May 1981
Vol 3 No 8
I have just returned from a thirty day road trip during which I attended and spoke at three national conventions, and taught three seminars. Although all the meetings were located in the West (California and Nevada), they were attended by investors and brokers from across the country.
I questioned everyone I talked to about the state of the economy in their area. Every area but Florida reported great buying opportunities. Speculators, amateur investors, brokers, and builders are all stuck with property they bought a year ago with one year notes, and nobody is buying. Thousands have learned how to buy with high leverage, but learned only half of the equation. They bought properties which have large negative cash flows and short balloon payments and now can find no bigger fool to take these off their hands.
One of the conventions I attended included a marketing session where investors tried to sell their houses to others. Those who owned houses which had positive cash flow found an eager market. But most houses were loaded up with 2nd’s, 3rd’s and more, and while they have real equity, there was no market for that equity.
The typical amateur owned a house financed like this – –
Market Value $100,000
1st Loan 60,000 10% VA 550 PITI
2nd Loan 15,000 18% 350 PI
3rd Loan 10,000 20% 160 Interest only. Balloon
_____________________ due next month.
$ 85,000 1060
Although there is a real $15,000 equity, there is no market for that equity. Many houses like this were offered with nothing down terms, but no one was buying. This example shows how you can butcher up a good house with bad terms.
In the seminar we continually stress that you should not finance with balloon payments shorter than five years and that you should not buy negative cash flow properties unless you are buying way below market. Keep negative cash flow in perspective by looking at annual cash flows instead of monthly cash flows.
A house which requires a five thousand dollar down payment and has a positive cash flow of $100 per month has a net negative cash flow of $3800 ($5000 — $1200) before taxes the first year. As your down payment is not deductible, it would be better from tax standpoint to buy the same house with $1000 down and a $100 per month negative cash flow, in which case the first year’s pre-tax cash flow would be only $2200.
Residential and sales people are seeing months pass without a sale. In desperation they are structuring “creative” deals to create sales, and are creating time bombs which will be causing distress in the house market for the next year or so. They encourage their “Client/Sellers” to borrow money on a bridge loan to take advantage of these tremendous buying opportunities and the poor sellers don’t realize that they are about to become an opportunity themselves.
Sellers, who have strong, safe, equities, like a $100,000 house with a $50,000 loan, are borrowing hard money seconds, or creating notes against their property to buy others. This turns a safe positive cash flow house into a risky negative cash flow situation as illustrated below:
BEFORE AFTER
Market Value $100,000 $100,000
1st Loan 50,000 – $500 per month 50,000 – $500 per month
Rent 600 per month 600 per month
2nd Loan 30,000 – $500 per month
Cash Flow + 100 monthly – 400 monthly
It would be far better to simply acquire another house which had a $400 monthly negative cash flow, with nothing down. Then in the event that you could not stand the payments, at least you are not jeopardizing your safe equity. Some people would call the $50,000 equity in the above house “dead equity” and worry that they are not getting the biggest return on their investment.
In the event that you have $400,000 equity in ten $100,000 houses, it is far better to have it concentrated in two or three houses, than spread evenly over your portfolio. The houses with big equities are your safety valve. You can give the ones you just purchased with high leverage and bad cash flows back in the event you can’t afford them and keep your safe, high equity houses. When you refinance your houses at every opportunity, you are not “using dead equity”, you are killing it.
This is probably the last great opportunity for acquiring relatively low interest rate, 30 year level pay loans. FHA rates are currently about the same as they were a year ago. Last summer they were briefly below 12% and in 1979 they were mostly below 11%. This means that there are thousands of houses with less than two year old, thirty year 10%–11% loans. I do not think that we will see loans like these again this decade unless inflation is lowered to less than 5%, which is virtually impossible.
The typical FHA house which sold two years ago for $50,000 is worth between $60,000 and $70,000 today and is a steal. The Banks and Savings & Loans are in terrible shape, and the Government will have no choice but to support them with their due-on-sale clauses and any other legislation or court actions needed to keep them from going down the tubes. You will not be able to borrow on those terms again soon – probably never.
Even in the event the seller insists on wrapping the underlying loan at a higher rate, buy! Include in the language of the wrap three important points: (1) That in the event they sell the wrap to anyone, you have a right of first refusal to buy it at the same price and terms; (2) That you have the right to pay off the difference between the wrap and the first and take over the first; (3) They will not pay off the first without your permission.
Even with the wrap you get the benefit of the existing loan as long as you protect yourself, and even if the wrap has a balloon, you can always resell on another wrap, borrow against the new loan, and pay off the balloon.
For example, let’s say that today you buy a house valued at $75,000, with an existing $50,000 FHA 11% loan for $70,000, $5000 down, and a $65,000 wrap at 13%, 5 year balloon. In three years you resell the house for $90,000, $5000 down and an $85,000 wrap at 13%. You now borrow $10,000 against the wrap, pay off your balloon, and have the benefit of the 2 point spread on the balance. Maybe interest rates will be higher but even if they remain level, you make a healthy return on the spread. Using the split wrap technique described in the December 1980 issue, you can further increase your profit potential.
