Real Estate Investing – Part III
A Bit of Valuable Theory First: Vince Lombardi Would Approve!!
Cause and Effect Relationships
We are familiar with “cause and effect” relationships. A particular “cause” or action will result in a predictable “effect”, reaction or response.
- “Laws of Physics” tell us that if you throw a tennis ball at a wall, you can accurately predict the direction that it will bounce off the wall.
That is an example of a “cause and effect” relationship within earth’s gravitational fields.
Further, if you change the “angle of incidence” (the angle at which a thrown ball hits the wall) then, you can accurately predict the direction that the ball will take as it bounces off of the wall.
The angle of incidence equals the angle of reflection, and predictability exists.
- “Laws of Human Response” tell us that if I use hurtful words or actions toward you, then I can anticipate that I will probably receive a predictable response in retribution from you.
If I don’t wish to receive that type of negative response, then I should be careful not to use hurtful words and actions toward you. We call that human nature.
While Laws of Human Response may be less predictable than the Laws of Physics (people can develop good acting skills), a good real estate negotiator learns to control his or her emotions in order to guide the negotiations to a desired result.
- “Laws of Financial Markets” tell us about the “cause and effect relationships” between “Supply and Demand”.
If demand for a scare commodity increases, but the supply or availability of that commodity decreases, you can anticipate an increase in it market price.
Qualifying Demand Factors:
1.Demand is influenced by purchasing capacity. When dealing with “demand”, only those with purchasing capacity should be considered. Point: If I would love to own one, but can not afford to buy one, my vote does not count as part of “effective demand”.
2.Demand is influenced by availability of financing. If I could afford to buy one with a loan with an interest rate at 5%, but interest rates just increased to 6%, then my “desire to own” remains strong, but only at a lower price that would allow me to finance its purchase within my capacity to service debt. Restated: My “demand” no longer counts at the previous price.
3.Demand for real estate is influenced by the attractiveness of the stock and bond markets. A large part of demand for real estate that caused the “Real Estate Boom of 2004 through 2007” was due to the wholesale rejection of the stock market and the bond market.
Point: Many people lost 40% or more of their retirement account that was invested in the stock market. Many flocked to real estate for fear of continued losses in those other markets. A “feeding frenzy” pushed prices up rapidly. Too many dollars were blindly chasing too few attractive properties.
Qualifying Supply Factors:
1. Supply Responds Slowly. It takes a while for supply for real estate to respond to an increase in demand. You can’t just leave the printing press going over the weekend at the US Mint to create more money. That is an option that is only available to the federal government.
Point One: Observation: To create a new apartment complex, it takes a year or so to acquire the right property, get plans approved as a building permit, build the complex, then rent it out until it’s full. It does not happen over night. This can cause a substantial increase in market price for an existing good looking apartment complex.
Point Two: My prediction: When the market finally stabilizes for apartment complexes, we will see a horrendous increase in “cost” of generating that new complex. Systems development charges, cost of building materials, and financing costs will boost the “finished price” of that property.
Suggestion: Consider buying existing “pre-owned” apartment complexes right now. You will look like a hero later!
2.Political Considerations Influence Financing. The federal government has the capacity to regulate interest rates. The easier it is to finance the acquisition of an income property, the more appeal it will have.
Question: Why isn’t this a “supply-side” factor?
Answer: It is. The easier it becomes to buy a property, the more available property becomes to buy.
However, it is also a demand-side issue in that it is now possible to obtain a new mortgage with ten year fixed interest rate.
Observation: Ten year fixed rate financing allows the investor to neutralize the “cost of capital” issue during a recession.
Suggestion: Take advantage of available new financing.
3.Tax Law Changes Influence Appeal. Recently the federal government provided real estate investors with the opportunity to increase their tax shelter from real estate. Cost Segregation depreciation allows such an opportunity.
Understanding Changes in the Real Estate Financial Markets
These “Laws” or financial cause and effect relationships have recently become substantially altered, and thus have become far less predictable.
- Change One: Artificial Supply-Side Pricing. Real estate prices are being adversely impacted by a large number of “forced sales” caused by defaulting borrowers being forced to sell under pressure to sell, and foreclosure sales by lenders in need of a quick sale.
