In many places in America, the single family market is transitioning into the beginning phases of a buyers' market. This is a mixed bag of blessings. The good news is that there will be plenty of houses around from which to pick and choose bargains. The bad news is that there will be fewer buyers to sell to. Those with unsold inventory are going to be forced to either learn how to manage, or spend additional money hiring those who do. Rental cash flow will be less spectacular than appreciation has been. Buying solely for appreciation will be more risky. In this month's letter, we'll explore the ramifications to entrepreneurs of the changing market, and how they can deal with it profitably.
Although credit and interest rates tend to follow national trends, there is no national or regional market for single family houses; there are only local housing markets. To measure what my local market is doing, I look at three factors:
(1) The average number of houses listed for sale compared to the past six months.
(2) The average time on the market prior to sale. (3) The number of houses that go off the market unsold. A fourth criterion that also measures the strength of the local economy is the number of houses being sold at foreclosure sales at prices below their defaulted loan balance. Good times are on their way for buyers and investors; but “fixers” and “flippers” are going to have to learn new tricks.
In the last great buyers market of the 1970s, I was a struggling broker. I could list and sell houses, but my buyers couldn't get affordable loans. It wasn't only because interest rates were high but that lenders also wanted high down payments and “points” which couldn't be financed. At one point, FHA wanted 11 points on a 95% loan. That required a seller to pay 11% of the buyer's financing costs. Most lenders refused to sell on FHA or VA terms and conventional lenders wanted 10% down from the buyers. That pretty much dried up sales except for buyers who were selling their existing homes or who had lots of cash.
Instead of focusing my efforts on more advertising in order to sell my listings, I concentrated on buying from all those unfortunate owners who had waited too long to put their houses on the market and who were now highly motivated to sell; even if it meant selling at a much lower price. Initially, I'd buy using creative seller financing, then pass on a portion of my potential profits to buyers. For instance, if I could buy at 80% of fair market value, I was willing to sell at 90% of fair market value. This worked only part of the time. The rest of the time I would “wrap” the existing financing with terms that buyers could afford, and which would provide a profit to me. In the “olden” days, this worked well; later, the tax laws changed to make this a fully taxable transaction to me, so I had to adapt.
I was forced to adopt a completely different approach to real estate: I became a long term investor rather than a short term buyer and seller. The math made a lot of sense. First of all, when buyers stop buying houses they are forced to rent. As rental demand picks up, so does the quality of the prospective tenant. Rents also can be increased to catch up from the years of soft rental markets when landlords had a hard time making ends meet. The icing on the cake is that the tax laws give landlords a lot of tax write-offs that make much of their rent tax free. I could create instant equity by buying a house at a discount to fair market on easy financing terms, then rent it at a premium to hand-picked tenants. The yield on my invested cash became very attractive.
For instance: Suppose I could buy a $200,000 house for $160,000; paying $10,000 down and taking over an existing $125,000 loan with P.I.T.I. payments of about $950 per month. If I could give the seller a principal-only $25,000 Note with payments of $250 per month, my financing costs would only be $1200 per month. In a tight rental market this house should rent for $1500 per month; producing cash flow while building equity through fast amortization of the zero-interest 2nd mortgage.
ASK FOR WHAT YOU WANT . . .
For those readers who have only seen a sellers' market, it may seem far fetched that a seller would provide financing and be willing to accept a zero-interest Note as part payment for his equity. When there is no other source of credit in the market, sellers who need to sell have few choices. In fact, in the great buyers markets of the early 1970s and late 1980s, it was not uncommon to find sellers advertising that they would pay cash bonuses to anybody who would assume their loans. Things will have to get a lot worse before we can expect to see that scenario repeated, but impatient sellers who have speculated on houses that they can't afford to pay for are growing in numbers with each monthly payment.
Buying houses from motivated sellers isn't quite like picking up gold coins off the pavement; you're going to have to negotiate to be able to buy at your own price and terms. That's going to require some preparation on your part. The first rule of negotiation is to know what you expect achieve, and to be willing to ask for it. Odd as it may seem, it's just as hard for a person to turn down an offer as it is for you to make it. Hence, there's everything to gain and very little to lose (except “face”) by making offers that may disappoint sellers who had pie in the sky visions of instant riches. This is where negotiating skills pay off.
