January 1991
Vol 14 No 3
I've been cleaning out my files going back to my first house that I built in 1952. In the intervening years I've been a real estate investor/operator during recessions in 1954, 1958, 1960, 1966, 1970, 1973, 1982. I've also been lucky enough to have been a highly leveraged landlord with fixed rate assumable loans during the 1970's real estate explosion that created fortunes. One thing my files revealed was the contrast in ways to approach the real estate game between good times and tough times. In general, 'good times' are characterized by easy availability of credit. This enables buyers to enter the market with maximum leverage at relatively low cost, increasing demand and driving up prices.
With fixed rate financing and assumable loans, it was easy to make money when the housing boom hit in the late 70's. Now, lenders are a lot smarter. Most loans are no longer assumable without qualifying and personal guarantees. And many of them are INDEXED so that they effectively capture the appreciation in the property. Under these conditions, LEVERAGE DOESN'T WORK TO BUILD WEALTH in inflationary times. Another way to say this is that CONVENTIONAL INSTITUTIONAL FINANCING tends to work against estate builder's objectives.
Because CREDIT controls the real estate market, so COSTS OF CREDIT control all the profits. The goal of those who sell, carrying back financing, has to be to use credit instruments that are a store of value for PURCHASING POWER in the future at a time when payments are received. To achieve this end, the lender might make loans RE-NEGOTIABLE or CALLABLE at a future time – say 1 to 3 years. Here's how that might work:
Suppose you, as the Lender, sell a property with a $100,000 10% mortgage that you provide to the borrower. In one year it is callable upon demand. At that time, the borrower can either (a) pay it off – giving you immediate cash, or, (b) hand you back the property without prejudice so long as it is in the same condition as when first purchased, or (c) at your option, you can foreclose the loan and re-take possession. Alternatively, you can just extend the loan another year while retaining all your options in the event the market won't offer a better opportunity. This way, if prices rise, you'll either be paid off with cash and be able to buy back in if you want to or you'll get the property back at the appreciated value. Or you'll re-sell it to the buyer at a price and on terms that reflect the current credit and real estate markets. Thus, you'll have been able to capture most of the up-side while hedging yourself against the down-side.
Let's talk about that down-side market a little. Markets slump when availability and/or cost of credit drives buyers out. Sellers have to offer lower prices and better terms in order to sell. Buyers have a field day. Lease/Options are usually negotiable from sellers who can't find conventional buyers. As the public perceives prices dropping (even though they were originally above market), they're less willing to buy, putting sellers into even more dire straits. As an owner of property, it's better to wait it out and sell later. But if you've got to meet a demand or balloon note payment, you'll have to sell out under distress conditions at a lower price. This is a vicious cycle that continues to lower the CASH SALE price of housing, but not necessarily the price at which the owner can afford the time and money to carry back the financing. Here's another illustration.
The seller has a $50,000 loan coming due. The buyer can qualify for a $35,000 loan, at 70% of value. Payments will stretch the buyer's budget to the outer limits. The seller carries back a 2nd mortgage of $15,000 at 12% (slightly above market) WITH NO PAYMENT for 3 years, then with a balloon payment due then. Interest to accrue. In this way, the
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.
seller has transferred the debt to a buyer, along with the inherent risk of balloon note financing. In the event the buyer can't meet the balloon note payment because of lack of available institutional financing, the seller is in the same position as an indexed note holder. He can renew or take title to the real estate either by foreclosure or accepting a deed in lieu of foreclosure.
Note that most of the emphasis so far in this month's letter has been to help the seller unload property. If we expect the economy to change in any way that PURCHASE POWER of our income is diminished, it pays to re-position ourselves to restore any reduction. But first, we have to understand how the forces interact. Credit costs, inflation and taxes are the main culprits when we talk about diminished purchasing power. These are deceptive.
THINGS AIN'T ALWAYS WHAT THEY SEEM . . .
In 1979 I paid 22 1/2% for an emergency loan. In 1988, I could mortgage using 8 1/2% fixed rate. Which cost of credit was higher? In 1979, my properties were appreciating at a rate of 20% per year. Thus, the interest was costing me a net 2½% over the appreciation rate, right? Wrong! At that time I was able to deduct the full 22 1/2% against my BUSINESS INCOME. With a 22% marginal rate AFTER DEDUCTIONS, I was only paying an effective 18%, so I WAS PAYING MINUS INTEREST OF 2 1/2% AFTER INFLATION AND TAXES. Conversely, in 1988, inflation was running at about 4.5%. I was only able to deduct a fraction of my real estate shelter losses against my other income. And my tax bracket was 28%. Thus I was paying a higher portion of my income out in taxes without the benefit of being able to shelter my interest payments on my mortgage. Added to this, my house wasn't appreciating much at all. The 4 1/2% inflation rate somehow-had passed my real estate by. So my REAL INTEREST RATE was about 4% – much higher than when my APPARENT interest rate had been 22.5%.
