July 1984
Vol 7 No 10

THE ROLLER COASTER IS ABOUT TO COME OFF THE TRACKS!

The problem with trying to manipulate the economy in order to fool the public one more time is that you have to maintain control over it. It seems clear that the Reagan administration hasn^'t been able to do this. Somehow, I get the feeling that I^'ve gone through a summer like this once before – at about this period in the Carter years. He too was trying to get the voters to give him another four years to keep his promises. And you might remember that he failed. There^'s a fair chance that Reagan will fail too!

In spite of everything, real interest rates are beginning to move up sharply! The recovery may go down as the shortest one in history. Already, government bonds are being rejected by the market in anticipation of even higher interest rates. The ominous portent is that yields started going back up this time at a point which marked their peak 10 years ago. This is happening in spite of the administration^'s efforts to hold interest rates down – at least until after the election. A political tug of war is taking place between those who believe we should reduce the deficits by taxing citizens at ever higher levels and those who think we should free credit and lower interest rates even at the risk of ^“moderate^“ inflation.

Unfortunately, we don^'t live in a vacuum. Our economic policies impinge on the economies of almost every other nation on earth. We have the power to destabilize both their economies as well as their political institutions – and in fact – we^'re doing that with our high interest rates. Brazil is a case in point. The constitutional government is in danger of being replaced by a military junta who has already announced its intention to repudiate Brazil's debt. Why? Because their debt to the USA is pegged to our interest rate. As it rises, they fall farther and farther behind in their debt payments and their ability to pay. This is happening everywhere in underdeveloped nations. And it^'s happening here at home too!

Chronic over-spending is being referred to as the ^“American disease^“. At the Congressional level it is tolerated because deep down inside everyone knows that we^'ll just manufacture more money as we need it. But at the consumer level – where you and I must exist – we can^'t print our money. We have to earn it or our investments have to. So while our elected (soon to be re-elected) representatives continue to seek every avenue of relief other than to reign in their orgy of spending to reduce deficits, our citizens are going to start paying the piper – and very soon!

 

HOME MORTGAGE FORECLOSURE RATES ARE POISED TO TAKE OFF!

A sinister feature of the current recovery is that foreclosures have continued to increase despite rising employment and personal income levels. During the past 2 or 3 years, many adjustable rate mortgages – and variations thereof – followed the inflation rate downward to more or less comfortable payment levels. Now things have started back up. Payments will rise. Defaults will rise with them. A lot of people are going to be unloading negative cash flow properties into the distress market, depressing prices. It won^'t be uncommon for people to find out that after several years of sacrifice they^'ll have less equity than they started out with. All because of poor financing. Tampa is reputed to be one of the ^“hot spots^“ in the national housing scene. Yet even in this robust economy there will be many homes foreclosed upon once payments

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on variable rate mortgages begin to jump. For example, suppose a young couple bought a new home in 1982 when sales were slow. It was typical for a builder to ^“buy down^“ the interest rates to 9% or so. On a $65,000 loan, this left payments of about $523.00. The buy-down period might have been for 3 years at which point the 14% rate would have been expected to be picked up by the buyer. In 1985, without any increase in inflation or in home mortgage rates, this young family^'s payments would have risen $247. to $770.

But that's just the tip of the ice berg. During that same period, as the recovery picked up, tax rates also picked up. Both property taxes and income taxes. In some areas, new construction was taxed as vacant land the first year. The second year's taxes would have been increased to reflect the value of the completed new house. On top of this, many state and local governments increased taxes to offset unemployment costs and loss of government revenues. This would have increased our young couple^'s payments even more. Now, on top of this, their loan will earn interest which has been indexed to some component of either inflation or interest rates. Millions of people will find it impossible to make their payments. It's already happening now!

Lenders won^'t be enjoying a free ride. Sandwiched between defaulting Latin American banana nations and defaulting long term mortgage loans, they^'ll be hard pressed to survive. About 10% of the 600 problem banks will go under in 1984. MANY MORE S&Ls WILL BITE THE DUST! They've never fully recovered from the 81-82 recession. They^'ve gotten involved in loans other than home loans in which they have only limited experience. They^'ve gotten a little greedy, making new buyers qualify for aggressively indexed interest rates as a result of their enforcing due-on-sale clauses. Get your money out now if you have it on deposit with a Savings & Loan. There^'s going to be a blood bath unless some sort of relief is offered home owners who can't afford to pay.

 

THIS MARKET IS FRAUGHT WITH OPPORTUNITY FOR DISTRESS BUYING.

