March 1996
Vol 19 No 7
The word on the street is that investors are beginning to return from the securities markets to real estate investment. Today, with after-tax market stock and bond yields dropping while the market climbs higher and higher, investors are becoming jittery. How much lighter can the stock market go? If it drops, how far will it drop? When?
The theory is that one can ride the prices up in the stock market, then switch to real estate and ride them up again. While few actually accomplish this feat, it’s only natural that investors begin to prospect for values in the real estate markets where rental yields are 5 or 6 times higher than the stock market, and where prices are at historic lows in many parts of the country. This happened when the stock market topped out in the mid-1970s and real estate prices rose by several hundred percent in some areas. Then, in the 80s, the stock market soared off the bottom under the Reagan administration while real estate prices, beset by a sea of troubles in – not the least of which was the 1986 tax act and the RTC – collapsed along with the lenders who’d invested $billions in mortgage portfolios.
It might be a mistake to think of all this as just another repeat of the real estate cycle. A lot has changed since the last overall price-rise. NAFTA and GATT have been signed. The dollar has been on a roller coaster ride against foreign currencies, the government has shut down numerous times over ways to balance the budget. The labor market is undergoing dramatic changes. Skilled manufacturing jobs are being supplanted by computer-controlled automated machines. So are a lot of middle management white-collar jobs. Middle class incomes are vulnerable to change.
Displaced people will either have to learn new job skills, or accept lower incomes what’s going to be a pretty competitive market for unskilled jobs at low wage rates. A lot of wage earners are going to have to relocate into areas with better job prospects. That means that the lower taxed, pro-business States are going to see their populations and incomes per family grow while the reverse will be true in States that maintain high tax rates. These changes in numbers of people will create housing shortages in some areas and surpluses in others.
The information super-highway is ushering in an age of a new decentralized society. All over the country you can see jobs being relocated into outlying areas, far from high taxes and social/political problems. Now that retirees can flee State taxation of their pensions, this growing revenue base is opting for Manufactured Housing communities far from the maddening crows where their pension dollars will stretch farther. The handwriting is on the wall. The future for real estate investment is going to be in providing affordable housing in areas where both population and family incomes are rising. How should we respond to this mega trend?
If I were going to start acquiring real estate as a small investor, I’d place my bet that the future for real estate is going to be in single family housing that consumes only about one third of a family’s net after tax monthly income. This will ideally be situated near jobs and good schools in small towns with reasonable access to medium sized cities in States where taxes take a lower bite out of income.
This affordable housing will consist of many types of styles of houses manufactured off site, as well as stick-built housing, where prices will permit it. I think you’ll see zoning laws relaxed to permit manufactured homes to be situated on more individual lots, but the upscale, secure, attractive manufactured community is going to do well too, IF it can be priced competitively. Now, let’s see if we can’t find a way to put all these guesses to work to make money.
A WHOLE NEW MARKET IS OPENING UP . . .
In many cities, urban housing can be characterized as being highly taxed, over 25 years old, and served by deteriorating community amenities which are even older. Of course a lot of urban housing is located in attractive neighborhoods which continue to offer ease of access into the city centers. But there’s also a lot of it situated in functionally obsolescent, blighted, high crime areas in which schools more resemble juvenile detention facilities than centers of learning. People are moving out. Does this mean that whole cities will become empty? Not at all.
It boils down to economics. People must live near jobs! Those employed by local government administration and services, retail and wholesale businesses, school teachers and staff will remain. Others will include employees and local businesses, salespeople, retirees who want to be near public transportation and medical facilities, young families who need lower cost housing, medical staff who must live near hospitals. Employees of high profile corporations that need access to centers of commerce and finance. Wage earners in transportation, heavy industry, and warehousing. At the same time, many others have already started moving out.
Over the past 20 years, where I live, the vast majority of real growth has taken place outside the incorporated areas of the county. The infrastructure has followed them, bringing shopping, schools, light industry, payrolls, and thousands of new houses. Adding to this housing upheaval are those whose incomes have dropped either because of industry down-sizing or transfer of jobs into other areas. Many of these job-seekers are going to have to relocate from one residence to another in many cases. Possibly into rentals. All this will involve both buying and selling of houses. Where there’s lots of activity, there’s profit potential.
