August 1985
Vol 7 No 11
Long time subscribers to the Commonwealth Letters are aware that conventional thinking isn't held in particularly high esteem in these pages. And regardless how one might wish every investment decision were the correct one, rather than try to reinforce the popular hypocrisy that real estate values automatically appreciate, I think it would be more beneficial to try to acknowledge that investment has to be carried out in the real world. Furthermore, in that world values fluctuate constantly. To the extent that you can devise an investment strategy which suits your particular situation – financial, geographic, sociological, philosophical – you'll continue to prosper despite the economy.
What does all that mean? Simply this: don't lament that changes are taking place in your market. Learn to anticipate those changes and to adjust your strategy in a way to take advantage of them. When you see that YOUR real estate is losing value, or financing is drying up, or rents are softening in your market, ask yourself, 'How can I make a profit because of the effect on others in the same market?'.
Let's face it. All of us share similar misgivings about the new tax proposal. Financing for investors IS TIGHTENING UP. HUD has issued instructions to the field that investors will no longer be permitted to 'unlock equity' via refinancing. That means all those people who expected to gain liquidity via refinancing will have to come up with a new game plan to thwart HUD or to use a different method of obtaining cash. We've been warning readers not to use credit to generate income for several years. FNMA restricts investors to 5 loans with them – when they can identify the investors and the loans. Our world is changing whether we like it or not. But it's changing for others as well. If we can adapt to the change we'll be able to use it to our advantage.
THE GOOD NEWS IS THAT THERE'S BAD NEWS . . .
Every few years I find that headline impossible to resist. It was never more true than today. First, the bad news: In this 3rd year of one of the strongest periods of economic recovery in our history, we are seeing the highest number of bank failures in our history as a nation. Farm values are falling faster than silver did in 1980. Thrift institutions – Savings and Loan Associations chartered at State and National levels – are in grave danger all over the United States. FSLIC is almost broke. A movement is in the works to try to merge them with FDIC. Bankruptcies and Foreclosures are competing with the IRS and county Tax Sales for cash all over the country. Those who signed notes in the early 1980s calling for balloon payments in 5 years are running out of time just as credit starts to get more scarce. Real long term interest rates have been continuously rising when measured against average growth in real estate values.
Now for the good news: Construction starts and sales of existing homes seem to be holding firm in many areas. Financing for owner occupants is available on fixed rate loans at just over 12%. FHA and VA loans are still fully assumable with no qualifying – but this could change swiftly. Because the proposed tax bill won't become effective until next year, buyers can still lock in 18 year ACRS, non-recourse financing, Even though the Senate failed to pass the bill required to exempt most small investors from the imputed interest rules, it is anticipated that the version passed by the House will be retroactive to July 1st once it's passed. Last, but not least, there's never been such a good season for buying distressed property. We'll be taking a hard look at these opportunities in this issue. Don't worry. There will be plenty to go around.
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THERE'S NO SUBSTITUTE FOR CASH . . .
Most of the competition for distressed property occurs PRIOR to the actual sale. In a typical scenario, the budding entrepreneur approaches the distressed owner and tries to buy his house using as little cash as possible with a variety of 'creative financing' techniques which involve multiple mortgaging. Understandably, the field for this kind of buying is crowded. After all, it doesn't take much money to buy 'nothing down'. Everyone can become a distress buyer. The 'distressed owner' does what anyone should do when there are lots of buyers. He raises his prices. Or he negotiates the right to remain in the property at reduced rents. Quite often this is coupled with the right to re-purchase the property at some point in the future.
What's wrong with this approach? It's very competitive! Only a few people are successful out of the thousands who are trying to buy bargains without any cash. Many of the loans are not assumable, especially where 2nd Mortgages or Trust Deeds are being foreclosed and the underlying first lien can't be assumed legally. Anytime the occupant has the right to buy the property back after renting it, the IRS might maintain this to be merely a financing technique and deny tax benefits to the owner. To make matters worse, if the amount the buyer pays down in cash is small compared to the profit he is able to negotiate from the former owner at time of the repurchase, it can easily be deemed USURIOUS and carry some hefty penalties. Of course, the former owner can go into court once the heat is off and convince the judge that he didn't know he was selling his house. Typically, the old owner maintains he thought he was just getting a loan. Guess who the judge rules for?