- Situation: A borrower is unable to make the mortgage payment, and has attempted to sell the property.
- He discovers that it will not sell for enough to pay off the existing loan. He then notifies the lender of the situation.
- The lender must then decide which course of action to take.
- If the borrower has not been declared to be in default, the lender frequently ignores the borrower’s plea for relief.
- If the borrower has been declared to be in default, then the lender will either:1. agree to accept less than the full loan balance in satisfying the loan (a “short sale”); or,2. take steps to foreclose on the property, then resell it quickly to recoup the amount of the loan.
- Result: Discounted sale prices resulting from “short sales” and “foreclosure sales” impact all property values and force prices down. You will have difficulty attracting a buyer who would pay more for yours than they could pay to acquire a very similar property offered through a short sale or foreclosure priced property. Even if you are successful in seemingly avoiding the impact of “forced sale” discounts, the appraiser who the buyer’s lender will use to value the property for loan purposes will include those low priced forced sale. The buyer will not be allowed to borrow as much, and your sale may be in jeopardy of closing.
- Observation: Until the lenders sell off all of their REO and the number of short sales is substantially reduced, the value of real estate will continue to be adversely impacted.
“Real Estate Foreclosures 101”
What is a “Short Sale”? A “short sale” occurs when the lender agrees to accept less than the full loan balance as repayment of the existing debt.
Why Would The Lender Agree To Accept Less? Once a borrower defaults on a loan, the lender must form a course of action that would result in the least loss to the lender.
Would the short sale be less costly than a foreclosure resale of the property on the open market? If so, agree to the short sale and be done with it.
Observation Concerning Short Sales: As a buyer offering on what will be a “short sale”, there is never a quick decision to allow the deal by the lender.
The lender’s decision making process causes the potential transaction to travel through several departments of the lending entity before a decision to accept the short sale is reached.
It has been known to take months for the lender to finally agree to a short sale. By that time, the buyer lost interest in the property, and has walked away by the time that the lender approves the short sale.
Lenders are slow to agree to lose money, even if money is being lost with each passing day.
What Happens to the Lender When the Lender Forecloses? The lender’s financial statement will be immediately and substantially altered. The previously performing loan (an asset held as a “Loan Receivable”) is converted to a less liquid asset known as “Real Estate Owned” or “REO”.
Lender’s Financial Consequence of the Foreclosure: The lender will experience several negative consequences as a result of the foreclosure.
- The lender is often the only bidder to show up at the foreclosure sale.
- At the foreclosure sale, the lender makes a bid equal to the balance of the debt. If no other bidders bid higher, then the lender receives title to the property.
- If the lender receives title to the property, then the dollar amount of the previously performing loan is subtracted from “Loans Receivable” and the value of the property acquired through foreclosure is added to a category known as “Real Estate Owned” or “REO”.
- The lender is well equipped to make loans, but much less equipped to hold real estate in lieu of a Loan Receivable.
- The lender is often the only bidder to show up at the foreclosure sale.
- In order for the lender to get out of real estate ownership and back into the lending business, the lender must resell the foreclosed property on the open market.
- Probable Result: If the prior borrower could not escape foreclosure by selling the property, then the lender probably can’t do any better. This is where the lender’s bigger problems begin.
1. “Mark to Market” While the previous “Loan Receivable” and the “Real Estate Owned” are both “assets” owned by the lender, the bank auditors will soon require the lender to periodically mark down or reduce the reported value of the REO to reflect what it would sell for in a quick cash sale. Any action that reduces the value of the bank’s assets will directly reduce the lender’s “Shareholder’s Equity” (the bank’s net worth).2. “REO Reserves”. In addition, the auditor will require the bank to create a “Reserve for REO” or a cash fund set aside to cover the performance of the REO asset.
This reduces the amount of available funds that could be used to create new loans and generate more revenue for the bank.
Summary: Both of the above actions will reduce the bank’s ability to generate more revenue and increase Shareholders Equity.
