Peter Pays Paul

This parody of the current economic times is quite entertaining!

The “bailout” or “rescue” is the hot topic on most lips these days. In fact it is hard to escape on any of the media outlets.

Below are a few articles for you to ponder on this issue.

Is Purchasing $700 billion of Toxic Assets the Best Way to Recapitalize the Financial System?

Nouriel Roubini argues against the proposed plan. He summarizes, “Thus, the Treasury plan is a disgrace: a bailout of reckless bankers, lenders and investors that provides little direct debt relief to borrowers and financially stressed households and that will come at a very high cost to the US taxpayer.”

You Can’t Rescue the Financial System If You Can’t Read a Balance Sheet

John Hussman details the reasons that the current plan only provides a benefit if the Treasury pays above market value for the value of the securities, a very reassuring thought (sic). (HT:Naked Capitalism)

Bankruptcy, not bailout, is the right answer

Jeffrey Miron from Harvard argues that the government should do nothing and let the companies that invested in the bad investments go bankrupt. He states, “Bankruptcy punishes those who took excessive risks while preserving those aspects of a businesses that remain profitable.” He argues that bad government policy should not be fixed with more government. He also reasons that credit markets are frozen is likely caused by the current owners of bad securities being unwilling to sell them at the offered price, because they are waiting for Uncle Sam to come in and pay a higher price.

Real estate investors that are seeking to grow their invested capital commonly use 1031 Tax-Deferred Exchanges.

These exchanges allow the borrower to apply more of the proceeds from the sale of an existing investment property to the purchase of a new investment property.

1031 Exchanges Defined

This is an explanation of an 1031 exchange according to the IRS website:

Generally, if you exchange business or investment property solely for business or investment property of a like-kind, no gain or loss is recognized under Internal Revenue Code Section 1031.

My explanation in a nutshell: a real estate investor can sell a piece of investment property, defer the capital gains tax until a later date, and roll the entire gain into the purchase of a new piece of investment real estate. The taxes are deferred (postponed) until the investment property is sold the final time.

Benefits of 1031 Exchanges

Deferring the taxes due on capital gains (appreciation) can reap huge rewards over time. Deferring payment of capital gain tax allows the savvy investor to apply more capital towards the purchase.

Leverage should allow the investor to generate a higher return through appreciation and/or cash flow.

1031 Exchange Hurdles

Now of course the government doesn’t make it an easy process and sets limits and restrictions on how a 1031 Exchange must be executed.

One of the main restrictions is the timing on completion of a 1031 Exchange. The exchange must be completed within 180 days of the transfer of the exchanged property. This deadline can put pressure on all involved to complete the deal within the 180 day period.

The costs of missing this deadline can be large. The borrower will be forced to pay capital gains tax on any gain as well as any penalties that might be incurred if the contract date is not met.

Most exchangers will typically qualify for standard financing. However, on occasion an institutional lender will be unable to provide financing within the mandated 180 days.

Using a Hard Money Loan to Execute a 1031 Exchange

If the primary lender is unable to close on time, what is the investor to do?

One of the benefits of using hard money is the speed that hard money lenders provide. A hard money lender that lends their own funds and is well operated can provide commercial financing within 14 days of receiving a complete package.

Another benefit is that most lenders offer loans on a short term basis. The hard money loan can help an investor close the transaction while a more permanent loan is arranged.

While the fees associated with hard money may be higher than a traditional source, the benefits of completing the transaction within the mandated time may outweigh the costs.

1031 Example

The following example should help demonstrate my point. Below are the assumptions we will use for our example.

Below are the costs that would be associated with a failure to execute the contract on time. I have only included what I would cite as the most basic and immediate costs. (There would be the potential loss of future returns as a result of cash flow and/or appreciation.)

The current capital gains rate is 15% but is set to increase in 2010. By including the deposit I am assuming that the deposit became non-refundable at some point.

Below I have computed the after tax costs of a hard money loan. The pricing below is on the high side for a short-term, conservative LTV loan.

Conclusion

As you can see from the example the after-tax cost of hard money may be less than the cost of not executing the 1031 exchange on time.

Hard money is not the best option for all scenarios. When a deal is on the line and speed is needed, hard money is a good alternative to institutional financing.

For more information head on over to Jeff Brown’s blog to find out more about 1031 exchanges and when to execute them.

I returned Saturday from a trip to Central Asia. The trip was not work related, but I wouldn’t call it a vacation either. It was very pleasureful and rewarding, but it involved a lot of effort.

