February 1988
Vol 11 No 4
The trouble with reading financial publications is that everyone has an opinion. You can find any prediction that you want and the savant who makes it will also provide an exceptional array of hedges so that the future won't prove him wrong. So what's a person to do? I think the answer lies in the Boy Scout Motto: BE PREPARED. Let's play 'Suppose'.
SUPPOSE YOU LOST YOUR JOB? That's what the word DEPRESSION means – that YOU can't earn a living. We live in a world in which we compare ourselves to others rather than to any absolute standard of value. If others have more money, freedom, ease we feel left out. If we have more, we feel successful. Rich is more, poor is less. We don't know the quantity of dollars that spell success in absolute terms, only relative terms. So when you lose YOUR job, that's when the depression strikes you regardless of how others are affected. What have you done to prepare for that contingency? Cash reserves? Independent income? Spouse employed? 2nd job? Rentals? Mortgages? 'Back-up Business'? Special skills or markets?
SUPPOSE YOU HAD TO RE-LOCATE? Would you be able to sell your house? Keep it? Do you own any rentals? Who would manage them? Will they support a 10% management fee off the top? Is there a ready re-sale market for cash? Would you be willing to sell with owner financing? Would there be any severe tax consequences? Would you have enough ready cash to move? Have you signed any Notes with full recourse or non-assumable mortgages? Can you liquidate fast?
ARE YOU PREPARED FOR A MEDICAL EMERGENCY? If YOU had an accident it could be the same as losing your job, but with additional expenses. If a member of your family required medical care, you might be forced to liquidate or re-locate under trying circumstances. Do you have adequate insurance? Do you have a plan for raising cash on your investments? Is your spouse well versed in your financial affairs so that necessary decisions can be made in your absence. Are your accounting records in order so that taxes can be paid on time? Are any transactions pending that might 'fall through'? Does your family support your activities?
SUPPOSE THEY CALLED YOUR LOANS? How would you pay them? Have you lined up a private source of funds? Do you hold liquid assets you could use? Is there a ready sale market for your real estate? Do you depend upon institutional financing to roll over loans? What would you do in case of a credit crunch? Can your properties support high interest rates? Could one foreclosed property trigger the loss of many more properties? Do you have personal liability?
WHAT ABOUT JUDGEMENT LIENS? Delinquent taxes, mechanic's liens, deficiency judgements and Lis Pendens can attach to healthy properties as well as unhealthy. Most creditors prefer the cream of your crop to the dogs and they could move to deprive you of them. What have you done to protect your assets? What about 'partners' who could contaminate them? Do you have a lot of money/equity tied up in jointly owned properties with people you don't know?
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WHAT ABOUT AN ECONOMIC DOWNTURN? O.K., you're in good shape, but what about your tenants? If they lose their jobs, you've lost your rents! If those who owe you mortgage payments can't pay, you'll suddenly become a landlord with non-paying tenants. Both mortgagees and landlords will face new challenges. Courts probably won't be sympathetic as was demonstrated in Pittsburgh a few years ago when a judge refused to foreclose for non-payment of loans. And those who've 'Equity Shared' with tenants may find it impossible to remove non-payers. All of the above 'what ifs' may descend upon you by virtue of your dependence on others. If you expect to weather an economic storm, it behooves you to PLAN FOR TROUBLE but hope it never comes. Or you can join those legions of tape/book salesmen 'cheer leaders' who never considered the 'down side' and who've disappeared into oblivion leaving the followers behind.
IT'S HARD TO CLIMB UP WHEN YOU'RE LOOKING DOWN . . .
I think you could characterize the CommonWealth Letters as being more oriented toward capital preservation than fortune building. Having seen so many people fail because of their inability to forecast financial problems, I'll admit to a certain amount of caution when it comes to investing hard earned cash or hard won time. I've probably lost more than most in more ways over a longer period of time, so I know something about down side risks. I'm trying to spare you that experience. On the other hand, I've also managed to pay all my bills and retain a certain degree of solvency by staying on top of opportunities that emerge.
One of the virtues of caution is that it enables you to build a firm foundation for future investment when opportunity encounters preparation. Let's understand that most true fortunes were built through the use of leverage and appreciation in the early stages. They were maintained by income and management which enabled them to grow steadily, safely. I believe we're poised at the onset of another great period for real estate investors – and specifically – single family house investors. Here's why.