In the above example, suppose the seller insisted on a cash to loan transaction, but would take $15,000 in cash for a quick sale. You offer to buy the house with nothing down at a price of $70,000, and a wrap with $20,000 equity, 13% interest, with a 10 year balloon. Now you find a buyer for the wraparound for $15,000 cash. The buyer of the wrap will get an above market yield and you get a safe house, below market, for nothing down. Remember to always put the language in your wraps discussed earlier, so that you can buy the loan down to the 11% underlying balance.
In the next year, there is certain to be many foreclosure situations. Often you are able to contact the people only after they are in default on their loan. By then they are obligated for legal expenses, or are several payments behind, and the loan cannot be reinstated. Think how nice it would be to have these same homeowners call you before they get in arrears on their payments.
For the last several years I have been running an ad in the paper which indicates that I have cash available to purchase notes. Many people interpret this ad to mean that I loan money, and call to borrow against their home, or for other reasons. Although nine out of ten calls produce nothing, that tenth call often leads to a buy.
Most people will attempt to borrow their way out of a negative cash flow situation. This rarely works and generally compounds the problem. When they get behind in their bills they borrow money to “consolidate” their debts. When they discover that they now cannot make the payments on their consolidated loan, they again try to borrow. This time they find few, if any lenders willing to place a third loan against thin security, and to a borrower who is headed the wrong direction.
In their search for money many in this situation run across my ad, and inquire as to what it means. I begin by trying to discover whether or not I have any interest in the property, and then go on to determine the degree of motivation of the homeowner. Typically, they have not seriously considered selling the house, and in the event that they had to sell to pay off their debts, it would be a defeat. Because of this unusual situation, where the owner of the house needs money to meet current cash flow needs, does not want to sell, and has no present way to repay a loan even if he could get one, there is opportunity.
Once I concluded that the people are serious about solving their problem, I have them come to my office and bring all the information on the house, especially the information on the loans. Several offers are available to me, but one I am particularly fond of, especially in light of some of the do-gooder legislation in California, goes like this. I will solve their cash flow problem by lending them the money they need to make the payments on the consolidation loan. They can continue to live in the house for another three years, or as long as they keep their payments current on the first. In three years I am going to buy their house at a price half way between today’s market value, and the current loan balance.
Assume the following: Market Value $70,000
1st Loan 50,000
2nd Loan 5,000 payable @ $125 per month
New Loan 5,000 funded @ $125 per month
Option to purchase at $65,000 for three years.
We record the 3rd and the option to purchase and open an escrow with a title company. We place a deed from the owners to me in trust with the instructions to record that deed in the event that I bring in a check within three years in the amount of five thousand dollars. This option can be written so that I cannot exercise it before a certain time, guaranteeing them ownership and occupancy for a set period.
Each month I write a check in the amount of $125 to the lender on the 2nd loan. Therefore at the end of the first year, if everything goes as planned, I will have fifteen hundred dollars invested. This will be secured by a 3rd, which is secured by a growing equity. In addition, I have an option to purchase the property at a set price, so that I profit as the property appreciates in value.
In the event that the homeowner fails to make the payments on the first, I immediately step in and make them to protect my interest, and start foreclosing on the third. In this case, I owe the homeowner no further consideration. The third will contain language to the effect that if the homeowner borrows any more money, using the house as security, or causes any liens to be placed against the house, that these actions will constitute a default and I will immediately foreclose. Again, I need not pay the owner further consideration.
I could obtain the same protection by simply purchasing the existing second and modifying the terms. However, that would require a substantial amount of cash. With this plan, I invest only $125 per month, so that my average investment the first year is only $750. This gives me a dramatic yield compared to the appreciation on a $70,000 house over the same period of time. Quite often, as you might suspect the homeowner defaults on the 1st mortgage. This triggers immediate foreclosure by me. Because I’d rather buy someone out than go to court, I prefer to offer the non-paying owners a small amount of cash provided they turn the premises over in good condition without opposition and move out at once.
In the event I should find myself in a position that makes it impossible to exercise my Option, at the end of the allotted period, all is not lost. I’ll still have my loan position which will balloon along with the accrued compounded interest. At the end of the first year the property should be worth about $75,000. I’ll have an option to buy it for $65,000 for two more years. Should the $125 per month that I am paying become difficult, I should be able to interest an investor by giving away half interest in the Option in consideration of his funding the balance of the loan and repaying me my contributions to date. Now I would be in my favorite position of “nothing down and nothing a month”.
Back in October, we announced a dynamic political concept incorporated in the DUCK BOOK, published by Bob White. Since that time, readership has soared into the hundreds of thousands. Local Duck Clubs have been formed in virtually every town and hamlet across the country. Meeting, attracting thousands of people have begun and Nationally prominent speakers are rushing to offer their services. If you feel it important to preserve our property rights and traditional freedom, send $10 to P.O. Box 1928, Cocoa, FL 32922. That’ll buy you a lifetime subscription (his, not yours) to a conservative magazine full of some of the best “hard money” thinker’s articles and newsletters. But it! You’ll like it! Better still, jump in and form a Duck Club in your town. Drop Bob a note along with your $10 subscription to find out how to get started in protecting YOUR property rights.
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