September 1980
Vol 2 No 12
Who cares? Reviewing the results of the economy directly following the past few presidential elections, you find that no matter who wins, the economy prospers. This may be a relatively short term phenomenon, witness 1973, but will probably carry us through next year. Few things will change. Inflation will continue at its double digit pace, interest rates will continue their long term upward trend, and the demand for single family houses in prospering areas will continue to outstrip the supply.
The strategy remains the same. Continue to acquire, for long term holding, houses in growth areas that you can afford. Even if you live in the Mid West or Northeast, where forward progress seems to have halted, there are still neighborhoods within your town which will appreciate far faster than the inflation rate. Remember that inflation does not affect the country equally. Inflation is an expansion of the money supply and in the event that credit is tight and unemployment is high in your area, you may not be enjoying the inflation that the South is.
Stay away from the banks! Over and over again people stage their own financial funeral by borrowing short term from bankers who promise them they will be able to renew. When they go back to the bank to renew, either the bank policy has changed, or just as likely, the banker has been changed. No deal is so good that you should sign a note due in one year or less in these times, unless it is to be used to purchase inventory; property which you intend to immediately resell. I have refused to sign notes of less than four years for some time unless I had the right to extend the note by paying down a percentage of the remaining principal. For example I would sign a three year note in the event that at the end of three years I would have the option of extending the note an additional year by paying off ten percent of the principal due. This technique adds nothing to your costs; it just reduces your leverage by a little.
Banks across the country are still in trouble. In the recently passed Depository Institutions Deregulation and Monetary Control Act of 1980, the Fed is now allowed to lend to non-members as well as member banks. Reserve limits may be set without limits by the Fed, that is the required reserves could be pegged at zero. If necessary to keep a bank floating, the Fed can now purchase from the bank stocks, bonds or mortgages. It is obvious that the government expects the worst and is preparing for it.
As always, banks are for taking, not putting. Keep your capital and that of your investors invested in real estate or real estate backed securities, i.e. mortgages and trust deeds secured by property you would like to own. These paper investments will keep you afloat should we have a period when people cannot pay the rent. The best defense against a recession is a strong management program. The only way you can lose your investments in houses is to not make the payments. If you are in the habit of letting your tenants slide on their rent now when things are not that bad, they will really take advantage of you when it gets really tough.
Take this opportunity to clean house of your late paying tenants. Start enforcing your late charges and maintenance discounts with a passion. One way to eliminate houses which continually attract problem tenants is to sell them on a contract for deed. This week I sold such a house which was rented for two hundred and twenty five dollars per month to tenants who were not good payers or fixers. After buying them out, instead of evicting, I ran an ad which read “$500 down, handyman special”.
If you are ever lonely and want someone to talk to, run that ad. We were inundated with calls and sold the house to people we were confident could make improvements to the house within a week. It is important to be as selective when selling a house with little down as it is when renting. Many who wanted to buy would have lived there for a few months and then fallen behind on their payments.
How did the sale affect our portfolio? We sold a house at a price that the house would be worth in one year on a contract for deed that balloons in one year. This means we get tomorrow’s price tomorrow. In addition we have changed our cash flow from two hundred and twenty five dollars per month to three hundred and twenty dollars per month. This is interest only and will be taxed the same as rental income. However, we lost the depreciation which gave us a deduction of seven hundred per year, which relates to a tax savings of around two hundred dollars annually. This I feel is a good trade off for the additional cash flow and probable elimination of management headaches.
As the contract for deed is based on our estimate of next year’s prices, and as it balloons in one year, we have effectively indexed the contract to inflation. Last month the Acre Almanac, (a publication of the Academy of Real Estate, 46 North Washington Blvd, Sarasota, FL 33577) reported that the Union Planters National Bank in Memphis, Tennessee had won a decision in a county court which allowed them to increase the principal balance on their loans at a rate which would compensate for inflation. I doubt that the bankers will catch on that this is a bonanza, but any of you who make loans of any type should study this concept.
Along the same line, a student in a recent Denver class noted that he had been able to charge tenants an additional twenty five dollars per month rent in exchange for granting them the right of first refusal to purchase the house. By giving them the right of first refusal, you do not obligate yourself to a price or terms today. Instead you simply say that in the event that you ever decide to sell, they can buy the house at the highest price that you can command for the house at that time. What could be fairer?
Likewise, I have been able to rent houses which are in less than great areas at prices far above what they are actually worth on the rental market, by giving people an option to purchase and applying part of their rent to the down payment. Today for example I am advertising a house which normally rents for three hundred per month for three hundred and fifty on a lease option. In the event they buy, fifty dollars per month would be applied toward the purchase. The price will be established at the time they wish to purchase by an appraisal at that time.
Because we apply a healthy amount to the purchase, they take better care of the house. In addition, as we can collect sales commissions on other properties they may buy, we agree to give them credit for the fifty dollars per month, in the event they purchase any property through my office. This again is their money, so we cannot lose.
A group in New Jersey, Home Partners of America, and Inc. is publicly offering to underwrite home buyers’ down payments, for one half of the profit. Under their plan they put up three quarters of the down payment, and half of the closing costs, for one half of the house. They then collect a monthly rental from the owners of the other half for their use of the house.