In the final analysis, negotiation is simply a process whereby you first try to discover the factors that will affect a deal as you parley over a property, then find productive ways to deal with them. Your first task is to gather rather than to give information. The best way to do this is to ask the sellers a lot of questions. These might include: Why they're selling? How soon they expect to move out? Where they're moving to? How much repair and fix up they're going to do to get the house and grounds ready for sale? How much this will cost? Where they'll get the money to pay for this? How much the house has been appraised for and by whom? How much they expect to net by selling their house after all expenses of fix up and sale? Whether they'd take less for a quick sale “where is, as is”?
You'll notice, you haven't been giving out much information, nor have you made any kind of offer to buy, lease, list, or finance their house. Not making an offer too soon is a powerful negotiating tool. Another is to avoid reacting to any of the information they give you. You're not there to give them a report card on their plans, and any sign of disapproval will cause them to stop responding. By the same token, when you nod your head in approval of what they are saying, then stop suddenly, this is another form of disapproval they'll quickly apprehend. The trick is to stay neutral until you've extracted as much useful information as you can. This isn't a one-way street. You're going to have to respond to the information as you receive it. I think a great way to convey your interest without being judgmental is to respond by asking another question. The longer the seller continues to provide information, the more tools you'll have to work with when you begin to negotiate.
When the “discovery phase” of negotiation runs out of steam, you're going to have to come up with a way to make a deal that you can live with. To do this, you're going to have to get your own ducks in a row so that you can use your imagination to contrive a way for them to meet as many of their goals as possible at a price you can afford to pay. It's important that you know why you're buying the property? How long you intend to hold it? How you expect to sell it? How you're buyer will find the money to pay for it? The answers to these questions will have a direct bearing on the price and terms you can pay.
If you can sell for cash and recoup your investment fairly quickly, you can afford to use an all cash offer to drive the price lower. If mortgage loans are going to be hard to get, either for yourself or for a potential buyer, sometimes it will pay you to offer a higher price in order to conserve your cash. This can pave the way to a “subject to” combined with creative financing for the seller's equity. If you're going to hold the house as a long term rental, price will matter much less than terms that will enable the house to generate a positive cash flow from rents.
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WHEN ALL ELSE FAILS, TRY THE TRUTH . . .
There are many aspects of the art of negotiation that increase the odds that a person will make a better deal. One of these is called “The Power of Credentials”. It is derived from a level of confidence and trust that one party has in another. As a buyer, you'll be listening for inconsistencies in the seller's “story”. The seller will certainly be trying to judge just how much he can trust what you're saying to him; particularly when you're explaining how the market has changed and just why his house isn't worth as much as he was led to believe.
The key to establishing this climate of mutual trust between yourself and the other party is to be scrupulous in admitting when you're not certain of something while being adamant about facts that can be verified. The first fact that is going to have to be supported will have to do with the current fair market value of the house. This can be a very sensitive issue, involving the seller's ego, his initial investment, his perception of what comparable houses are selling for, and family issues posed by a spouse who “told him not to buy” to kids or tenants who don't want to move. You don't want to win the battle, but lose the war.
One way I've established current fair market value without ruffling too many feathers is to let the seller do his own appraisal. I used to provide the seller with a “comparative sales book” which listed recent sales. I'd explain its format and invited him to pick any five houses in his area that were the equivalent of his in size and amenities. I'd get his prior agreement that the average selling price of the five houses he chose would approximate the value of his house. Use caution here: When prices are rising, this is a safe way to start, but when prices are dropping, the average of prior sales might be above true fair market value.
Once fair market value is agreed to, the next step is to begin deducting the costs of sale and settlement. Take a look at a HUD-1 statement sometime and note how many beaks dip into a seller's trough before he receives the net sale proceeds. Brokers, title agents, abstractors, attorneys, mortgage brokers, lenders, appraisers, surveyors, insurance companies, tax collectors, messengers, administrators are all represented together with origination fees, warehousing fees, notary services, preparation of documents, etc.
It's important that you explain all these costs and deduct them from fair market value to arrive at net sale proceeds. Next, you have to explain that if you paid this much, you'd be lucky to break even because of the expenses for lawn maintenance, insurance, taxes, and mortgage payments; plus any required repairs need to be completed. You've got to deduct these plus estimated “holding” costs from the net sale proceeds. Last of all, you've got to deduct the profit you expect to net.
