Are The Inmates Running The Asylum?


November 2008
Vol 32 No 2


          Thank heaven I bought houses instead of stocks.  The stock market roller coaster continues to set new records.  Two and one half Trillion dollars was lost in the stock market in the second week of October!  It lost 20% of its value.  This is more money than has been lost in the housing market in the past 3 years.  We can all agree that the credit crisis started with home mortgages, but how did it create the current financial panic?  Congress in its usual flurry of poorly thought out emergency legislation laid the groundwork.  First it mandated that lenders would make loans to poorly qualified borrowers, and that FNMA and Freddie Mac would buy them.  Lenders created a slurry of unconventional loans that enabled millions of people to buy houses who had never owned homes before.  Hidden away in loan terms were escalator clauses that automatically increased interest rates after the initial period.  To raise money with which to buy loans, FNMA and Freddie Mac re-packaged and re-sold these loans into the stock market as mortgage-backed securities. 


          Everybody jumped in for a piece of the action, driving up prices. We’re all guilty: Speculators, Investors, Builders, Developers, Material Suppliers, Real Estate Brokerages, Home Furnishing industries, with their eyes firmly fixed on profit, all heedlessly made a lot of money as the housing bubble grew bigger and bigger.  As gasoline, interest, taxes and insurance costs rose, Johnny Paycheck met these increases by borrowing against his equity or on his credit cards.  One day the debt-straw broke the camel’s back and home buyers just stopped making payments.  Loan defaults and bankruptcies exploded and financiers found themselves holding securities based on loans that were being foreclosed at steep discounts


          In the second act of this little drama, as a result of the Enron collapse Congress passed a law that required corporations to “mark to market” their loans, and to reflect these values on their balance sheets at heavily discounted values.  When they subtracted debt they had incurred to buy mortgages plus the guaranteed yields they guaranteed on loan-portfolios they had sold into the stock market from the discounted value of their mortgage assets, they had no equity value.  This put financial institutions and their investors into the same position as homeowners who found out that their houses weren’t worth as much as they had paid for them.  Stock prices plummeted, and so did the financial security of workers, retirees, investors, savers, pension plans, and IRAs; as well as State, City, and County investments. 


          To combat this, Congress, within the space of just a few weeks, approved a series of bailouts and mergers that totaled about a Trillion dollars.  They were aided and abetted by our leaders: the President, Secretary of the Treasury, the Chairman of the Federal Reserve, and Chairman of the SEC. In spite of all the hand wringing about people being foreclosed out of their homes, hundreds of billions of dollars are bailing out financial institutions so they can lend more money, not cash squeezed homeowners who are drowning in debt and who can’t pay their bills.  As I write this, none of this $trillion seems to have helped existing housing very much.


          A number of solutions have been proposed that seem to make more sense than merely throwing more borrowed money at lenders.  One such proposal is to rescind the “mark-to-market” rule and let corporations reflect mortgages at values based upon the equities securing them.  Another is that if government insured lenders against loss, then lenders wouldn’t have any reason to foreclose and could offer payment adjustments.  With no foreclosures, there would be no loan discounting so the balance sheets of those holding mortgages would once more reflect capital values based upon the guaranteed value of mortgages held, providing some stability to the financial markets.  And it would be cheap.  It is estimated that a combination of insurance and payment subsidies would cost about one tenth of the current bailout. Of course, this wouldn’t allow Congress to buy votes with pork barrel projects. 



          Today, with higher taxes and inflation looming on the horizon, a brand new untried and inexperienced administration and financial disaster threatening on all sides, investors are eager to find a simple, secure, trouble-free, tangible investment that they can understand, see, feel, and touch.  By and large, they aren’t looking for the highest yields, just safe, reasonable yields that they are certain they are going to get.  They’ve heard the stories about investors being fleeced in blue-sky schemes that didn’t turn out, so they’re skeptical when they are promised astronomical yields by people they don’t know.  That’s why they’ve still got much of their money tied up in cash; waiting for a good deal to come along.  For active real estate people a truly good deal is where need meets opportunity         


          Suppose you, as a passive investor, could buy an upscale house in a new subdivision for less than half its original new cost; would you be interested in buying it and dividing all future appreciation with an entrepreneur who could find it?  How much would you be willing to pay someone to attend foreclosure sales in areas you like, and bid on such houses at liquidation auctions?  Would you rather share future profit and risk instead of paying a cash fee up front?  Even if a house went down in value for the next year or so before starting to appreciate back to its original fair market value, would you prefer buying it to investing in the stock market where fortunes were made and lost every day?  Or to leaving cash in a bank account where, if the bank didn’t declare bankruptcy, inflation and taxes could steal purchasing power daily? 


