Peter Pays Paul

The LA Times is reporting that a Record number of California homeowners default on mortgages in 2nd quarter.

Year over year the actual number of homes being foreclosed on has increased 261%. The percent increase is dramatic. However the total number is only 63,061.

Based upon the U.S. Census Bureau Data California had 13,174,378 household units and 56.9% of those are owner-occupied. If these statistics are correct, there are 7,496,221 owner-occupied homes.

Though the increase is dramatic, the total number is still a small percentage of the total owner-occupied homes. This means that at most 0.84% of the owner-occupied homes are being foreclosed upon, or 8.4 out of 1,000.

However, my statistics do not breakout condos or home that were owned by speculators or investors. Many investors will stop making payments on their investment before they will stop making payments on their own home.

Likely, a lower percentage of owner-occupied homes are being foreclosed upon. A larger number are likely investor and speculator homes that were bought during the run-up in the real estate market.

Does the small increase from last quarter to this quarter signal that the damage is coming to an end? My crystal ball is broken. We will just have to batten down the hatches and ride out the storm.

This the third post in a series I am writing on finding distressed properties. Posts 1 & 2 can be found here.

Marketing

Marketing to owners of distressed property is the third method of finding distressed property.

Marketing Costs

For purposes of this post we will define marketing as the process of informing owners of distressed property, that you are interested in purchasing their property.

Almost all forms of marketing will have an out of pocket cost, before you see a return on the marketing investment. These costs may include printing, postage, design, or mass media expenses.

Marketing Budget

It is important to prepare a marketing budget prior to investment in any system. A budget will help you track marketing effectiveness and control spending.

Consistency is key to any marketing strategy. Most marketing takes time to show results. Dividing your marketing budget over months or weeks, will help to develop consistency and prevent you from “betting the ranch” in one marketing blast.

Market to Your Sphere

Each one of us has a sphere of influence that we touch on a regular basis. Our sphere includes friends, family, neighbors, clients, employees/employer, service providers, etc.

The easiest way of informing your sphere of influence that you are in the market for distressed property is through the use of business cards.

Business cards are an inexpensive way of informing others of who you are and what you want. By including a list of desired property characteristics on the back of the card, you remind the holder of what you are seeking.

Direct Mail

Direct mail consists of mailed advertisements to potential sellers. Direct mail is a proven marketing method, but has in general only a 2% response rate.

Printing and postage costs are both associated with direct mail. If first class postage is used, costs can be in excess of $0.50 per marketing piece. These costs add up very quickly and may limit the number of people you are able to reach.

Direct mail will have a greater efficiency if it can be targeted to individuals that have been pre-screened for relevant criteria. Criteria that may be helpful could include property owners, age of property, length of ownership, and building age. Title companies may be able to provide this information to you.

Signage

Bandit signs, fliers, and other types of signs can be used to garner the attention of would be sellers. This type of advertising is more likely to be utilized for residential properties than for commercial properties.

Fliers with your commercial property description could be distributed to local commercial brokers. This may be a way to inform the brokerage community of what you are searching for.

Classified Ads

The classified ads of your local newspaper may be a cost effective means of advertising your desire to buy distressed property.

Typically, those reading the classified section are in search of something specific. Classified users tend to be in the market.

A classified ad stressing that you buy real estate of all shapes and sizes may draw the attention of someone in need of selling or tired of dealing with tenants.

Mass Media

Mass media includes radio, television, and billboards. Though these methods have a broad reach, not everyone that sees or hears your advertisement will be a suitable customer. Thus, in general they are not a cost-effective means of advertising for distressed properties.

Conclusion

While there are many different marketing channels, you must find the method that works best for your property characteristics and fits within your budget. Once a channel begins to produce results, you should re-invest in that channel in order to produce even greater results.

Marketing takes time and requires consistency. Invest in marketing over the long haul in order to reap the rewards.

This is part two in the series on how to find distressed property.

Use a Professional

The second method of finding distressed property is to utilize the services of a professional real estate agent or agents.

Sidebar:
I have chosen not to use the term REALTOR®, because a professional real estate broker/agent may choose whether to pay for the use of the term REALTOR® or not. Many qualified broker/agents do not see the value in paying for the licensing agreement.
End sidebar.