We have been doing the same thing in reverse. We first purchase the house or condominium at an advantageous price, and then sell one half interest to a better than average tenant. They are better than average because they have enough cash for one half of the down payment. We are then delighted if they will just make the payments until a certain number of years pass when we mutually agree to sell the house and split the proceeds.
We have an obvious advantage over “Home Partners” as we have our profit locked in going in. we structure the sale to the tenant on a contract for deed to simplify any foreclosure procedure that may ensue. “Home Partners” will surely be attacked as a villain when the day comes that their “partner” can no longer make their share of the payments, and they have to foreclose to protect their investment. They, and those who imitate them, will be co-venturing with home buyers who have far less than a normal down payment, and therefore will surely be faced with the problem of what to do with delinquent payers, without hurting their own image.
An investor in the right place at the right time may be able to lease option the whole house from “Home Partners” on terms and at a price that would allow both to make a healthy profit. On the other side of the coin, you may be able to option the interest of the half-owner occupant for a nominal sum, and allow them to continue to occupy the house for many years to come. For example, in the event that the payments on the loan and the payments to “Home Partners” totaled six hundred dollars a month on a house worth seventy thousand dollars in today’s market, and the occupants had a one hundred dollars per month problem and would like to remain in the house, offer this option. You will agree to give them a note payable at one hundred dollars per month for three years for an option to acquire their equity at today’s price.
Structured properly, the one hundred per month payment will be all interest, and therefore deductible by you. You are controlling the appreciation of a one half interest in an asset worth seventy thousand dollars or at ten percent three thousand five hundred dollars per year. This is about a three for one return on your investment and would require little, if any management. The profit on the option could be realized as long term capital gains when it is resold to another user, or to the company.
Across the country there are great buys on properties which have extraordinarily high interest rates, fourteen percent and above. The problem lies in the fact that these same houses, which are typically in tract V.A. and F.H.A. subdivisions, can be purchased today by owner occupants at the same prices which were paid six months ago, and at much lower rates and constants.
In order to take advantage of these situations which require no cash up front, but will have larger than ordinary negative cash flows when rented, you should be in a high tax bracket. Many people have large amounts of interest income on which they pay taxes as high as seventy percent of the last dollar earned. To oversimplify the situation, in effect a person in that bracket is paying only three percent in interest when he pays the bank ten percent. The government is paying the other seven percent.
Therefore, should a person in the seventy percent bracket own a house on which there is a loan at fifteen percent interest, he is paying only four and one half percent. Because of the tremendous interest offsets these people receive, they would make excellent people to joint venture these properties with. The owners of these houses with the high interest rates feel ripped off as their neighbors in a house identical to theirs down the street have a new loan at twelve percent which really means that their payments are eighty three dollars per month less. As these people are not in a high tax bracket, but are typically in a cash flow bind, they often choose to walk away from these houses.
Offer to acquire their equity with a note payable in five years, but payable only in the event that they rent the house back from you during that time at a fair value. You may now own a sixty thousand dollar house which will have a two hundred and fifty dollar per month negative cash flow before taxes, but will break even after taxes. The note for their equity acts as a security deposit, and they only collect it when they stay for the entire period at fair rents, which will certainly increase over the years. Obviously, only houses which have a tremendous upside potential should be purchased, as other properties will probably offer better cash flow.
This month’s “Dear John” letter asks, “How much equity should I have before I refinance a house to purchase another?” The concept of “refi and buy”, or refinance your house to acquire another investment property, has some serious flaws which must be considered. First, you generally pay off a low interest loan and replace it with a loan at or slightly below today’s rates. If the loan is rewritten at the same bank or savings and loan, you should be able to negotiate a rate below the advertised rate for new loans. This rewriting of the loan has a great effect on the bank’s portfolio, and unfortunately has just the opposite effect on yours.
For example, assume that you own a house worth seventy thousand dollars on which you owe forty thousand at nine percent. You now pay thirty six hundred dollars in interest annually. A new loan for eighty percent of the value or fifty six thousand dollars is available at thirteen percent. In the event you close the new loan you will net after costs fifteen thousand dollars and will pay seven thousand two hundred and eighty dollars in interest in the following year. Your interest expense has increased by thirty six hundred and eighty dollars on borrowings of fifteen thousand, which is slightly over twenty four percent.
That is a lot of interest to pay unless you can immediately reinvest the proceeds at a much higher rate. Many of us get nervous about that big equity which is not working for us. Look at the difference in your cash flow before and after you made the new loan. Before, the principal and interest payments would be about three hundred and twenty and after, nearly six hundred and twenty dollars.
When you refinance at the bank you pay retail rates and get retail terms. You can borrow that same amount of money from a person anxious to sell his house on interest only terms at the worst, and get a moratorium on payments for years. No bank can match those terms.When you consider all that you own as a conglomerate of assets and liabilities, you see that it is the overall leverage you have that counts. One million dollars worth of assets with loans of six hundred thousand against them is leveraged to sixty percent. It does not matter that most of the money is owed against just a few of the properties. There are many advantages of an unequally leveraged portfolio.
Last, but not least, money tends to burn a whole in most of our pockets. When you refinance a property, the cash you realize will sit in the bank for a while, and then you will be in a rush to spend it on something. When you have ready cash to work with, you often pay more than you should and do not negotiate long and hard enough to get the best terms available.
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