The new tax act has driven millions of investors and billions of dollars out of the real estate markets. Buyers will have less competition for properties and for loans. Prices in many areas are falling off even though demand for housing is strong. A year from now millions of FHA loans will be emerging from the 2 year non-assumability period with low interest rates that can be assumed easily, and with low equities. This leverage will enjoy a period of inflation which is almost unavoidable because of Reaganomics. For the beginning investor, I think we'll have a repeat of the 70s. For the mature investor, I think the tax benefits for cash-flow properties are going to be increasingly valuable in comparison to the harsh treatment being meted out to savings and dividends – and capital gains. In areas of increasing population/job/income growth rents will rise rapidly. So will cash flow.
It seems that both leverage and growth are going to be in place within the near term. Even though there may be a down-turn in some areas, local demographics/economics in many areas will be creating lots of opportunities. For the person who's resolved those dilemmas posed on page 1, the future seems bright indeed. In some instances, the present isn't bad either. The easiest way to get fast appreciation is to buy at prices which are only fractions of economic value – and where there is a way to realize that value by means of special skills and/or insights. That's a nice way to describe distress buying.
The distress 'trap' is that YOU won't be able to harvest the gap between price and economic value because of lack of management skills, financing, or local economics that you don't understand which continue to hold appreciation down. Timing can be critical. An example of this might be Houston, Texas. Few can doubt that Houston is a 'world class' city with virtually unlimited potential. But many have foundered on the rocks of adversity while they awaited a turn around. I think that time is just around the corner for several reasons.
Houston has diversified its economic dependency on the energy industry while it has maintained its contact with the oil and gas business. It has plenty of low cost labor. Excellent port facilities. Centralized geographic location with access to all forms of transportation. The local 'work ethic' is strong. So is optimism. There's plenty of cash for profitable ventures. It will benefit from improvement in trade. It has pretty much wrung the soft spots out of its financial picture. Lenders are down to the nitty gritty in structuring dispositions of their REO properties and the recent stock market crash has made them even more willing to make a deal. Construction and growth reflect this.
IT'S GOING TO BE A BUSY SPRING . . .
Hoo Boy! Have you seen those new tax forms? When they said 'tax simplification' did they really mean 41 new forms to fill out. Just think, all those people with tax exempt bonds will fill out forms. All those kids with taxable income or who need social security numbers. All the people claiming residential interest deductions. All those people with passive losses or gains. People with Alternate Minimum Tax. Corporations, Trusts and other entities with fiscal years who are transitioning into calendar years. Those with new W-4s.
If you expect to meet the April 15th deadline, you can't wait. Get the forms you need NOW and start entering figures right away. There are lots of arcane computations that are going to require you to research your records and reconstruct your financial data before you can even start. And there are penalties if you do it incorrectly. Line up professional support that you're going to need right now. Tax preparers, CPA's, Accountants, Bookkeepers, computer services are going to be swamped. Like the man said, 'When the lines form, raise the prices.'. Don't be surprised to find a real shortage of people who can help you – and expect to pay high prices when you do. It wouldn't hurt to apply for an extension form 4868.
We've presented 5 seminars on the tax act starting with the first one 2 days after it was signed. Go back and re-read your notes and workbooks. I've already started getting calls from people who are trying to re-do their 1987 now that they see the tax effect of the decisions they made last year. Sorry. About all you can do is to start right in 1988 by getting your financial house in order so that you won't face the same problems next year. You're going to have to segregate each property so that you can (a) identify the ones that you actively manage, (b) group 'loss' properties and 'gain' properties, (c) allocate any unused loss carryover (35% in 1987, 60% in 1988) back to each individual property to be held as an offset against gain from that property in subsequent years. Why not use a spread sheet?
I use a computer, but you could use a manual system just as well. Across the top I array an identifier for each property. In the case of multifamily or mobile homes I like to treat each rental as an individual property for financial management purposes. Once I've entered these, then the next step is to go down the left hand margin. Starting with rents and other income such as lost deposits, pay telephones, parking, storage, etc. list each item and pick up a sub-total for all income. Next, list all expenses. Because I like to see where I'm spending my money, I prefer to break these down quite a bit. By taking a total on the right hand margin, I can compare total expense in each category on a house-by-house and year-by-year basis. You can use the Schedule E categories, then refine them to suit.
