February 1991
Vol 14 No 4
Investing is tough. Real estate investing is tougher. Investing in mortgage paper secured by real estate can be the toughest part of the business – when equities are falling during a recession! Why? Because the mortgagee is merely holding a PROMISE of payment secured by a claim against that falling equity. In today's climate, one of the easiest promises to break is a promise to pay. When that is given legal and ethical sanction by the law, the natural result is that millions of loans go into default.
The Soldiers and Sailors Relief Act of 1940 is aimed at protecting the property of service personnel who have lost their earning power as a result of their entering into the armed forces during a period of national emergency or crisis. They are given relief from payment of full interest and principal under this act so that they won't be victimized during the time they are serving their country. But what happens to their creditors?
The Bankruptcy laws currently in effect are aimed at giving a debtor a chance to re-structure debt, re-organize business, prevent future liability and even default on some of their pension obligations. All this to help the DEBTOR at the expense of the CREDITORS. These laws will surely be called upon by INSURANCE COMPANIES who've invested in both real estate mortgages as well as JUNK BONDS to fund their policies and annuities – with the full approval of the courts – at the expense of the elderly and the prudent people who sought to secure their retirement years and the survival of their families. More broken promises.
Let's not forget to include good old FDIC and FSLIC (now merged). The 'I' stands for INSURANCE. If these agencies weren't sponsored by your government, they wouldn't be allowed to operate because of their lack of reserves with which to fund even one major bank failure. How comfortable would you feel if your automobile or life insurance company were only holding 6C with which to pay off every $1.00 in future claims? That pretty well is the situation over at the insurance company that's insuring your bank savings today.
More and more, I'm hearing from unfortunates who relied upon the PROMISES of their employer (who has now gone out of business), their lender (who has been taken over by RTC), their insurance company (who is in bankruptcy) and their speculator-creditors who have lost interest in making payments on properties that are worth less than the amounts that are owed on the outstanding debt. Now, even the government has started to waffle on the guarantee that each account in a bank account is insured up to $100,000, First they say that this was NEVER A GUARANTEE, it was only a TEMPORARY RESOLUTION of a single Congress that WAS NOT BINDING on any other Congress. Next, they say that they didn't mean EACH ACCOUNT. They meant the AGGREGATE OF ACCOUNTS held by one – or related – depositors. Just a few more promises that are being broken. What ever happened to honor and commitment? BEWARE OF BUILDING YOUR ESTATE ON SHIFTING SAND.
O.K., O.K. We know the problem. What shall we do? Let's start with your faith in your government. By now, even the most dense should realize that, when we have 5 of the most influential Senators accused of selling out to protect a failing lender, that something is seriously wrong at the very top of government. Let's not ponder too much on the son of the President whose name has suddenly dropped from public view in connection with Silverado S&Ls failure or that, despite total inability to come to grips with massive compounding deficits, that 96 of the incumbents were returned to office by the voters in 1990. But we should recognize that THE PROBLEM IS NOT GOING TO CURE ITSELF, EACH OF US IS GOING TO HAVE TO GENERATE OUR SECURITY THROUGH OUR OWN INDIVIDUAL EFFORTS instead of relying on promises.
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Once we've mentally thrown the switch and made a commitment to ourselves to work for our own financial security, we'll feel a little better about the state of the Social Security System and fate of health care systems whose funding is in jeopardy as the country sinks deeper and deeper into debt. Nor will we continue to get upset over the fact that more and more taxes are buying us less and less quality of life. Or that education in the public schools is a cruel joke not only on tax payers but on young people who graduate without any job related skills above the minimum wage. Or growing legions of non-productive vagrants that we've institutionalized as government wards and now call the 'HOMELESS'. No indeed. Now we'll begin to focus on things that will help us to help ourselves to prosper.
First, let's position ourselves as safely as possible with regard to what we now own. Call VERIBANK at 1(617) 245-8370 or write to them at P.O. Box 2963, Woburn, MA 01888 and buy a report ON YOUR BANK, S&L AND INSURANCE COMPANY to determine whether or not your savings are safe. If they're not, remove them and put them somewhere where they'll be safe. And liquid! If you're relying on the promises of a soon-to-be-defunct insurance company, see about borrowing out all the cash values or cashing in your policy while they've still got some money to pay you with. If you have the option, consider taking any company or union pension in the form of a lump sum payout at the first inkling of financial trouble. This will affect your income taxes, so look into it NOW in order to be fully prepared then.