One of the interesting notes that I came back with is that the country I visited experienced a real estate bubble and liquidity crisis along with the U.S. market.

Real Estate Bubble

According to my contact in country, this is the story. Banks in the West and the U.S. would lend money to banks in the East. In turn these Eastern Banks would lend to the locals to purchase real estate, start a business, or buy a car.

As the cost of money (interest) grew less expensive, more individuals and companies were able to receive loans from Eastern Banks. As the number of qualified buyers grew so did real estate prices. They dramatically increased, almost doubling in a few years.

When the Western Banks suffered a liquidity crisis, the faucet was turned off for the Eastern Banks. The supply of money was gone. Fewer buyers could afford to purchase real estate causing the rising values to fall.

Speculation is not isolated to the United States. Prices have fallen in the past year. My contact in country told me that his organization had benefited from the sale of one asset during the peak of the market. After the bubble burst, they were able to buy a more affordable piece of property and begin the construction of a new facility to meet their needs.

The Cost of Money

Another new friend worked for one of the Eastern Banks. She was in charge of arranging loans from Western Banks to her Eastern Bank. The last transaction she arranged was $500 Million.

If you think interest rates are bad here, be glad you do not live there.

My friend told me that her Eastern Bank borrowed money in the 8-10% range from Western Banks. I assumed that the bank’s margin would be 1-3% to Eastern Borrowers. Her answer was “No, more like 6% to 9%. That is not including the fees. They have fees for everything.”

On the low end the Eastern Banks were going to charge 14% and up to almost 20% before fees. All this in a country where the per capita GDP is about $11,000.

Oh, so many things to be thankful for.

Head over to Yahoo! Finance to take a look at an interesting article by a former subprime lender.

Richard Bitner was an owner in a mortgage shop that made subprime loans and sold them to investors. He is writing a book about his experience from “behind the curtain”.

In the article he details 3 loans that cost his company thousands of dollars.

The article also describes how investors’ desire for mortgage related securities drove the market to make loans to borrowers with riskier and riskier profiles to satisfy the demand.

Confessions-of-a-Subprime-Lender-3-Bad-Loans: Personal Finance News from Yahoo Finance

Part of my job is to take incoming cold calls. We advertise in a commercial lending industry magazine that generates a good deal of call traffic.

On a regular basis I get requests for “construction” loans. After asking some questions to determine the nature of the loan, I usually find out that the broker/borrower is actually searching for what I would call a “development” loan.

What’s the Difference, Who Cares?

Why does it matter if you call it a construction loan rather than a development loan?

First, it reflects on the broker/borrower. If a lender has to educate the person requesting money, it sets a bad tone for the deal.

Second, some lenders offer construction financing but don’t offer development financing. Asking the right question allows you to get a correct response and save you time.

Finally, loan to value and equity requirements may vary depending on whether the loan is for development or for construction; I know ours do. This information helps the lender determine if the loan is within their parameters.

Construction vs. Development

Construction by definition has the connotation of putting things together. In my mind, moving dirt for roads or infrastructure does not meet this definition (no offense to those in the fields of civil construction).

The definition of the word develop includes the idea of being made usable. This is perfectly suited for the installation of roads, pads, and infrastructure; as the land has now been made usable for a building.

Defining Loans

Consequently, I would recommend that if you are asking lenders for a construction loan, a building should be in place when construction is complete.

Loans to improve land should be titled as development loans.

There are ways, even in a down market, to make money with distressed properties. The key to succeeding with distressed properties is to focus on “buying right“. Warren Buffett is quoted as saying, “Price is what you pay. Value is what you get.” Buying right is ensuring that that price you pay is congruent with the value you are receiving.

In any market, good or bad, there are those properties that are under-performing or distressed. Usually through physical repairs or through prudent management practices a poor performing property can increase in value.

The key to successfully investing in distressed properties is finding, controlling, and repositioning these assets. We will not deal here with controlling and repositioning distressed properties. The purpose of this article is to help you find them.

Distressed Does Not Equal Foreclosed

Foreclosures are the hot word in the media these days. However, distressed property does not mean that it has to be in foreclosure. Some websites that sell you information on foreclosed homes would like to have you think otherwise.

Divorce, death, illness, or absence can all lead to a properties disrepair and decrease in “apparent” value.

Pay Attention – Method #1

Have you ever driven the same route home and noticed a store for “the first time” that may had always been there? This seems to happen with new cars also. Once you buy a car you suddenly notice that everyone has the same model.

