Whenever you buy from owners in areas with wide spread distress, it's likely that you'll have trouble finding tenants who can pay rents high enough to cover costs. If they'd been plentiful, doesn't if stand to reason that the former owners would have moved out and rented rather than to lose their homes? Beware of buying, where EVERY ONE is being, foreclosed. You'll lose the property too. And be careful about justifying a negative cash flow with a phantom equity that exists only in a larcenous mind. It's more prudent to only buy those properties which have reasonable payments and which are in distress more because of the individual problems of their owner than as a symptom of wide spread economic malaise.
How do you find the right properties? As we've discussed in an earlier letter, cold-canvas sing in the neighbor hoods, putting out flyers door-to-door, running .ads, paying “bird dogs”, direct mail, and contacting lenders all helps. Look for people to whom “creative finance” boiled down to placing 2nd and 3rd loans against properties. These virtually guarantees feasible properties In foreclosure situations.
To illustrate the point, suppose a buyer assumed an 8% loan at $40,000 with payments of about $375/month then pulled out some cash – $15,000 -via an institutional loan and paid that to the seller in cash. We'll say that the loan was at 18% interest only for 3 years and balanced due; with monthly payments of $225. As a part of the deal, the Seller carried back a zero interest rate loan for 5 years of $15,000 with balance due.
The property will rent for $500 per month but total payments are $600. When all the deductions are added up, after taxes, things pretty well balance out. Nothing down and nothing a month. Just what a lot of people are looking for, right?
Now, the plot thickens: Taxes increase by $50/mo. Insurance costs go up $15/mo. Interest rates climb toward the 15% mark for home mortgages. The 2nd mortgage comes due. Our intrepid buyer finds that he can't refinance the property because he can't qualify for a new loan sufficient to pay off everyone. The 2nd mortgage holder forecloses, and takes the property-subject to the first mortgage. The foreclosure action wipes out the seller's 3rd mortgage of $15,000. Now let's see where everyone is.
The original seller has only received $15,000 of his $30,000 equity in the property. The buyer is completely wiped out, having performed management chores for 3 years for nothing. His credit is impaired as far as institutional loans are concerned.
The first mortgage holder continues to receive his now $440/mo payments. The former 2nd mortgage holder now owns the property. He doesn't know how to manage it, so must pay for management out of his operating cash flows.
His cash flow now becomes critically short. His only alternative is to go into the management business personally and learn to manage the property or to stop making payments and to be foreclosed by the first lender. If this same thing is happening with other leveraged borrows throughout the area, there will be little chance of selling the property except a large discount to value.
Look at the different levels of opportunity here
(A) You can lend the buyer enough money to pay off the 2nd in return for a major interest in the property.
(B) You can buy the 3rd mortgage position at a deep discount first, then do (a) above.
(C) You can buy the 2nd lien position at a shallow discount after (b) above; then do (a) above.
(D) You can buy the 2nd position and simply foreclose, taking the 3rd mortgage plus any equity which may have been gained through appreciation which remains above that lien.
(E) You can buy the property from the 2nd lien holder following the foreclosure sale and negotiate a favorable loan from him in his distressed circumstances.
(F) You can offer to lease the property with a cash-flow sandwich position of $100 under prevailing market rents to alleviate the management problems of the 2nd lien holder or,
(G) You can lease the property break even with an Option to purchase which will provide a profit.
(H) You can do (f) or (g) above.
(I) Or you can wait until the 2nd lender is in default on the 1st lien, and repeat the process