As in anything, the more you can change your technique to avoid competition, the more you can enhance your chances of success and eventual profits. Here are some garden variety variations on buying ahead of the sale. But I have to warn you. It will require some cash.
1. Lend the distressed owner sufficient money to catch up delinquent payments and to carry current payments until the property can be sold in the conventional market. Charge a high rate of interest plus 'points' and servicing fees for your profit.
2. Do the same as above, except, make your loan a Demand Note which you can call at a later time when there's less competition. In some areas, the lender can call for a foreclosure sale, then switch the location and time of sale with only minimal notice. Or the notice of sale itself doesn't require wide distribution. By being the lender and carrying your loan as a 'wrap around', you'll also get the benefit of any interest spread you can structure into the 'wrap' position.
3. Suppose the distressed owner agreed to sell you the property under terms you could negotiate once the foreclosure had been cured. Without any competition this might be easier than you'd imagine. He could sign a deed which you might decide not to record. If you had already recorded a wrap around mortgage in the public records and had taken over responsibility for making the payments on the underlying lien, your position would be reasonably secure against any further liens against the property. You'd have all the benefits of ownership, most of the security a recorded deed might offer, and any non-assumable underlying liens would thereby he effectively circumvented. The Garn-St. Germaine act permits junior liens on affected property.
4. Exchange the plaintiff one of your seasoned and well secured mortgages on another property for the one he's foreclosing. Most people don't like foreclosures. This way his income stream would be restored and you can do the dirty work. This puts you in the same position as in 112 above, but without the use of cash. Now YOU can control the foreclosure and have a priority position in negotiating with the owner.
TAKE A THIEF TO LUNCH . . .
For some time we've been offering complete sets of back issues (except for the current year's issues) plus a bonus booklet for $95. Many of the articles in those prior issues deal with ways to raise cash without borrowing it. It's doubtful that we've ever advocated using institutional sources for financing. That's because they're expensive, slow, unreliable, and probably don't have money to lend to people who need money. You could do a lot worse than to obtain these back issues and start cutting and pasting some of the hundreds of ideas they contain. Until I run out of what I already know about this business, I don't expect to start repeating any of the old material. That's why the complete collection is priced so low. Back to cash. Where do you get it to use to buy?
Have you ever noticed that there are people in every town who ALWAYS SEEM TO HAVE READY CASH? Let me name a few: Bail Bondsmen, Undertakers, Automobile Dealers, Plumbing and Heating Contractors, Restaurateurs, owners of small clubs and bars – or liquor stores, wrecking yard owners, flea market operators, successful insurance agents, owners of MacDonald's and ACE Hardware franchises. Notice I omitted Doctors, Pilots, Bankers. They're the ones the people with no imagination are soliciting on a full time basis. If you're going to be creative, CREATE! Don't follow the crowd. Why do they stay liquid? What do you suppose their tax brackets are? How much opportunity do they have to invest – particularly in real estate? Can you see any ways to attract their cash?
The reason these people have cash is that they understand it! They have lines of credit with commercial lenders FOR THEIR CASH FLOW BUSINESS NEEDS. Bankers love small businessmen whom they can turn into Money Junkeys with borrowing habits only bankers can satisfy. It's a lot harder for an investor to get an operating line of credit. Think about that for a moment. Isn't an investor a competitor of the bank's? He wants long term fixed fully amortized assumable financing for 30 years. The banker wants short term, high yielding commercial paper secured by cash flow earning assets. When a speculator gets an investor to fund his acquisitions, the investor takes his money out of the bank to give to the entrepreneur. The bank loses control over its funds. Why should the banker want to encourage you by making you the loans you want?