          If you bought such a house, who would take care of it?  Many investors have been led down the primrose path by promises made by promoters who put them into bad properties in remote locations, then grabbed the cash and disappeared into the night.  How might you prevent this from happening?  More to the point, how much would you be willing to pay someone to manage such a house with a guaranteed net after-tax yield of 6% per year?  Let’s make it even better; would you be willing to sign a 5-year lease on such a house with the right to sublease with an entrepreneur/lessee who had a solid track record and who would pay 6% net to you annually each year?  Before saying yes or no, you’d want to protect your investment.           


         Let’s put some teeth into a proposed transaction:  Suppose someone bought you a bargain, leased it back, sub-leased it to occupants, paid all taxes, insurance, HOA fees, maintenance, and other operating expenses for five years, then sold it?  Instead of paying anything to the entrepreneur up front, upon sale, you’d divide what profit remained 50/50 only after you had recovered all your cashWouldn’t you feel better about paying only after the entrepreneur had kept his promises?  If he got tired of keeping his part of the bargain and left you in the lurch, he’d walk away from all his work and share of profit; leaving it all to you.


         Here’s a practical example of how this concept might be applied to a recent purchase: The 4 year old house in a newer subdivision was bought new for $485,000  The original buyer had paid $50,000 down and had signed a $325,000 first mortgage lien, plus a $110,000 second.  At foreclosure the house was bought for $165,000.  All the existing mortgage liens were wiped out.  Let’s look at the possibilities:


          An investor could either have given the entrepreneur the funds to buy the house; or could have bought it for $165,000 following the sale.  The house would be titled to the investor, or to an entity he controlled.  The investor would net-lease/Option the house to the entrepreneur for five years for just enough to pay for insurance, taxes, and HOA fees.  The entrepreneur would pay all other operating expenses; but retain any net sub-lease income. His Option would give him the right to buy the house for a price that would evenly divide all sums remaining after the investor had recovered $165,000 plus any other sums paid to prepare and sell the house.  As an investor in today’s turbulent times, would you prefer this kind of proposition to stocks; particularly after seeing the DOW drop 20% in one week, then bounce back 10% in one day?  Would you be more comfortable leaving cash in a money market fund that invests in stocks, or in a bank loaded with bad home loans?



          Let’s put the shoe on the other foot:  Suppose you were the entrepreneur who tracked down a fantastic bargain that you could buy either via a Short Sale or at a Foreclosure Sale; would you be willing to make and keep all of the foregoing promises for up to 5 years in lieu of being paid each month?  Sure, you’d be able to make money from your sandwich lease, but if you needed more, you’d have to buy, sell, or rent other houses for a fee, or earn cash from other sandwich-leases, while the foregoing deal matured.  By doing this, you could build a fortune with sweat equity that wouldn’t have been possible when things were booming.  If you did a lot of these deals, you wouldn’t need to do much else to earn a living.  Take a look:


          Assume at the end of 5 years, house prices had returned to 2005 levels.  Suppose the free and clear house were sold for $425,000 net after all expenses?  First, the investor would take out his original $165,000; then you’d divide the remaining $260,000 evenly.  His totally passive compound yield would have been a very safe 12+% per annum without regard to any tax-shelter he might have gotten from depreciation.  On just this one house, without any debt, your future equity would be $130,000 in addition to an average $1000 per month in net rents over the 5 years; or another $60,000.  With no investment of your own money at all, your sweat equity would have made you more profit than his money.  It boggles the mind to think of how much you’d make if you were able to do 6 of these per year for five years.


         Where people go wrong is to isolate the foregoing as if there would only be one deal; but absent of political tinkering, your upside profit potential is only limited by three things:  First, you have to find good enough deals to attract investor money.  Second, you’re going to have to research all the houses scheduled for foreclosure and find the best one to buy.  This means you can expect to spend hours and hours researching houses and attending foreclosure sales before you are able to find the right deal.  Still, it would be quite reasonable for you to be able to buy at least one house every other month.  Lastly, you are going to have to be able to attract, screen, and select good long term tenants, rent each house quickly, and supervise your tenants so the houses will generate rental income for you.


          Just to get your juices flowing, let’s extrapolate the foregoing figures out five years.  If you could buy a house and rent it up every two months for 60 months, you’d wind up with 30 houses.  The first year you’d be adding a house every two months, so have 6 houses that averaged $21,000 in gross rents.  At the end of the 5th year, you’d have 30 houses that produced $12,000 each per year in net rents, completely free of payroll taxes.  Rents could be raised as needed to adjust to any inflation.  If you stopped buying right there, you could retire comfortably just about anywhere you wanted without worrying about selling the houses.