Let's not overlook your current employment situation! Take a lesson from past recessions. How many companies closed down never to return? How many towns? Take a slow drive through the Rust Belt, Farm Belt, the old textile towns of New England. You'll see entire towns that are mere shells of their former selves populated by defeated oldsters who stayed too long and then were trapped in free and clear real estate they couldn't leave. Over a year ago I did a two day class in Massachusetts entitled 'Surviving a Down Turn' in which I advised people to take their profits and invest elsewhere. I recently heard from one of the attendees WHO DIDN'T TAKE ANY ACTION TO PROTECT HIMSELF. Here's his tale of woe:
He bought 10 houses with a combination of seller carry back and institutional loans, signing PERSONALLY. Then as the real estate market took off, he got carried away and placed EQUITY LOANS on his cash-flow properties, taking advantage of the $25,000 in remaining deductions available to active landlords. Next he began to use CREDIT CARDS to borrow short and invest long. Then both he and his wife LOST THEIR JOBS as their employer cut back in the recession. As a manufacturing employee, HE'S AN UNSKILLED LABORER IN THE GENERAL ECONOMY, despite combined earnings that approached $100,000 per year. Now, with payments of almost $5000 per MONTH, he's unemployed and unemployable and the costs of trying to liquidate his over-leveraged equities will leave him with little to show for years of work and sacrifice. He couldn't believe it would happen to him. He failed to get liquid when I warned him to. Now it's probably too late for him to recover. Can YOU relate?
If you DO relate to his situation, now's the time to take immediate REMEDIAL ACTION. First, take a critical look at the situation with your employment situation and potential job/income stability in the event of both a pro-longed war (which will help only defense oriented businesses at the expense of many others) and a quick peace (which could restore the 'PEACE DIVIDENT' cutbacks in defense spending, and result in layoffs in defense areas). One of our subscribers got a $2 million paving contract for a military base. He borrowed $400,000 to buy needed equipment. Then the government cancelled his contract (another kind of promise), leaving him with personally endorsed debt and no income to service it. Even independent businessmen can be adversely affected when government changes its mind. He's filed for protection under the Bankruptcy statutes, thereby infecting his creditors with his financial illness. If they too file Bankruptcy, even more people could lose their jobs!
The inherent weakness in promises is that they are INTANGIBLE and can he broken. Currency, Bonds, Stocks, Checks, Money Orders, Notes and REAL ESTATE MORTGAGES are PROMISES. Real Estate itself is TANGIBLE. The value and security it provides – while vulnerable to GOVERNMENT MANIPULATION via rent controls, zoning, taxing and 'taking' aren't based upon the promises of others. Of course, when it's leveraged too highly, it begins to become vulnerable to the promises of TENANTS, hence loses much of its desirability and security.
MORTGAGE 'PAPER' IS NO BETTER THAN THE ASSURANCES OF THE BORROWER . . .
I'm continually amazed at people who invest in 'paper' because they don't like managing real estate. They fail to realize that the only thing that guarantees their investment is their willingness to take over the collateral and to make it pay whether by re-sale or their own management performance. We've got billions of dollars of real estate held by RTC which is the proof of this statement.
First of all, S&Ls and Banks loaned money to a person who wanted to buy property. Then, for all the reasons previously stated – and more – he defaulted on his loan. Lenders were slow to foreclose BECAUSE THEY DIDN'T WANT TO OWN THE COLLATERAL AND TO BE RESPONSIBLE FOR OPERATING IT! Thus, they compounded the felony allowing the unpaid debt to compound and to drag down their own portfolio performance. Finally, they surrendered to the tender mercies of their government in the form of the RTC. Nothing's changed. THE RTC DOESN'T WANT TO OPERATE THE PROPERTY FOR PROFIT EITHER. It relies upon discounted sales to AVOID THE MANAGEMENT TASK. So the property value plummets, driving down the price of HEALTHY PROPERTIES. Or, in some cases, government owned properties are converted via tax incentives into low income housing. This attracts tenants from healthy projects who are forced to lower rents to maintain occupancy. Their value as a multiple of gross rents is thereby LEVERAGED DOWNWARD, making them worth less than their mortgages. The owners default in turn
Let's look at the numbers. Suppose you owned a twenty unit apartment house you'd bought in 1985 for $600,000 with a debt of $550,000. Across the street, the RTC sells its 20 unit complex for $15,000 per unit, or $300,000. Because of it's condition, after 2 years of government ownership and neglect, that's all it will bring at auction. The new owner restores it to prime condition, using government grants and low income housing incentives, then rents it out to low income tenants for $50 per month less than you've been renting to un-subsidized tenants. Say, $300 versus $350 per apartment per month. In the rational real estate investment market, your units would be worth about 8 times annual gross rents. Thus, at $350 per month X 20 units X 12 months (ignoring vacancy and credit losses) the old market value of your apartments would have been $672,000. Not any more after RTC!
For the moment, let's assume that you are making payments of $85,000 per year on your mortgage plus property taxes and insurance. You're doing all the maintenance and management yourself. You've had negative cash flow, but have been enjoying the feeling of building your estate while sheltering some of your negative cash flow with offsetting tax deductions against your regular income. In 1986, government changed the tax rules but now all your deductions except the $25,000 active management shelter have been phased out. And to add insult to injury, you've got to REDUCE YOUR RENTS. Your old tenants don't like to live next to welfare types. They've moved out, you've had to replace them with others who are less desirable. And you've had to match the rents of your competitor across the street. So now, you're getting $50/month less cash flow – $12,000/year less! That just adds to your negative cash flow, And it also reduces the value of your property by 8 times that amount, or $96,000. You're working harder and enjoying it less while you lose money. Sure, you're out $50,000 in your original investment, but you're not signed personally on the loan. You let the bank eat this one, and walk away. Now, it's the bank's problem. Or the RTC's!