Opportunities are springing up for buying homes inside the cities from those who want to move out, and selling them to those who need urban housing. The older housing stock, coupled with readily available long term, low interest financing make urban housing a fertile field for those who want to rehabilitate and modernize older housing for sale into this market. Expect to see special low interest loans made available for this ‘politically correct’ activity, especially where blighted derelict housing can be restored and incorporated into the property tax base.
There will be big profits available for those who can build a ‘spread’ into prices between older houses inside a city and newer houses outside of it. Those who can make trades between those occupying stick-built houses, and manufactured homes will do well too, in or outside of cities. Just as wage earners everywhere have to accommodate our changing world, so must we learn to play the cycles. It all boils down to supply and demand. Sell when others are buying, and buy when others are selling. When both things are happening at the same time, try to facilitate each side of the transaction. Devising a form of creative financing is one way you might do this. Here’s a case in point:
This particular seller had to abandon his free and clear residence to relocate to another job out of State. He’d been unable to sell it for several months. I offered him full retail market value for his house with terms in the form of a single payment, non-interest bearing Note secured by a first mortgage on his home. It was due in full anytime that I sold the house. He took the deal, subject to his being able to use that Note as down payment on an acceptable replacement house in his new locale prior to his house sale being concluded. Who in the new area would accept such a Note? That’s easy. A home seller in more desperate straits.
The Note was passed on to the seller who had also been required to relocate to a new job out of State. He was making two house payments! He was only too happy to have someone take over his $364 monthly payment while he protected his full equity in the form of the secure Note. Consequently, I closed on the original house. A few years later, when it sold, the Note was paid off. In the meantime, my profit came in the form of rental cash flow out of which no payments nor interest had to be paid, and in the appreciation of value that occurred once the real estate market firmed up.
NEGOTIATING ZERO INTEREST LOANS IS THE KEY TO PROFITS . . .
Take a look at your current real estate loan payments. Calculate how much of the rents that you collect are paid out in interest on the mortgage. Even with low interest rates, payment of interest out of cash flow extends for years beyond the time required to build equity by paying down mortgage loans. By avoiding interest, every dollar of payment reduces what you owe by one dollar. The amortization period becomes breathtakingly shortened. Moreover, tax deductions generated by depreciation expenses will generate free cash flow to use in pyramiding more leveraged property.
Who’s going to give you zero interest rate terms? Those who need your business. In Houston in 1987 – 88, you could obtain these terms from distressed Savings and Loan Associations who were strapped for cash, and overburdened by thousands of foreclosed houses and apartments. Only the RTC’s intervention dried up this fantastic credit market. Principal-only terms have been available from motivated sellers for decades for those willing to trade off something to get them.
Take a look at some of the things that can be given up at fairly low cost by you to motivate a seller to cooperate: Occupancy, cash in advance, sporadic lump-sum principal payments, a short pay-off period, higher cash-flow, higher overall price, quick closing, delayed closing, pay-off of overdue loans are all things you might offer in exchange for zero interest financing. Here are some examples of how you might use these to induce a seller to accept zero interest financing terms:
1. Seller of a $100,000 house with a $40,000 mortgage on it payable at $450 per month needs $10,000 to buy another home elsewhere. You buy his house with $10,000 down, and wrap the current loan with a $90,000 loan with payments of $700 per month at zero interest. The loan will be fully amortized in just under 11 years. Out of payments received he’ll make the payments on his underlying loan. The $250 per month extra cash flow to him can be used to help make the payments on his replacement home. With $850 in rents, you can use the cash flow after vacancy, management and repairs to repay the $10,000 you may have borrowed to provide the cash, or as a return on the $10,000 invested. You might sell the property later on a wrap-around loan for $110,000 with $3000 down and payments of interest only at 9% ($825/mo). That returns $3000 of your cash, relieves you of tax and insurance, maintenance and management costs, and gives you more cash flow. At the end of 11 years, your cash flow will jump up to $10,200 per year, and your equity in the property will still be $103,000. Just ten deals like this one would make you a millionaire with $100,000+ income.
2. Same seller, same $100,000 house but first mortgage is in arrears by $10,000. You buy the house for $80,000 from the seller and bring the first lien current, paying $10,000 in cash. You lease the property back to the seller with no rent payments for one year. This way, he can’t default. After he’s moved out, you commence zero interest payments of $300 per month until the loan is fully paid off.