Everyone understands that businesses are entitled to a profit. The contention arises when it comes to whose going give it and whose going to receive it. I think an easy way to convince the seller that you are entitled to profit from a sale is to stress that you are taking on all the risks and costs of sale, which could include a long delay between listing and sale. During this time, the market could be collapsing. Or mortgage money could completely dry up as it has in the past. Or costs of repairs could be much higher than anticipated. Or something could happen to the property or neighborhood to make the house lose value. Or, the next buyer may be a much better negotiator who might offer even less. These are all persuasive arguments to convince a seller that in return for absorbing all the costs of time and effort, you are surely entitled to a reasonable profit.
The important factor here is that you're simply explaining the economics of a house transaction that he may have never thought of or perceived. Hopefully, while you're presenting your case, you're also doing some mental arithmetic to be sure you're not offering too much, or figuring your profit too closely. From time to time, in the midst of negotiating a deal, I've suddenly realized that there was no profit to be had without a drastic reduction in the offered price. The result was a complete loss of credibility (and the deal) when I've reneged on my offer.
YOU CAN MAKE MORE DEALS WITH THOSE WHO KNOW YOU . . .
Contract law makes it legal to change an offer before it is accepted, but it leaves a bad taste in everyone's mouth; especially when you could have avoided it by doing your homework prior to making the offer. Even the most conscientious and diligent person can wind up wishing he'd offered less when external factors that materially affect value change. A highway project may have been canceled without warning. Or a school district line re-drawn capriciously. Interest rates may have increased. As a Broker, I lost one sale for a large estate because, unknown to me, mobile home park zoning was approved for a nearby parcel. I also lost the confidence of my customer who thought I'd misled him by not warning him about this.
When an offer is withdrawn, a lot of the Trust that has been carefully built up between parties can disappear; so it makes sense to lean over backward to maintain a reputation for fair dealing. When you've done business with a person previously and built up a reservoir of good will, that goes a long way toward reestablishing rapport when something happens to change a deal. When it's your first transaction, there's little to go on to create reliance on your ethics and character. That's why people like to deal with the same people over and over again.
When you're buying people's homes, it's rare that you'll buy more than one from anybody, but when you're renting houses, or repeatedly buying materials from suppliers, or offering services for pay, or entering into a maintenance contract; having a reputation for reliability and keeping your word is money in the bank. Then, when a random occurrence requires that you renegotiate deal, the good will you've built up in the past goes a long way to keeping a deal intact.
Although it can't be seen, ethical considerations are present to some degree in every negotiation process. In so many words, both parties to a transaction want assurance that, if some fact has been omitted that change the nature and benefits of a transaction, that the responsible party will make amends to the other. A good example of how this is created is with the L.L. Bean Company. It sells expensive outdoors ware through the mail and guarantees 100% satisfaction. If you don't like one of their products, even after you've used it, you can return it for a full refund. For years, Sears replaced broken Craftsman tools the same way.
Two of the primary modes of negotiation are competitive and cooperative. The competitive mode is seen most often when parties who don't know each other put a deal together. Everyone holds his respective cards close to his vest and expects the other party to do the same. Nothing anyone says is taken as the unvarnished truth. In competitive negotiation mode, it's like Flip Wilson used to say: “What you sees is what you gets”. The competitive mode is used when neither party ever expects to do any repeat business. A bankruptcy sale is a good example.
The cooperative mode of negotiation comes into play once the parties have gotten to know each other, have done prior deals together, and have established some ethical boundaries. This makes doing business much more efficient. I recently got a letter from one such person who told me about an attractive land parcel that he wanted me to invest in with him. In his FAX, he didn't say much about the land. He merely said, “You know me, and you know I don't make bad deals.” All I needed to do to get in on the action was to send in my money. Once you get to this point with your own contacts, you'll be amazed at how much more effective you can be.
That isn't to say that just because you can verbally accept a transaction that you always have to give concessions, or that the other party does. In most instances, each party will drive as hard a bargain as he can, and he'll insist that normal closing and settlement procedures be observed together with the appropriate documentation, duly signed and witnessed. Ethical negotiation creates a much higher probability that the transactions you enter into will produce the benefits and profits that you expected when you first considered them.