It's easy to be cavalier about handing off a problem to a bank or the RTC. But what about the person who's signed PERSONALLY on the loan? He can't hand it off. He's got a major, long term problem that he'll have to live with a long time – or file bankruptcy. And, suppose YOU WERE THAT BANKER! Small apartments typically are financed by sellers in many areas of the country. And the mortgage paper is sold or exchanged regularly into the secondary market composed of thousands of small investors who 'don't like real estate and management'. Suppose you were that person who had to make a choice as to whether to take back an unwanted property in a distant locale, or to re-structure you loan? Would you be able to come up with something a little more creative than an institutional lender? Remember, for you, there's no RTC to bail you out. As seen above, the RTC IS YOUR COMPETITION!
A FIRST MORTGAGE MAY BE SAFE. SECONDS AND THIRDS ARE MORE LIKE JUNK BONDS . . .
In 1962, right in the middle of the Cuban Missile Crisis, Miami experienced a real estate recession. I held a 2nd mortgage on a house there. The borrower filed for Chapter 13 Bankruptcy and I was given the choice of accepting the property subject to the first mortgage or to lose everything. In an instant, I was converted from a comfortable investor in an income stream to being an absentee owner with $75 per month payments to make. Unfortunately, this same bankruptcy made me the owner of 3 additional houses with about the same payment obligations. THE COMBINATION OF PAYMENTS EXCEEDED MY TOTAL INCOME FROM WAGES! Eventually, after years of struggle, I lost every one of these properties because I just couldn't afford to carry the first mortgage payments or to manage the properties.
Had I held 1st mortgages, I'd been the owner of 4 free and clear properties and would have been able to hold on until the market came back instead of losing all the capital I'd been able to painstakingly save over a 10 year period. When real estate prices are rising, 2nd mortgages can be profitable indeed. When they're dropping, they can become millstones that can drag you down unless you can foreclose and manage the collateral to make it produce the income needed to pay the senior liens.
This parable is a warning to those who blithely jump into the paper market to get an income stream without understanding that there are wide ranges of QUALITY, DURABILITY and YIELD to consider. Risk should be discounted in Yield, thus you should get a much higher yield on paper with lower quality, whether that's a factor of the CREDIT RECORD of the payor, his PERSONAL ENDORSEMENT PLUS OTHER ASSETS, HIS SOURCE OF INCOME WITH WHICH TO MAKE PAYMENTS, TOTAL DEBT LOAD, INCOME, DISCRETIONARY SURPLUS INCOME, THE QUALITY OF ITS SOURCES. Durability relates to how well all these factors will stand up in an economic down turn. I'd be reluctant to lend to someone (or buy their Note) who was (a) eligible for the DRAFT, (b) had an unstable marriage, (c) was over-leveraged with personal debt, (d) wouldn't sign with full personal recourse, (e) was a leveraged real estate investor counting on rents to pay back loans, (e) was self-employed with very little business success over the years.
Test yourself. How much do you know about the person who's making you payments? How vulnerable are you to HIS MISFORTUNE? What about the collateral, are you SURE IT'S WORTH THE COMBINED DEBT? How prepared are you to foreclose and manage the property? Are you carrying any WRAP AROUND PAPER which could place you in jeopardy for the underlying payments if the person who's paying you files bankruptcy? Ditto for Lease/Option contracts through which you've guaranteed to deliver good title EVEN IF THE TITLE HOLDER IS FORECLOSED?
I'm vulnerable! But I'm doing something about it. I'm trading in my mortgage paper to buy distressed houses. It's a marriage made in heaven. I get something TANGIBLE with reasonable assumable 1st mortgages which my rents will carry even in a down turn. I'm giving up INCOME from an INTANGIBLE secured by something I don't want or can't handle to a person who's in dire need of INCOME and who needs something PORTABLE to take out of the area into a new job or personal situation in a different area.
And I'm already RESTRUCTURING DEBT to keep those who pay me as healthy as possible. I'm giving debt moratoriums, but letting interest accrue at high rates. When I need it, I get them to add more illiquid collateral to improve the QUALITY of my position. In some instances, I'm converting the loans into SHARED APPRECIATION MORTGAGES under which, in lieu of payments, I get both accrued interest and an Option to convert my debt into their equity at some point in the future. This gives them breathing room, and keeps me in a passive position. We'll spend time on these approaches at our LAS VEGAS COMMONWEALTH CONVENTION where we'll have some surprise speakers again. Check our brochure. Get your rooms early to avoid the problems with sleeping rooms that we always have.