Your brain now aware of the specific model of car, can identify the characteristics that distinguish your model from all the others. The same is true for distressed properties. Once your brain is trained to look for them they will stand out in your mind.

Train your mind to recognize the signs of a distressed property. These signs will vary depending on if you are investing in multi-family, single-family, office, retail, or industrial properties. Each property type will have different tells that can tip the savvy investor off that the property is distressed and may be a good investment.

The Alphabet Game

On long car trips my parents taught us to play “The Alphabet Game”. The game is simple enough: each person tries to get through the alphabet sequentially by spotting letters on passing billboards or vehicles. The first person to spot a “Z” wins.

As kids “The Alphabet Game” taught us to be attentive to our surroundings and to notice what it was we were driving past. The same can be done for finding distressed properties.

It is very likely that on a regular basis you are driving past property that is in some sort of distress. It could be a house with absentee owners or an office building with a high vacancy rate. Unless you pay attention you would probably drive right past it and never know that it could be an opportunity.

Listen Up!

There are opportunities in the daily conversations around us as well. Listening for specific reasons that a property can become distressed (divorce, death, taxes, marriage, complaints about tenants or landlords, etc.) might tip you off to an investment opportunity. I would never advocate taking advantage of another’s misfortune. If you can genuinely help the current owner to a win-win solution, you are not taking advantage. Avoid becoming a carpetbagger.

Conclusion

Remember that distressed properties are not always in foreclosure. Most of the time distressed properties are easily noticeable if you know what to look for. Pay attention to your surroundings and to the events that are happening in people’s lives to locate distressed property.

Buying right is disciplined work.

The work is not so difficult that only an elite few can do it.

However, it does require a meticulous and detailed approach that most people lack the discipline to perform.

At a recent conference I attended, this bit of wisdom slipped out:

“You cannot tell if a property is a good deal by looking at the price the last owner paid for it and the discount you are receiving. If the last owner overpaid by 20%, are you really getting a good value with a 20% discount from the last price?”

Buying with the End in Mind

In order to be successful at buying real estate for the right price, an investor needs to have a defined strategy – What is the purpose of the property? Cash flow? Appreciation? Rehab? Conversion?

Knowing the end goal allows you to work from that goal back to the present and to determine a price point at which you can reasonably achieve your goal.

In order for a property to cash flow, the rental rates must be higher than all of the combined expenses including the mortgage, taxes, maintenance, vacancy factor, and reserves.

For rehab properties the Acceptable Purchase Price = Sales Price – [Sales Costs (Marketing + Closing Costs) + Rehab Costs (Construction + Carrying Costs) + Desired Profit].

Details

The devil is in the details they say.

Details are the reason that most people fail to make wise buying decisions. Investors often fail to have the patience and discipline to crunch the numbers.

Many new real estate investors are like my wife at the department store. “Honey, it was 30% off! Do you know how much money I saved?!” No, but I do know how much you spent.

Many of the factors that go into determining the right purchase price are learned only with time and study. Estimating repair costs, knowing market rents, market growth rates, and projecting expenses are not innate to human knowledge.

Fortunately, they can be learned or ascertained over time. A wise investor will invest first in their own education.

The factors to determine a correct price can also be “borrowed” from a real estate agent with experience buying investment properties and knowledgeable in the target market. Only choose an agent that is going to listen to your goals, evaluate your present financial situation, and formulate a plan that fits your goals and financial abilities. Investors are not “one size fits all” and no one type of investment property is appropriate for all investors.

Understanding what your money is doing and how it is working for you is vitally important.

Buying right in real estate is not dependent so much on the discount from sales price; it’s dependent upon knowing what price will allow the investor to accomplish their investment goal.

My wife and I like to go on “dates” to Barnes & Noble Booksellers. Most of the time we do not buy anything. We will just spend hours finding and perusing books that we find interesting.

The last time we were there I picked up Mega-Producer Results in Commercial Real Estate: A Blueprint for Success. I only leafed through the book on my way to other books, but I noticed the author had a section on specialization, a topic I had been thinking about for a while.

Working with an Expert

The author recommended that new agents focus on becoming a specialist in a single type of property. The benefit of this approach is that you become an expert. Now you are adding value to clients because you have studied and know more about the subject than they do. They call you when they want an answer to a problem.

The author detailed an experience he had as a new commercial sales agent after moving to a new city. He was given a camera and the task of creating a “comp book” of all the shopping centers in the city. It took him a while to cover the entire area, but he was able to know the area and to know the product. He also began documenting which properties had vacancies, were sold, were in need of repair, and the property’s sales price.