A License, Does Not a Professional Make

Having a license to do something does not make you a professional.

I have a drivers license. However, that does not mean that I can get out on the track with professionals like Dale Earnhardt, Jr. or Kyle Busch of NASCAR.

During the extreme run up in home values many individuals saw an opportunity and pursued a real estate license. However, many of these same individuals only used the license for friends and family.

The newly minted licensees never committed enough time or education to support themselves fully through the marketing and sale of real estate.

Sidebar:
This scenario is more true in the residential market than the commercial market. However, it could be true of a residential agent that is transitioning to commercial real estate.
End sidebar.

Mark of a Professional

The term “professional” should only be applied to those agents that solely support their lifestyle from the marketing and sale of real estate.

Sidebar:
The professional’s lifestyle should not involve a rusted ‘85 Yugo or living in mom’s basement.
End sidebar.

A Professional’s Value

Market Knowledge

A skilled real estate professional is intimately acquainted with the target investment market. A professional should know what areas to avoid and which areas are ripe for investment.

Trained Eyes

Professional real estate agents have eyes trained to evaluate real estate assets. A professional agent will evaluate more property in a month than a layperson might in a year or more.

Agents and brokers, when trained to recognize what characteristics you are looking for, can provide quality leads. They are rewarded/paid only when they find a property you like and assist you in the purchase of that property.

Pocket Listings

Though “pocket listings” are frowned upon they can provide opportunity.

A pocket listing is a property that the broker has a signed contract to sell yet has not released to the general masses (MLS), but kept in their “pocket”.

Many brokers and agents have pocket listings that they release to a selected group of repeat buyers or investors that the broker knows will be interested in the property. Being on the short list of investors increases the likelihood that you will be able to find a distressed property to buy right.

The Network

Most professional brokers and agents have a network of individuals (escrow, mortgage, attorneys, finance professionals, other brokers, etc.) that can be put to work for the investor. Now the number of eyes and ears alert for an investor’s property type has just exponentially increased.

Downsides

The professional real estate brokers and agents that an investor wants to work with are busy people. An investor needs to prove to the agent that they are serious about investing and that the agent will be rewarded for bringing properties to the investor.

Brokers and agents need to be trained to find what types of properties meet your criteria. This can take a while and may also need some refining as they send you deals. Investors should follow up with brokers that send you deals. Let them know why a property is not right for your investment strategy.

Conclusion

While training a broker or agent what to look for may take time, it is definitely worth it in the end. Their trained eyes, experience, and network are well worth their compensation.

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.

As a commercial hard money lender I have to be good listener. The reason is that everyone has a story to tell about their need for money. Some stories are better than others.

What should you include in your story?

Introduction

A good literary story introduces you to the characters, the setting, and any history relevant to understand the narrative going forward. A good lending story will include some of the same attributes. Most of this information should be included in a easy to read executive summary.

• Who are the main characters? This includes the loan sponsors, and any borrowing entity that may be involved.
• What is the setting? The setting would include the property location and property type. Details are important in this section and should include: unit mix, income details, and tenant information. This would also include the loan amount and the current property value.
• What is the property’s history? This should include the property’s acquisition date, acquisition cost, repairs or construction, current liens, and any other items that set the stage going forward.

Body

The “body” of a commercial loan story should contain all the details that support the loan amount and property value. Not all hard money lenders will lend on the “appraised” value alone. Unfortunately, an appraisal is an opinion of value and not necessarily the price that the market will bear. Hard money lenders desire to protect their investment capital and want to be assured that the property can sell for more than their loan amount.

Property information and borrower information is very important in this section. The lender may ask for tax returns, income statements, balance sheets, rent rolls, leases, appraisals, operating statements, and other relevant facts to justify the loan. It is best to have these times beforehand from the borrower and be ready to provide them to the lender when they ask for it. Hard money lenders require different documents depending on their underwriting criteria.

Conclusion

When I review a deal, I want to have all the facts that are relevant to the deal. Market surveys, comps, and demographics are helpful to understand the project. The conclusion of your story should be the reason that they are searching for hard money. Is time a problem? Is the credit poor? Do they have unseasoned funds? Are there vacancy issues that will be corrected? Are they short on capital?