          That just accounts for rents; what about Option profits?  Using the same figures as in our pro forma above, starting with the 61st month, for the next following 59 months, suppose you sold each house after it had been held 60 months? Every two months you’d be getting half the proceeds from a sale, or about $130,000; taxed at capital gains rates.  Best of all, if you so elected, your Option profit could be exchanged tax free into more houses.  In lieu of continuing to collect rent, you could stop working and liquidate $3,000,000 in equity. That boils down to $600,000 per year for five years.  Is this worth doing? You tell me.      


          Of course, you might be able to buy all 30 houses in the next year of rampant foreclosure sales if you can locate people to put up the money as described above.  If you did, your profits could even be bigger over a shorter period of time.


          What’s the catch?  You’ve got to go to work!  You can’t “farm out” the hard work required to be able to find and buy houses in the competitive environment that the next year is going to spawn.  You can expect a lot of government meddling that will do very little good, and possibly a lot of harm, as it distorts the liquidation process.  Still, there’s going to be a lot of opportunity out there for the next couple of years for the person who is willing to risk work instead of cash.




          The tightening credit picture isn’t affecting all people equally.  Odd as it may seem, there are millions of people who long ago cut up their Credit Cards and started living within their means.  Many of these are retirees who have been around long enough to realize that increasing personal debt to pay for lifestyle doesn’t bode well for a time when Social Security and Medicare could be broke.  Others are from the old school that mistrusts debt of any kind.  Still others are not consumers.  They don’t buy the latest audio equipment, computers or cars.


          A major opportunity is emerging out of the opposite demographic segment; which will be the most affected by tightening credit.  Think of all those people who patronized the Sharper Image.  Those who prized “looking good” over being home owners; who placed their houses in jeopardy by using Home Equity Loans to buy Gucci sandals, Rolex watches, Hummers, RVs, boats, and other depreciating assets.  When houses were appreciating, they refinanced their homes with every increase of value, thereby transferring appreciating equity into over priced toys.  Now, they are desperately trying to stay abreast of their payments; but falling further behind.


          Consumers who mortgaged their futures to maintain their presents offer a mixed opportunity. They fall into two camps.  Foreclosure or Short Sale candidates mortgaged their homes to the point that they have negative equities.  The only way they can escape their own folly is to sell out and start over.  Buying their homes as pre-foreclosures isn’t a good idea.  It would leave you with over-financed houses, negative cash flow houses with no equity.  That’s where Short Sales shine. 


          A paradigm shift has taken place among over-stressed lenders:  They have started accepting ridiculous Short Sale bids that require them to discount all secondary liens and to pay real estate commissions.  But Short Sale contracts must be packaged and presented to the investor/decision-maker that is actually holding the loan; FNMA or other secondary mortgage investors.  To accomplish this, seek out a pro Broker or Escrow Company that specializes in Short Sales and knows whom to contact and how to present a Short Sale offer.  Because nobody really knows how much further prices may fall, it pays to make low offers; about 30% of the defaulted loan balances.  Most of these will be turned down, but when one is accepted, it makes up for all the others.  If you don’t have enough money to buy Short Sale houses, re-read page 2.  Before making your offer, find an investor, or a new owner occupant, to buy the house and either pay you a fee, or share in the profit.


          Another market opportunity is to offer “payment assistance” to distressed owners who still have significant home equity and who have managed to keep their indexed mortgage payments current.  With tightening Credit Card limits and bank refinancing drying up, they can no longer borrow their lifestyle.  They either don’t want to, or can’t, sell their homes or their toys.  Today, they can’t afford rising gas prices, taxes, and insurance, so are being forced to cut back their lifestyles.    Their financial body language is that they would prefer to sacrifice equity in their homes than to give up their toys or lifestyle. The stage is set for you.


          Suppose a family were living in an upscale house with $100,000 equity even at today’s much lower house values.  They can’t make their $3000 per month payments.  Your Roth IRA offers to pay $1000 per month for 3 years to buy a 5-year Option that will share their equity 50/50 at the end of five years.  You’ll secure your Option with a recorded Wrap-Around Mortgage or All Inclusive Trust Deed and arrange with a local bank or escrow company to combine your money and their money to make the house payment.  This will protect your interests against any future refinancing or liens. 


          At the end of the period, your $36,000 investment will have bought you  $50,000 in current equity, plus one half of the loan amortization and appreciation.

If the $1000 is too much for you, you’ll have to find another Roth IRA and split the profit with it.  Note that payment assistance in return for an Option side-steps and exploits the credit crunch because none of the above requires new bank financing


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