For the better part of the Reagan years this letter has been counseling readers to get liquid and to stay liquid. Now's the time to use your liquidity to buy at discount in the housing market. But be cautious. Even at distress prices, some properties aren^'t a bargain. Remember, we^'re all in the food chain somewhere. There^'s always a bigger fish to gobble you up if you make mistakes. Here's what I mean:

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 it stand to reason that the former owners would have moved out and rented rather than to lose their homes? Beware of buying where EVERYONE's 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. Equity is a lot like sex appeal. You may be the only one around who believes you have any! No, rather, 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-canvassing in the neighborhoods, putting out flyers door-to-door, running ads, paying ^“bird dogs^“, contacting lenders all helps. Look for people to whom ^“creative finance^“ boiled down to placing 2nd and 3rd loans against properties. These virtually guarantee feasible properties in foreclosure situations. Let^'s look at an example: Suppose the buyer assumed an 8% loan at $40,000 with payments of about $375/mo. He pulled out some cash – $15,000 – via an institutional loan and paid that to the seller in cash. It was at 18% interest only for 3 years and balance due. Payments are $225/mo. Then the Seller carried back a zero interest rate loan for 5 years of $15,000 with balance due. The property rents for $500 per month. Total payments are $600. After taxes, things pretty well balance out. Nothing down and nothing a month. Just what we^'re 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 mortgagee 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 mortgagee continues to receive his now $440/mo payments. The 2nd mortgagee owns the property. He doesn^'t know how to manage it, so must pay the first lender out of his operating cash flows. His profit suffers, but his only alternative is to go into the management business and to rent out the property or to stop making payments and to be foreclosed by the first lender. If this is happening throughout the area, there will be little chance of selling the property except at distress prices.

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) and (g) above. (i) Or you can wait until the 2nd lender is in default on the 1st lien, and repeat the process.

 

DISTRESSED LENDERS OFFER OUTSTANDING OPPORTUNITIES IN FORECLOSURE.

Anytime I discuss foreclosure buying I may suffer a twinge of conscience at the thought of depriving someone of an investment or a home regardless of their imprudence or folly. But this never happens at the prospect of dealing with lenders who are only in trouble because they were too greedy and too eager to make ruinous loans to poorly qualified borrowers – and who subsequently used the courts to force these same people to lose their properties. At least, if I buy at foreclosure sales, I wasn^'t responsible for making the loans and filing suit for foreclosure. The lender did this.

One lender I know of has been too eager to foreclose. Now he^'s loaded down with hundreds of attractive properties – many millions of dollars sitting idly by, neither earning any yield or offering much prospect for sale. The lender^'s portfolio yield is way down. He^'s already moaning about his costs of money. He^'s going to go broke and he knows it. Enter the entrepreneur. He knows how to manage property and has a track record. He has cultivated a following of investors who respect his ability, and who will qualify for loans to buy the lender^'s inventory. Let^'s say the lender^'s foreclosed property appraises for $150,000. His original loan was for $135,000. He not only agrees to sell for $90,000 but agrees to fund 100% of the price and to add $15,000 per house to repair the ravages of neglect and abuse during the foreclosure period. He^'s going to lose $50,000 per house and he^'s willing to suffer this loss because the alternative is financial ruin.

This is an actual case. We^'ve seen similar situations in Houston this past year. The entrepreneur who can round up opportunities such as these and divide the profit with investors will be able to reap enormous profits. In the above situation, 60 houses would generate $900,000 in cash for repairs plus $2.1 MILLION in profits. Heck, even with 6 houses, 10% of that wouldn't be too shabby. And you can see the possibilities of forming an independent company to use to perform the needed repairs. Money tends to breed money! The individual entrepreneur in the preceding example has only been in the real estate market for a few years. He^'s spent his time cultivating the acquaintance of people to whom he could present this opportunity and from whom he could elicit a financial response. And the people he attracted as investors were prudent high salaried professionals who^'d been patiently awaiting this major opportunity, maintaining their liquidity against just this sort of situation.

The key here is that distress can spread rapidly throughout the real estate industry if just a few things happen. (1) Inflation caused by re-funding of social programs or foreign loan defaults through expansion of the monetary base could drive the indexed mortgage loans through the roof – or at least to their ^“caps^“. (2) New tax laws could deprive millions of tax-shelters of any benefits at all, causing a collapse in the values of overbuilt office buildings and apartment complexes and a resultant default on loans. (3) A credit crunch could prevent the billions of dollars of balloon notes from being paid, resulting in a domino-chain foreclosure debacle. All these scenarios can take place during the recovery. And the situation could be worsened by any depression.

It^'s just about the 11th hour to prepare for the complexities of the uncertain near term future after the election. Get liquid. Put your funds into T-Bills DIRECT WITH THE FEDERAL RESERVE AND NOT THROUGH YOUR LOCAL BANK. Start building alliances with those survivors in your community with deep pockets who might be ready to co-venture some of the profound opportunities that are most surely going to come your way. And divest yourself of marginal properties for CASH or very safe paper from solvent purchasers. Beware of dealing in ^“paper^“” that is secured by vulnerable properties or vulnerable payers! I^'ve had a couple of near misses when sellers have filed for protection under Bankruptcy laws, taking cash from distress sales into the bankruptcy action together with the properties they^'ve sold. Thus, the buyers who provided that cash lost it and the houses too.

 

THE KEY IS KNOWING WHAT TO DO AND WHEN TO DO IT. TIME IS RUNNING OUT IF YOU'RE NOT READY.

 

 

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