June 1995
Vol 18 No 10
I came across an interesting statistic a few weeks ago. Despite all the hype put out by our public servants in Washington about rising employment and a booming economy, the current purchasing power of the average wage earner is at about the same level as in 1973, after being adjusted for taxes and inflation, and his net worth (after debt) is negative. As the post WWII generation moves into its 50s, it is awakening to the fact that, by and large, it has no reserve assets to fund retirement. Neither has the federal government nor many corporations. The situation is going to become critical without a fundamental change in the way that government raises and spends money. One way or the other, this could affect us all.
What wasn’t included in the wage statistics has yet to be factored in. That’s the purchasing power of the U.S. dollar in the world financial markets. Back in December in our Off Shore seminar, we advised attendees to open an account denominated in a market basket of foreign currencies at the Mark Twain Bank in St. Louis, MO. (800)866-6444. Those that did this have seen almost 15% increase in the value of their deposits merely because they were not denominated in our falling dollar. Conversely, those whose savings were invested in accounts denominated in dollars have lost 15% or so in terms of the currencies of other countries. This isn’t going unnoticed in global financial circles. For the first time in the memory of American citizens under the age of 60, there’s a real possibility that the U.S. dollar will no longer be the reserve currency of the world. What’s the falling dollar got to do with your personal financial security and that of your family? Let’s explore this topic and see if we can’t find the connection.
Real estate market values are dependent on availability of long term credit. So is the solvency of the United States government, and that of most of the political subdivisions in our country. The federal budget for most of the past 70 years has been funded by taxes, inflation and borrowing through the sale of T-Bills, T-Bonds and T-Notes. For the past 20 years or so, significant amounts of these financial instruments have been bought by foreign investors who have been attracted by our political stability and that of the dollar. With the dollar dropping like a rock on world currency markets, and with a Congress that seem unable to pass even a token balanced budget amendment, foreign investors are selling their dollar-denominated investments and looking elsewhere for a safe haven in which to invest their money that has ominous portents for us all.
A lot of the money raised by Treasury bond sales in passed on down the line to fund State and local programs. These programs in turn create jobs and income – in many cases at wage and salary levels above those in the non-governmental sector of the economy. Whether by virtue of sales, rentals or lower interest rates, real estate market values are directly linked to the availability of government money and/or credit – ultimately provided by federal borrowing. When you look at the government sources of funds such as the various FHA, HUD, VA, Section 8 subsidy programs used by real estate buyers and renters, you can see that withdrawal of funding for these programs would place a lot of real estate into jeopardy. So are your personal financial well-being and future security similarly jeopardized when they are linked to the availability of long term credit or government payrolls.
If you had to suddenly rely upon the income from your savings and investments alone to support your lifestyle, would you have to make some major adjustments? Would you be able to sell your real estate if mortgage interest rates rose by 3% in your market? Would your tenants’ earnings be enough to pay your rents without any government support? That could well be a description of the near-term future. That’s why the drop in the dollar is so important to all of us.
THE DOLLAR MUST COMPETE WORLD-WIDE FOR INVESTORS
Suppose a Japanese investor had bought an 8% US Treasury Bond a few years ago when a dollar was worth 120 yen. Over the past 3 years, he’s received 24% in interest, but the purchasing power of the dollar investment has dropped by 35% in Yen terms during the same period. Before he’d buy any more T-Bonds, he’s going to demand a higher interest rate. Former T-Bond investors have been flocking to German bonds this year. Their value can be relied upon to be more stable and real yield higher. Now, let’s see how this would affect us as real estate entrepreneurs.
Right now, the USA is almost $5 Trillion dollars in debt. We’re rising a little over $1 Trillion under the current tax system. And we’re spending about $1.5 Trillion each year, despite what Clinton has been saying. We’ve been getting away with this by borrowing from other countries through U.S. Government Bond sales and by manufacturing money from time to time. Suppose the Treasury had to pay 10% per year interest on the debt that comes to about $500 Billion per year. Think of the U.S. Government as a debtor with a series of $10 Billion balloon notes, each of which must be refinanced with borrowed dollars every week just to pay interest.