Look at our current situation. The maximum tax rate has been effectively raised by about 3% for most investors. Capital gains remain at 28% without regard to holding period. Inflation is beginning to nudge upwards. It will go into a full gallop in the event we go into a long war and interest rates will rise with it as government begins to use up all the capital. In that situation, we'll effectively have a reduction in REAL RATES, so housing should rise. But, let's talk recession without any war:
Current long term mortgage rates are just under 10% for fixed rate loans. As the banking/S&L/Insurance company financial crisis deepens, mortgage terms will become tougher. It's already hard for a non owner-occupant to qualify for loans even though there's plenty of money around. So housing is becoming much less liquid – harder to sell or to mortgage. This doesn't affect people who don't HAVE TO SELL. But, for those who MUST RAISE CASH, it' going to force prices down. CASH BUYERS WILL HAVE A FIELD DAY! They'll be able to buy at mere fractions of value as the recession deepens. Both private citizens and lenders will be competing for cash sales of idle assets. Someone once said that recession is a time when all real estate reverts to its rightful owners. Those who have the cash (or who know where .and how to raise it privately) will find that they can build considerable equity by buying LOANS as well as HOUSES. Here's what I mean:
In 1982 a speculator approached me in need of cash. (What else is new?) He was in default on a $15,000 second mortgage and the 3rd would balloon the following month. He was out of time, even though he was sure he could sell the property within 90 days for cash. I was unable to buy the 2nd and stall the sale, so went to sale instead and paid $15,000 for the property subject to the 1st lien. Thus I was able to get the property with the 3rd wiped out by the foreclosure. (That 'paper' buyer hadn't realized how vulnerable Notes can be in a down market. He too couldn't raise the funds to protect his position.) My equity consisted of the $17,000 third lien + $10,000 in equity above that + my $15,000. I then co-ventured the property with the original distressed party. It produces $600/month in rent.
In a similar situation, I was able to buy the 2nd lien, but the 3rd lien holder was too strong. He bid in the property up to the amount of the first and second liens and bought it. I'd paid 10¢ on the dollar for my lien of $5500. He paid 100¢ on the dollar to bid on it. While he had the title, I had the profit. I paid $550 and received $5500 in a matter of days – $4950 profit.
In both of the above illustrations, the profit related to the control over the middle position – the 2nd mortgage and note – between the 1st and 3rd mortgages. In the one instance I ended up with the house. In the other, I wound up with the profit. I was able to buy the 2nd at discount from a weak lender who couldn't afford to bid at the foreclosure. Both owners and lenders found themselves at a disadvantage because they'd relied upon credit to protect themselves. Without available refinancing, I, as a cash buyer, won the day.
BREAKING OUT OF THE CREDIT CYCLE IS THE KEY TO HAPPINESS . . .
When you ponder the eternal verities trying to comprehend ways to beat the ups and downs of the economy you'll eventually see a picture emerging of endless cycles. As credit loosens, millions of consumers rush in to buy, driving up prices. As they create demand for credit, it's cost is also increased just as the price of consumer goods (such as housing) is driven up by demand. So fewer people borrow money as it continues to tighten. After a while, the market demand slumps, lenders are once again forced to reduce interest rates, and the cycle repeats. Now here's where it affects investors.
As they follow the credit cycle, they're always borrowing when interest rates and prices are high. Sellers know they can sell for cash, so won't negotiate creative financing approaches. The buyers, forced to pay too much for the property and the credit, wind up with negative cash flow and short term loans (or variable rate/negotiable loans). They're vulnerable to any kind of down turn, tax increase or interest rate jump, so find themselves forced to sell in a Buyer's market after having bought in a Seller's market. Consequently, they always get the short end of the deal. High risk, low cash flow/profits.