The author’s knowledge allowed him to interact knowledgeably with potential clients. He could tell them if their building needed repair or the sales price of the property down the road. These interactions established him as an expert, and who doesn’t want to work with the expert?

Financing Specialists

So how does this all apply to the financing side of the equation? Why not become an apartment financing specialist or “The Shopping Center Loan Gal”? Choose not to be “a mile wide and an inch deep”. Choose to have a narrower focus, but a deeper knowledge of that focus.

A narrow focus targets your marketing. You no longer advertise to apartment brokers only to retail brokers. It also refines the list of lenders that you need to know. If XYZ Bank doesn’t do retail loans or doesn’t offer competitive rates, you don’t need to deal with them on a consistent basis. I know an experienced broker that had a handful of clients and only dealt with five lenders but closed over $100 million in loans annually.

Benefits of Specialization

1. Deeper knowledge of available financing options.
2. More efficiency underwriting loans. Well practiced tasks will become easier and easier.
   
3. Higher closing rate due to understanding lenders and what they prefer.
4. Greater likelihood of referrals and repeat customers because of your knowledge and skill.

Disadvantages of Specialization

1. The possibility of greater startup time while gaining market knowledge. It will take time to become an expert.
2. A smaller “pool” of deals to draw from. You must become a bigger fish to survive.
3. If your area of specialty slows, transitioning to other property types may be difficult.

Differentiation by Specialization

Being a specialist allows you the advantage of differentiating yourself from the competition. You will stand out like a shiny penny when you are an expert. Truthfully being able to say, “I have the perfect lender for that” will build confidence with clients and put you on the way to wealth.

For further reading check out: Riches in Niches: How to Make It Big in a Small Market

What is a Daisy Chain?

I field phone calls from commercial loan brokers all day long discussing the different loan scenarios that come across their desks. Our company advertises in the Scotsman Guide and this generates some “cold” incoming calls.

Frequently, we will get a phone call from a Broker A that received a loan file from Broker B. Broker B received the file from Broker C who received it from Broker D who knows the borrower. This is what we call a broker “daisy chain”.

Merriam-Webster defines a “daisy chain” as “1) a string of daisies with stems linked to form a chain, 2) an interlinked series”. One broker linked to another broker linked to the next broker, etc.

Problems with Daisy Chains

Human nature dictates that every broker involved in the transaction feels entitled to a piece of the pie. Each will often demand their own “fee” for services rendered. Often this is a deal breaker. If there are four brokers in the deal each charging a 1% fee the borrower is now paying a fee of 4% just to brokers! As Brian Brady writes , “what value does the agent bring to a transaction” to demand a fee?

If the borrower balks at the fee, Broker A is likely to say to Broker D, “I know the lender, you know the borrower, if we cut out B & C the fee is only two points and the borrower gets his loan closed.” Now Broker D is in an ethical dilemma, because he plays golf with Broker C on Wednesdays. Does he get the loan closed and burn Broker C to earn the commission?

Let’s imagine that this is a perfect world and all of the brokers in the deal lower their fee to an amount acceptable to the borrower. However, they are unwilling to give up their contact in the chain for fear of a future “circumvention”. So every piece of information needs to be passed from the borrower to Broker D to Broker C to Broker B to Broker A to the lender. (Did you ever play the game Telephone as a kid?)

How to Avoid Daisy Chains

Ask if the hard money lender lends their funds. Or you may ask if the hard money lender brokers their deals. Both of these questions should give you a better insight into the lender’s business model and how they make loans. If a “lender” brokers all of their deals, you may get caught in a daisy chain. Ask enough questions to get a straight answer and to understand the lender.

Remedies for a Daisy Chain

The smart broker that finds herself in a daisy chain situation will take control of the situation and work as the main point of contact for both the lender and the borrower. For example the chain of brokers lowers their fee to 2% of the loan amount. Broker D volunteers to coordinate between the lender and the borrower for a larger share of the commission, say 1%, allowing the other three lenders to split the remaining 1% without having to do any additional work.

Cutting out a broker from a deal, because they do not have a “signed agreement”, is a bad idea. This is a quick way to ruin a reputation and to never receive a referral again.

Summary

Daisy chains should be avoided at all costs. However, if you find yourself in the midst of this situation, take control and work to bring the deal to completion. This is an opportunity to gain a reputation as a broker that gets things done in the eyes of the borrower, other brokers, and the lender.