How to tell your story?

First, if you are a commercial broker don’t pass on a loan file that you received from someone else without reviewing it. This is the epitome of laziness and a lack of professionalism. It is frustrating to call a broker with questions, after reviewing a loan file, only to find out that the broker has no idea what the deal is because they just glanced at the package and passed it along.

Second, organize the data. Sorting through pages of data is frustrating and may mean that the borrower is trying to hide something. It is like an episode of “Law & Order” where the defendant sends over 15 boxes of documents in order to hide the document containing incriminating evidence.

Third, be as brief as possible. You may be very eloquent, but time is money. Also, a pig in a dress is still a pig. An ugly property with pretty words is still an ugly property. The executive summary should be a summary, not a life history.

Fundamentals are Still Fundamental

What do I mean? The value of a property is largely going to be based on income and cap rate. A lender is going to base their loan on the value of the property. The value may be today’s value or it may be a future value, but it will be based on a reasonable expectation of the property’s value. Property doesn’t generally appreciate at 400% or even 100% per year so take this into mind when you “estimate” your property’s value.

Commercial real estate is a great addition to the savvy real estate investor’s portfolio. One of my previous employers said that he would only invest in commercial real estate and not in residential. He reasoned that commercial real estate that housed a business would always be better maintained than a leased residential unit. “A business must keep up its workplace or their customer’s will stop patronizing the business.”

Commercial real estate is financed more stringently than residential real estate. Often more capital is required to invest in a commercial property than in a residential property. Most banks and institutions require a minimum of 20% of the purchase price as a down payment. This can be a hefty price with the value of many commercial properties.

Commercial income producing real estate is also valued differently. Residential real estate is valued by the price the market will bear. A home is much more of a commodity than it is unique (though this contradicts much teaching in real estate textbooks). Not many people are willing to pay $50,000 more for a house, if the exact same house with the same features is available next door for less. Hence, the value of a home is much more a product of the supply of like homes, and the demand for those same homes.

Unlike homes, commercial real estate (CRE) is often valued by the income it produces. CRE, for the most part, is viewed as an investment. Owners want a return on the money that they invest in the project. The value of CRE is derived from the rental income from tenants.

Often a capitalization rate (cap rate) is used to value the property. The cap rate is a measure of the return on the purchase price of the asset. Capitalization rates vary from geographic area to geographic area and are directly related to the amount of perceived risk. Areas with high vacancies or other problems command a higher capitalization rate. More stabilized rentals with fewer problems often are capitalized at a lower rate. In many parts of the country a cap rate from 6-8% is used. Currently, in San Francisco a cap rate in the 4-5% range is common, due to high home prices and a high demand for rental units.

The cap rate is calculated by dividing the properties net income (not gross see note below) by the value or cost of the property. So, a property that costs $125,000 and generates $10,000 in net income would have a cap rate of 8%.

By reversing the formula above, knowing the appropriate cap rate, you can determine the value of an income producing property based on the net income the property produces. This is done by dividing the current net income by the cap rate. For instance a property that generates $10,000 in net income divided by a cap rate of 8% produces a value of $125,000.

By changing the formula again we can determine the assumed net income for a property based on the asking price.

Other factors like property condition, location, and tenant characteristics may increase or decrease the cap rate. All these factors should be taken into consideration when determining the appropriate cap rate to use for a given geographic area. I recommend using a knowledgeable, experienced, and local commercial broker to help you determine appropriate cap rates and property values.

Commercial income property is a solid investment for the long term. Commercial real estate should generate consistent income over the life of the asset. Many savvy investors use commercial income properties to generate income during their retirement years. Investment in this type of property requires due diligence and capital. However, for the savvy investor with the right investment team it can be a powerful wealth builder.

Note: It is very important to base these calculations on the net income of the property and not the gross income. It is also important to verify the net income figures through the use of a rent roll, copies of the leases, and the previous two years’ expenses. Unfortunately, unscrupulous persons have been known to increase actual rental income and to decrease actual expenses to increase the net income in order to command a higher property value.

This current market is a great market to buy investment property or a first-time home.