Lender’s Decision Point: Consequently, the lender may conclude that it is less expensive to avoid a foreclosure and to accept less than the full repayment of the loan balance by taking a short sale, and being done with it.
Foreclosure Sales: What Happens
Nature of Sale: An All Cash Auction: The trust deed foreclosure sale is an all cash auction conducted by the trustee at a published date and time at a specified public place. Typically, the only all cash buyer to show up at the foreclosure sale is the lender who brought about the foreclosure. The lender bids in the amount of the loan, and receives title to the property.
- As the lender starts to convert more of its performing asset base (performing “mortgages receivable” on the asset side of the balance sheet) to “REO” or real estate owned, the bank auditors will force the bank to set aside available cash (that could have been used to make another loan), and hold it as a reserve to cover the REO portion of the bank portfolio.
- A double hit has just occurred:
- 1. The bank’s Operating Statement no longer has a performing mortgage loan, and now has instead a piece of real estate “REO”(Hint: banks are good at making loans and collecting monthly payments, but are not very good at holding real estate that must be managed and tenanted to prevent damage and further loss of value to the property); and,
- 2. The bank has to use a portion of their available cash to set up a cash reserve to cover the REO.
- Too much of that action, and bank auditors will write down the value of the REO property and increase the size of the REO reserve…both actions will reduce the “Stockholder’s Equity” (net worth of the bank). If it gets too thin, the Federal Reserve could close the bank.
- Example Two: The bank-owned foreclosed properties are soon sold at substantially reduced prices compared to other “non-foreclosure” properties in the same neighborhood.
- The reduced sale price creates lower neighborhood values. Those most recent low sale prices form the “comparable sales” data base that the appraiser will use when appraising your “for sale” property for a buyer’s lender.
- Your appraised value is reduced, and the entire process will continue to spiral so long as there is a bank-owned REO that is there to compete for the limited number of buyers for your property.
- SOLUTION: Only when the last REO is finally sold will the artificial reduced prices cease to exist. Buyers may love this environment, but everyone else is perplexed by artificially lowered prices.
FINALLY… Part Three
THE QUESTION: WHAT SHOULD I DO NOW?
THE ANSWER: If you can complete the following steps, then I may be able to help you sort out a course of action that you should take.
Part One: Where Am I Now?
Define your current position in terms of money
1.Complete a detailed “Financial Statement” of your current position.
a.The Asset Side:
i.What assets do you own?
ii.What is the current value of each of those assets? (ignore debts owed on each asset, since they will appear on the Liability Side of the financial statement)
Note: Organize the Asset Side of the financial statement in the sequence of “most liquid or cash-like assets” at the top of the list, and “lease liquid or hard to liquidate assets” at the bottom of the list.
Now total the value of assets listed on the Asset Side.
b.The Liability Side:
i.To whom do you owe money?
ii.How much do you owe each creditor?
Note: Organize the Liability Side of the financial statement is sequence of “shortest term debt” like short credit lines at the top and “longest term debts” like mortgages at the bottom.
c.Your Net Worth – The difference between what you own and what you owe is your Net Worth.
2.Complete a current “Income Statement”
a.List all incomes that you receive
Note: Separate various incomes by category: Vocational Incomes, Investment Incomes, other incomes
b.List all expenses that you incur
Note: Separate various expenses by category: Vocational expenses, Investment Expenses, and Living Expenses
c.The difference between Total Incomes per Year and Total Expenses per Year is the Surplus Available For Investment
Part Two: Where Do I Need to Be? (a retirement goal)
Project your living expenses to your desired date of Financial Independence
1.What will be your Survival Number?
This is the minimum monthly income required to cover all living expenses. ALWAYS KNOW YOUR SURVIVAL NUMBER!!!
2.How much of that Survival Number will be covered with “other Retirement Funds”? (e.g.: Social Security, pension fund distributions, etc.)
3.How much of a Short Fall appears to exist?
a.This is the amount that your real estate portfolio much cover on a dependable monthly basis.
Part Three: How Long Will I Be Willing to Work to Get There?
1.How long am I willing to work to amass my retirement portfolio?
2.Does it appear that my vocational employment will continue that long?
3.What happens if it doesn’t?