Each year the total debt grows by about $500 Billion, and the weekly interest payment increases by about $1 Billion. As long as international confidence in the dollar remained strong, foreign investors could be counted on to continue to buy our bonds, but the falling dollar is scaring them off. Except for institutions and retirement plans, Americans personally don’t invest enough in savings to be able to offset lost foreign bond sales. Without the financial assistance of foreign investors to fund the debt, the USA could get into financial difficulties in a few weeks. With Social Security funds already helping to pay for budget deficits, this would probably trigger a raid on all private retirement plans.
If foreign bond investors demanded that the Treasury pay higher interest rate yields to offset the risks posed by the falling dollar, investors would pull dollars out of the banks to invest in T-Bills/Notes/Bonds. The banks would have to compete by raising their interest rates. This would squeeze real estate and small business which create 85% of all the jobs in America. We’ve all seen the benefits of low interest in our most recent economic recovery, and how higher interest rates bankrupted Orange County as a result of speculation in the derivative markets. What’s a little less evident is the extent to which corporate America, mutual funds and banks where your retirement plan funds are invested have been investing in the same derivatives that so-called responsible officials did in Orange County.
We’re entering a period that is going to be critical to our financial future. Taxes will almost certainly rise over the next few years. We could experience inflation, deflation or stagflation as government wrestles with economic problems that politics won’t permit it to resolve. We could see home affordability rise beyond the financial means of our shrinking middle class. Building dependency upon government at any level into our financial planning is a risky proposition. It seems to me that we’ve got a couple of choices in our changing world:
(1) We can be short term speculators in the market, counting on our buying, Optioning and fix-up skills to generate cash flow. Liquid reserves can thus be built up from sale profits to hedge future emergencies and opportunities.
(2) Alternatively, we should be long term investors, willing to ride out the economic storms with good properties and good tenants, neither or which is dependent upon a government safety net for financial survival.
Fortunately, there’s room for wheeler-dealers who command the skills and market expertise to move quickly to acquire houses and to devise financial techniques using the secondary private mortgage Note markets. (Obviously, the more expensive the costs of credit, the more opportunity there will be for those in the discounted mortgage Note business.) On the other hand, management skills – ability to pick the right tenant for the right property at the right rent – are going to be an absolute survival necessity for long term investors in rental properties.
SELF-DEVELOPMENT IS THE KEY TO YOUR FINANCIAL SECURITY . . .
Government policy under Clinton has had the effect of dividing Americans up into classes then pitting them against each other. White against minorities. Rich against middle-class, Young against old. Private enterprise against public enterprise. Producer against consumer. As government funding wanes, there will be increased competition between these classes to retain as big a slice of the pie as ever. The problem is going to be that the pie itself is going to be shrinking. Today, retirees are claiming a bigger slice of government budgets than almost any other identifiable group once Medicare and Medicaid are factored into the equation. It seems clear that somewhere along the line, the younger generation is going to be able to stake out a stronger political claim to government giveaways than those in retirement. For Americans, the time has come to start building retirement assets.
Why now? Ask yourself whether or not you’ve learned enough and done enough to make yourself independent of government support. The answer for most of us is a resounding NO! If every government dollar we touched left a little dye on us, we’d all have green hands. Diminishing government subsidies and services are going to leave a lot of people with withdrawal pains unless they start the detoxification process as soon as possible. This is best done by eliminating tenants and properties that aren’t self-supporting while there’s a market for them.
If interest rates are driven upward by the effects of the falling dollar, variable loans are going to rob landlords of badly needed cash flow, so part of your program should be to replace these with fixed rate mortgages as soon as possible. Sell the properties to get clear of the personal recourse debt, and use deferred tax-free exchange techniques to replace them with non-recourse, seller carry-back fixed rate loans on solid rental properties for which there is high market demand.
There’s a large gap between those who know what to do and those who can do it. That gap can only be closed by hands-on experience. Finding, negotiating and closing a purchase, then attracting a good long term tenant and drafting a rental contract which will protect the property will teach you more about real estate than all the ‘book learning’ you could ever acquire. Applying the lessons you’ve learned is the ultimate test of what you’ve comprehended.