Let's contrast their approach with one in which institutional financing is avoided and only seller financing is used. Seller's are most prone to consider carrying the financing when they are motivated to sell for NON-FINANCIAL REASONS. Job transfer. Better schools. Deteriorating employment market. Personal problems. When things are booming, sellers can get cash buyers without much trouble. But when interest rates are high or money is tight, they've still got the same motivating problems as before, but now the only buyers in the market will require that they carry back the financing on terms that make sense. They've got little choice. Thus, buyers are able to buy at the lowest prices and on the best terms from motivated sellers with very little choice in the matter.
Conversely, these same buyers are in position to sell anytime that interest rates turn down. They can cash out their investment at a profit as the business/credit cycles turn upward, driving up the prices. By having control over the terms of their loans, they may have drafted their mortgages and notes to provide for non-qualified assumption without recourse by any person they sell to. There may be provisions which allow them to substitute collateral on the loans or discount them for cash. They're always buying in a buyer's market and selling in a seller's market. This is why private financing is so much better all around.
One more point to bear in mind is that the houses they buy ideally will have large equities. Amateurs seem to seek out recent loans from distressed people who are willing to walk away from their miniscule equities. This simply means that the new buyer must make the high payments. On houses with about 80% equity-to-loan ratios, there's still enough owed to make payments burdensome to the departing seller, but not enough to create a negative cash flow situation for the buyer. The buyer, on the other hand, has plenty of room to negotiate when confronted with as much as $100,000 in equity, much of which represents APPRECIATION that was neither earned nor paid for by the seller. Thus, it's easier to negotiate downward.
There's a final point to bear in mind. Our economy is becoming more volatile as the banks, S&Ls, Insurance companies and Government scramble for available funds. Rampant excursions in price and cash flow could become a feature of the real estate business, thus one can never be certain as to whether or not one will be caught in a financial vise by such arcane things as the Soldiers & Sailors Relief Act of 1940 which even now is beginning to have an impact on rents and mortgage payments. Or the EPA could find something wrong with a property. Or government price and profit controls (including rent controls) could be instituted. They were in WWII and they were during the Nixon administration. It seems a virtual certainty that they will once again be dragged out of the closet if the oil war gets much hotter. All of these things could create liability where none was apparent before, so one should never overlook the effects of institutional financing on one's personal privacy as contrasted to private financing arrangement.
Anytime you apply for institutional financing, you've got to complete a credit application together with appropriate income tax records, P&L statements, financial statement and income records. These reports are routinely shared by many people who become privy to your personal financial situation. On the other hand, private financing rarely requires you to provide all this documentation regarding your personal affairs. Probably 75% of all the calls I receive concern some aspect of liability that the other party has incurred. When all assets are exposed via the various credit reporting agencies that have approved your loan at the local institution, it's a fairly simple matter to attach them. By avoiding the use of institutional financing, you also avoid the negatives of being exposed to public view.
If you need money, let the other guy borrow it. Here's how one guy handled it: PROBLEM: $75,000 house with a $54,000 loan. Maximum loan to the new buyer was $50,000 due to conservative lender. Seller needed $4000 just to close, but the refinance would remove all personal liability from the old loan. He was willing to carry back a $25,000 2nd for the buyer who was getting in with nothing down – with lender's full knowledge and approval. The lender was safe with only 66.7% exposure. The seller sold the loan to me for $5000 with the right to buy it back after 2 years for $5000. In the meantime, I'll receive the $300/month payment. That's $3600 per year or 72%. I expect I won't hold it much beyond 2 years. It's a good yield for me, helps the buyer into the house, gets the seller off the hook in a tight market at a cost of only the loss of 2nd mortgage income for a couple of years. That's cheap!
HERE ARE SOME 1-LINERS THAT WILL HELP YOU AS SELLERS AND/OR BUYERS . . .
1. Never sign personally with recourse, or co-sign another's loan. Avoid short term notes.
2. Selling your house quickly at wholesale may be better than a slow sale at top retail.
3. When you need emergency funds, sell and lease back rather than borrowing more money.
4. Use surplus funds to reduce debt in a recession, and accrue higher cash flows for safety.
5. A bargain sale with carry-back financing creates cash flow to offset slow rental income.
6. Structure financing that can be sold by either buyer or seller to raise needed cash.
7. If the 1st lien has high payments, build in lower payments in any 2nd to offset them.
8. Keep mortgage maturities short when you're lending. Lengthen them out when you borrow.
9. Trade-Ins can create down payments for new financing – and be sold later for more cash.
10. Personal property (RV, Car, Boat) makes good currency whether buying or selling.