Once I've taken a sub-total for all actual expenses, I subtract this from my total income figure to show net operating profit. Then I plug in depreciation for each property. By subtracting this figure I'll know what my taxable income or loss is per property as well as the total on the right hand margin. This tells me which property needs remedial work for the next year. For example, those with negative cash flows should be definanced or sold. Positive cash flow properties might be able to carry more debt or more repair expense. If I've had lower income from one, I can concentrate on solving management or vacancy problems. And in any event, I will have established a ready reference for tax reporting without a lot of last minute head scratching and guessing. I'll plug loss carry-forward in for next year at the very bottom as a minus figure just ahead of taxable income to it will be used up fast.
In instances where you find you've got too much Passive Activity Loss, one of the best ways to use it up is to contribute the property to a 'C' corporation. It can be used 100% to offset active income earned by the corporation. This is especially important for those who earn over $100,000 a year, but affects everyone with losses which must be carried forward. This will be increasingly critical with each passing year. But corporations must be considered from many angles prior to your embarking on their use merely for tax shelter.
COMMENCING TO COMMENCE . . .
The two biggest fraternal associations in the world are the 'I COULDA' and the 'I SHOULDA' clubs. For example the latest group of candidates for entry were those who 'coulda' shorted the market in July or who 'shoulda' sold out in early October. I'm sure we'll never run short of applicants. In April we'll hear from those who shoulda planned for their taxable event. And we'll continue to hear from those who coulda bought when the price of property and financing were low, but didn't. Or those who shoulda arranged for fully assumable, fixed rate loans without any recourse or who shoulda made an offer just to see if someone would have taken it. I wonder how many will take page 1 seriously enough to actually implement some contingency planning which could save their economic lives. No one can say precisely how much procrastination costs all of us, but it's considerable.
In delving into the mysterious world of financial success, I've found that a fair amount of self-discipline attends those who arrive at the top. That's linked to the desire to attain goals. And that can't be done without some goal setting prior to the actual work that has to be done. Now's the time for you to set your goals for the coming year. Here's a suggested outline which might do until you can come up with something better for yourself:
1. Secure the success you achieved up to this point. Get rid of non-productive property. Eliminate problem loans and tenants. Sell enough property to give you liquid reserves sufficient to carry all your properties for 3 months. Limit your liability. Insure.
2. Lay out a master tax plan. Determine what's good for you and do it. Make necessary adjustments in your income to optimize your tax position. Select a good accountant. Start a good records keeping system. Decide about incorporating and Pension Planning.
3. Array your present assets and decide where you are on your road to success. Do you need more? Do some of your properties 'bug' you? Should you be doing more? Less? Do you have too much leverage? Not enough? Is your spouse/family involved? Should they be? Make a plan that you like. Write it down. Follow it. Measure your progress.
4 If you need to acquire more property, start to do it. Set up a schedule of sources of leads, money, management, materials, labor to meet present and anticipated needs. Take a hard look at your locale to see if it will afford you the opportunity you need. If not, lay out a plan for either relocating or investing in another area. Budget the time for work on your estate building program. Reduce your intent to writing and learn to recognize when you're failing yourself. Building success is just like going on a diet. The more you talk about it, the less you'll do about it. Quiet determination is the key.
5. Answer the questions posed on page 1. Take remedial action to cure any vulnerability.
The ultimate financial position is a HEDGE – the middle of the seesaw. No matter which way the ball bounces, the middle doesn't move much. To do this you need to provide for income that's not related to your principal source of salary, wages, or investment. You need inflation hedges so you can offset the loss of purchasing power a falling dollar causes. And you'll need liquidity – maybe in something other than dollar currency. (International Cash Portfolios Mutual Fund (800) 826-0188 invests in short term debt denominated in strong currencies to hedge the falling dollar.) When no one knows THE PRECISE TIMING of any up or down movement, the middle of the seesaw is the place to be until a trend emerges. In most instances, a portfolio of prudently leveraged/free and clear houses provide much of this.
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