Peter Pays Paul

CBS’s 60 Minutes investigated the CDS market that Wall Street created.

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.

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.

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

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.