We never know what we don’t know until we start trying to use what we’ve supposedly learned. If you’ve been buying property simply by signing a mortgage at the bank, or writing checks out of your cash reserves, then hiring a management firm to handle your investment properties, you’ve missed out on a lot of experience that would serve you in good stead if you were to encounter difficult economic times.
Quite often, people don’t want to start trying to achieve something until they feel perfectly prepared. Naturally, we’d all like to hit a homer when we go out to start buying property, but it rarely happens. It’s a lot more common to end up with an imperfect deal that we’re not especially proud of. That’s to be expected until our skills are honed. Even after many years, you can expect to still be making mistakes when you buy and sell, but it’s the willingness to chance mistakes that enables you to move forward. Hopefully, you’ll start with the simplest and least expensive properties where your mistakes will cost you the least so that you’ll be a lot wiser when you tackle the more complex and expensive properties.
Investing is tricky. Errors and mistakes are going to happen. I shudder at the mistakes and errors in judgment that I’ve made over the years. Oddly enough, I’m a lot further along in spite of my mistakes than I would ever have been had I waited to learn all I needed to know. Rarely can one expect the ‘perfect’ deal to come along. Even if it did, it’s unlikely that it would be handled ‘perfectly’. Sometimes, imperfection is the price of getting things done. The most important part of an estate building program is to get it started as early as possible. The most costly mistake is to procrastinate, doing nothing while the years flow by and opportunities slip through your fingers – sometimes never to pass your way again.
WHAT SHOULD INVESTORS BE DOING NOW?
On my recent visit to Chile, we were discussing financial safety nets with a couple who had survived years of economic ups and downs such as we have yet to confront in America. Chileans have an expression, ‘secundo ganancias’. This means to have second source of earnings. That’s their protection against interrupted professions, lay-offs, and economic turmoil. It doesn’t sound like a bad idea for Americans today. A practical, second source of retirement income would be a few rental houses valued at the mid-point of the market which determined families of wage earners and entrepreneurs would be able to, and could afford to rent. There are a lot of places in the country where conventional wisdom would say that feasible rental houses just don’t exist. But conventional wisdom will have little to do with how well you live in the America of tomorrow. Those who succeed in our brave new world will be those who persevere to protect their net after-tax purchasing power.
An outline of actions to take in building a cash-flow investment to provide funds for retirement would include the following principal steps:
1. Start tracking actual house sales through the Multiple Listing Computer or County Tax Collector’s office in your area to establish retail market values. Study the demographics by using market data compiled by your local Chamber of Commerce, Appraisers, and newspaper to identify decent neighborhoods near schools, jobs and amenities where skilled blue-collar workers have bought their own homes.
2. Advertise. Use signs. Go door-to-door or mail flyers to every house. Let occupants know that you want to buy a house – even one with physical or financial defects which you can handle. Use ‘bird dogs’ – people in banks, title companies, law, real estate and accounting offices, personnel departments, small loan companies, etc. to direct people to you who need to sell their homes quickly.
3. Focus on sellers who are motivated to sell by other-than-financial reasons – for personal problems such as death, divorce, job change, changes in family size, schools, etc. Ideally, your purchase should attempt to solve their problem.
4. When you negotiate a purchase, avoid conventional bank terms. Innovate. Be willing to trade a higher price and quick sale for lower payment terms and interest. Split your promissory Note into two parts, one with a higher market value which the seller can sell for cash, and one with a much lower market value – and possibly, delayed payments – to provide a monthly cash flow in excess of all costs. Walk away from negotiations that don’t produce a profitable and feasible investment property.
5. Once you’ve bought the right house and readied it for rental, seek a long-term tenant for it who will pay a reasonable rent, AND enhance the property value by contributing repair and maintenance effort in return for rental stability.
6. Once you’ve closed on each house and gotten rents under control, repeat the process using what you’ve learned to try to do everything a little better each time. Get your family involved so that each member eventually has his or her own house.
7. Cultivate mentors from among successful people you meet. If you’re going to pay for education, spend your money with teachers who made their money doing what you want to do, not from seminars. Focus on know-how you intend to actually put to use.
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