Why? In many markets, including the East Bay Area of California, the market has returned to a more normal status. The insanity of the seller’s market during 2004 and 2005 has shifted to a buyer’s market. In some areas of the country there has been a price correction for homes.

The buyer’s market is a simple product of supply and demand. Currently, there are more homes on the market than buyers. This creates a surplus of homes. In Concord, California there was roughly a 12 month supply of single-family homes available, according to my calculations.

Two things can resolve the current surplus of homes. 1) More home buyers enter the real estate market. This is the more unlikely solution. Mortgage lenders have tightened their qualifications for loans. Eligible home buyers must have better credit scores and a stable financial situation to qualify for loans. Also, interest rates have increased in the past few weeks, decreasing the amount home buyers qualify to purchase. The combination of these two factors make this solution less likely than the other.

2) Home owners decrease their home prices. Sellers will need to make their home more attractive to the available home buyers in the market. One of the ways will be a reduction in listing price. This can be evidenced through buyer incentives (credits toward closing costs) or by lowering the asking price. Home sellers are forced to compete on price to entice buyers into the home.

Home sellers cannot immediately increase the number of home buyers as a result of their actions. However, a home owner can lower the price of their home to increase the home’s attractiveness to the available buyers. If you can buy more house for less money, why wouldn’t you?

This makes it a great market to buy a home for investment or personal use. I say that with a caveat: The holding period should be greater than two (2) years. I make this caveat because I think that we are near the bottom of the current real estate market correction. I am not sure that we have reached the absolute bottom yet. A two year holding period allows for the real estate market to reach bottom and begin to rise again.

My advice to buyers and investors: Call your agent today and get in the market! This in my opinion is a great time to buy for the long haul.

My advice to sellers: Do not expect to set the terms of the deal. You are no longer in the driver’s seat of the real estate market and need to make concessions to home buyers.

Using a Little Stick to Move a Big Rock.

This is the description of leverage most common in Physics classes. Then you have the diagram: a person using a stick with a little rock underneath it to move a big rock on the other end.

The physical principle of leverage is very simple. A smaller weight over a long distance, when applied to the long end of a lever, can move a larger weight a small distance. Hence, a small man can move a rock larger than himself through the use of a lever.

The Principle of Financial Leverage

Financial leverage is similar to the physical concept. But instead of using a smaller weight to move a larger weight, a smaller equity investment is used, in combination with debt, to purchase a much larger investment.

Leverage has the effect of multiplying the return on investment, whether positive or negative. With a smaller initial equity (cash) investment control is gained over a larger investment and the returns on that larger investment are reaped.

Let’s look at an example. The first model is the purchase of a $100,000 investment with $20,000 of equity and by borrowing $80,000. The second model is the purchase of a $100,000 with $10,000 of equity and by borrowing $90,000. You will see two scenarios, one with 10% gain, the second with a 20% gain on the investment.

As you can see from the table, a return of 10% generates a 50% return on equity with a 20% investment. A return of 10% generates a 100% return on equity with a 10% investment. Debt always comes at the cost of interest. When the interest cost is less than the total return, a greater return on equity should be realized through the use of leverage over not having used leverage.

Leverage has a similar multiplication effect when an investment has a negative return. This means that you can lose more than your initial investment if the negative return is significant. Hence, leverage should be used cautiously and prudently.

This can mean reap huge rewards for a real estate investor. Imagine an investor with $100,000 of capital for investment in addition to their Sominex Account. With this capital as a 20% down payment they can purchase roughly $500,000 of investment property. Assume the property appreciates at a (moderate) rate of 8% per year for three years. At the end of the three years the equity in the property has increased over $120,000, a return on equity of 120%. When was the last time your IRA performed so well?

Now with close to $220,000 (initial $100,000 + $120,000) in equity the investor can gain control of $1,000,000 in investment property. If the $1,000,000 in investment property appreciates at the same 8% rate, the equity will grow by $80,000 per year.

Hopefully, you can see that real estate leverage can significantly increase return on equity. It needs to be used wisely and in accordance with a well developed plan. Using debt foolishly is called speculation and is the fast-track to foreclosure and ruin.

The carnival of real estate investing is up over at Financial Freedom Through Real Estate. These carnivals are a great place to learn more from other authors on the web.