, your income stream remains uninterrupted and your valuable rent-paying tenant can continue to provide the money to fund your mortgage payments.
Copyright © Sunjon Trust All Rights Reserved, www.CashFlowDepot.com. (888) 282-1882
Quotation not permitted. Material may not be reproduced in whole or part in any form whatsoever.