3. Same seller, same house, all payments current on $40,000 first lien. Must move and buy new house. You offer $5000 ‘moving money’ and agree to give him a $10,000 line of credit which he can use as a down payment once he’s found a new house, or which he can draw upon at will to supplement his rent in the event he buys his new home on a rent-to-own arrangement. Offer to pay him $10,000 each year thereafter for the next 5 years commencing in 2 years. A variation would be to schedule lump sum cash payments of principal-only to meet periodic obligations up to 25% of the loan balance. For every dollar paid in these periodic payments, the remaining loan balance would be reduced by $1.25. Either approach would work out well for you.
4. Same seller, same house, same loan. Offer 6 Notes of $10,000 each which will be due and payable in single payments in successive 2 year periods. In addition, you’ll agree to make the payments on the underlying loan. If the seller needs cash, offer to find a buyer for the first two Notes for $9,000 and $8000 cash respectively. (Buy them yourself if you can’t find a buyer. That amounts to over 5.5% yield, about the same as a money market fund.) The seller will have the option of realizing $17,000 in cash and being paid off completely in 12 years in return for giving you payments of $10,000 every two years at zero interest. If rents can be increased by 10% per year, commencing with $850 per month, you’ll be able to accrue almost enough in rents to retire the loans every two years as they come due.
5. Same seller, same house, same loan. Offer an initial payment of $20,000. The balance of the loan to be paid at the earlier of the date that fee title to the property is conveyed or 10 years. What you are offering is full market value and ready cash in return for zero payments for the next ten years. During the intervening period, you can use cash flow to retire the $20,000 if you have to borrow it, and to accrue rental income over and above financing and operating expenses.
6. Offer the owner $10,000 for an Option to buy the house in 7 years for $100,000. Let him continue to reside in the property, but have the title transferred into a holding Trust, or secure your Option with a wrap-around mortgage or all inclusive deed of trust during the intervening period to be certain that all payments are being made. Alternatively, with nothing down, sign a lease for the amount of the first mortgage payments only in return for the above Option. Either the seller gets ready cash which, as an unemployed person, he probably can’t borrow, or you gain control over the property, its appreciation, its cash flow and some tax benefits.
7. Same seller, same house, but with 10 payments of $100 in arrears on an ‘equity loan’ of $10,000 secured by a 2nd Deed of Trust or mortgage. Foreclosure is threatened. Your competition is trying to ‘steal’ the property for 60% of value. You offer to stop the foreclosure. You can do this by: (a) by paying off the arrearage and reinstituting the loan which you’ll start paying back, or (b) by buying the loan at discount if possible and substituting a zero-payment, reverse amortizing loan which you can offer the seller in return for an Option to buy the house at the loan balance in 1 year, or sooner, after he’s moved on to his new job. You’ll repay his equity as in paragraph number 1, above.
In the above passages, I’ve tried to show several variations on a theme. Some of these approaches are better than others, but they’re all better than buying an income property using conventional mortgage terms and payment schedules. This isn’t a case of trying to hornswoggle an innocent owner into making a bad deal. What I’m trying to convey is that there are many problems that owners who must move confront. You’re entitled to charge an extra profit because you are uniquely qualified to devise a workable solution. This profit best takes the form of swift amortization and avoidance of interest. If property values rise, so much the better, but if they remain flat, the amortization and cash flow the above approaches can provide will generate sufficient profit for your trouble even without appreciation.
Your probability of success will increase geometrically if you refine your screening process so that you only deal with people who are motivated by their personal circumstances rather than by you. That means that you’ve got to spend time with them patiently examining their true situation and the degree of motivation that it creates in them. There’s no point in falling in love with a ‘cookie cutter’ approach that only affects a small percentage of the population. It’s far better to become conversant with a variety of approaches to problem solving which will enable you to devise an acceptable solution to which the seller will be attracted.
Regardless of the particular approach you use, don’t lose sight of your own financial objectives. You want to avoid interest expense while amortizing underlying loans, make certain that every dollar of negative cash flow is returned with an attractive yield, and provide yourself with a discounted price either arrived at initially through a below market price, or mathematically through the discounted present value of a series of zero interest loan payments.
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