The solution: offer one of these money-men a piece of the action in return for funding the acquisition. Let's assume that you're going to buy distressed property either at sale for cash or from the lender later on. In both cases, you'll probably find that it can be bought on better terms or at a lower price because fewer people can compete for the property when cash is involved. Later on, you can use your benefactor's borrowing power to get cash needed for fix-up or to negotiate with any holder of underlying loans which HE might be better able to have transfered into his name than YOU would be. Of course, the best thing to do is to be a dealer in the business of buying and selling until you can realize sufficient cash profits to be able to fund your own foreclosure activities. Look at a simple transaction's costs and maybe you'll see why this is true.
PROPERTY: Single Family House. $33,000 1st being foreclosed. Value: $68,000. Divorced owners have left the area. $17000 in 2nd lien. $13,500 in 3rd lien. Both held by out of state owners. Insufficient equity for distressed owner to be able to sell and pay closing costs. He has no personal liability on the loan.
Here's how this transaction might be handled:
1. Bid $33,000 cash at sale. No competition. Profit: $35,000. Sell and divide $28,000 netted after paying selling costs. Over 4 month total time he earns $14,000 net on his $33,000 plus the return of his invested funds. That beats the bank's interest.
2. Buy the 2nd and 3rd liens at discount – I've seen these at prices ranging from 5% to 70% of the face amount without any regard to accrued interest. Say you get them for 30% of face value, and at the sale another buyer bids $50,000 for the house. You can bid against him and try to raise the profit. You can sell at $55,000 and realize a gross profit of $22,000 over the first, since they'll have to use any excess to pay off the next junior liens. You'll get $17,000 plus interest on the 2nd, and the balance will go to pay off the 3rd. But you'll have bought both liens for $9150 and have made a quick $12,850 in a very short time. Your ½ would be $6,425.
3. Buy the 2nd at discount – say the same 30%. Offer the holder of the 1st to join in the foreclosure and merge your interests. Minimum bid would be the face value of the total loans, or $50,000. That would scare off the competition but would still attract many potential home owner occupants. If it sold at the minimum bid price, you'd be paid back $17,000 and realize a profit of $11,900 prior to dividing up.
4. Negotiate with the lender to buy the first with a Note secured by your backer's assets or business. In effect, the lender would be avoiding the bad publicity that surrounds foreclosure of a residence – that's important in a small town bank – and he'd be able to replace a bad loan with another one of equal value and much higher quality. His alternative might well be to have to take the house back. While that would represent a lot of equity for him, he's more interested in cash flow income on his deposits. That's what he has to pay his depositors with. And he's heard of other banks in trouble for taking back too much real estate. If he hasn't heard of them, you should certainly bring that up in any negotiation with him. Now, proceed with the foreclosure. All sale proceeds would be yours to keep up to the amount of the $33,000, tax free. If you'd also bought the other liens at discount, any excess proceeds over $33,000 would also revert to you. Profits can be startling!
The key to dealing with your financial backer is to give him a profit greater than he would normally get in his bank or business operations. And people who understand cash will be more interested in quick turn arounds than in 'equity' positions as a rule. You should start using your own cash at the earliest possible moment. Look at what you paid in the above scenarios just to use another person's funds. Now you know why thieves always have spare cash. They know what to charge for it. Don't pay 'em. Join 'em! Incidentally, the above property is real. I bought it. Guess which of the above I used?
THERE'S MORE THAN ONE WAY TO SKIN A CAT . . .
Lots of lenders sell at foreclosures. Most people go to Trustee sales and to mortgage foreclosures. I usually avoid these in favor of IRS sales, VA direct loan foreclosures, Trustee in Bankruptcy sales, Small Business Administration, FDIC, and FSLIC liquidation sales, Sheriff's sales, Tax Sales and estate sales. In my area we also have Customs, Farm Home Administration, and Military surplus sales. All of these are potential sources of profits for the entrepreneur who will take the time to learn the rules and to get on the mailing lists so you'll be notified about up-coming sales in your area.
