Sherman's RANT: "The Great Real Estate RIP-OFF of 2006..."

Every once in a while I see something that so badly ticks me off, that I have no choice but to go on a RANT!

The thing that is most likely to be the tipping point for me is when I see people getting ripped off by someone or some institution behaving badly in the real estate business. Using a tactic that is a SURE-FIRE way to put someone out in the street. A tactic that is almost guaranteed to HURT the persons who participate in their diabolical scheme.

If you joined me on the tele-class with George Ross yesterday, I trust that you got a lot from listening in. You may have also been surprised by two statements that George made yesterday:
1 - That more fortunes have been lost in real estate then ever made, and the reason for this is that many people who get into real estate investing DO NOT KNOW WHAT THEY ARE DOING before hand,
2 - The dumbest thing any investor, or homeowner can do is to agree to an APR, or Interest Only - Adjustable Rate Mortgage (ARM's).

These two statements summarize this RANT!

There is an evil taking place across the real estate markets in this country and the evil is being played out by banks and financial institutions pushing their DOPE on unsuspecting, uneducated, uninformed home owners and investors, AND THE BANKS KNOW IT!

If you are not a subscriber to Business Week, you may want to pick up a copy of this week's (September 11, 2006) edition. The cover story is entitled: "How Toxic Is Your Mortgage...?" You can also see it online at: http://www.businessweek.com/the_thread/
hotproperty/archives/2006/09/how_toxic_is_yo.html?chan=search

The problem with interest only (a version of the ARM) is that it completely undermines the wealth creation aspect of real estate investing.

You have heard me say (or have read my blog) that real estate is the IDEAL investment, with each letter representing one aspect of real estate investing that makes it absolutely superior to any other financial investment (stocks, bonds, mutual funds, gold, private placements in start-ups, etc). Specifically: I = income (monthly income that comes to the investor after expenses); D = Depreciation ( or more specifically the tax benefits that are unique to real estate); E = Equity Build-up (with a fixed rate mortgage a certain percentage each month goes to reducing the principal, and therefore real estate investing has a "forced-savings" component); A = Appreciation, in most markets with most categories of real estate the values (over time) tend to go up faster then the rate of inflation; and of course, L = Leverage. Unlike stocks, bonds and other investments, it is rare that a seller expects you to purchase their real estate with the cash in your bank account. Almost EVERY real estate transaction involves borrowing from someone else to make the transaction work. Leverage is simply the additional "buying power" you achieve by combining our money with someone else's to make the deal work, and therefore, you can control a much larger asset for less money than any other investment. E.g. to buy $100,000 worth of gold, you need $100,000 in cash, but to buy $100,000 in real estate, you need considerably less than $100,000. Assuming both the gold and real estate were held for the same length of time, and experienced the same rate of appreciation, you would be far better off owning the real estate if for no other reason then the leverage. Please Read on...

If the gold increases in value by 10%, the the gold would be worth $110,000, so your rate of return on your $100,000 investment in gold would have increased by 10% (for this example assume ZERO transaction costs, to keep it simple);

If the real estate increases in value by 10%, the real estate would be worth $110,000, also. However assume you do use leverage and can purchase the real estate with $10,000 of your own money (very conservative, simple example) And let's further assume that the income you got during the holding period went to pay the expenses and the cost of the mortgage, and as with the gold example above, assume ZERO transaction costs. With the investment in real estate, you would have made $10,000, on your $10,000 (actual cash investment) and therefore, your "Cash-on-Cash" return would be 100%.

Two things this example demonstrates (albeit simplistic by design): 1 - You can control a much larger asset with less money than a comparable investment in another asset class ($10,000 controlled $100,000 worth of real estate, but $10,000 could not get you anywhere near $100,000 worth of gold). Granted you can use leverage to purchase other assets such as stocks on margin, etc., but even on margin you will not get the amount of leverage you can routinely get on real estate - even without using any "creative" strategies. 2 - If you had $100,000 to put into an investment (congrats, please email me if you have this kind of money laying around ;) you can either invest in $100,000 in gold, or "leverage up" and control $1,000,000 in real estate (i.e. such as ten, $100,000 real estate investments with an initial investment of $10,000 each).

So, here comes the problem with interest only, adjustable rate mortgages:

1) Any adjustments in the interest payment can quickly wipe out your "I"ncome - particularly if you used an adjustable rate mortgage because the deal was marginal to begin with;

2) "E"quity Build-up - THERE ISN'T ANY! With an amortizing mortgage, each month a portion of your monthly payment to the bank is applied to both the interest and the principal. Granted, in the early days it almost all applied to interest, but even if only 1/10th of your monthly payment is applied to principal, you are still paying down the original amount borrowed, each and every month - a forced savings plan. I often tell people who have a hard time "stashing away" some money each month into a savings account - go buy your own home with a "traditional" mortgage. Each month when you write your check to the mortgage company you are paying down a piece of what you borrowed and as long as you don't steal it through a home equity line of credit (HELOC) you are actually forcing yourself to put something aside as savings. Its just in your home equity, not in a savings account. Even better for real estate investors is that YOU are not paying down your mortgage and putting something in your savings account, your tenant is!

3) "A"ppreciation - while it is true that in the long-run real estate markets go up, the reality is that sometimes prices dip. If you have created a solid deal structure, YOU SHOULDN'T CARE! Why? Because you are not going to sell just because the "market value" of your house (investments) have dipped. To sell when you know the values have dipped would be FOOLISH, UNLESS - you have to. And if you have an interest only mortgage that has you "upside-down", you may be forced to sell at the very moment YOU DON'T WANT TO, but your lender makes you. They make you not by saying; "Go sell your property", no they simply keep on raising the interest rates as high as they can, at the very moment in time it is impossible to get someone else to make you a new mortgage. There are hundreds of investors who will tell you their war story of how the market got soft and they were tempted to sell, but couldn't and when the market went back up it went back up much higher than before and ultimately they either sold, or refinanced (tax-free money) and were glad they did not sell "prematurely". At the end of the day, it is not about buying, selling, or holding, its about making intelligent decisions on your terms and your timetable. If bankers knew so much about real estate and more importantly real estate timing, they would not be bankers, they would be investors - or at least bankers in transition into becoming investors. Banks do things based on their timetables not yours! By starting off with a fixed-rate mortgage you put the bank on your timetable, by agreeing to an adjustable you automatically place yourself on theirs.

4) "L"everage - we all know about leverage and believe leverage is ALWAYS a good thing. NOT TRUE. There is positive leverage and there is negative leverage. Positive leverage is any time the amount paid out to your lender(s) actually increases your rate of return on the amount you actually have invested in the deal, and of course negative leverage does just the opposite. This is why some "nothing down" deals are not worth doing. If a nothing down deal actually winds up costing you money each month in "carrying costs" then you may have been better off putting up some cash and getting better terms - but now you have me starting in on a post for a future blog... The problem with adjustable rate loans is that in the beginning, the monthly payment on an adjustable rate loan is lower then the fixed-rate option. HOWEVER, if interest rates go up enough, after the adjustable rate loan "resets" a few times, the actual payments can be more then what the fixed-rate option offered, but by then it is too late to choose a fixed-rate option, because interest rates would be higher than what was available before... WORSE, is that some loans can actually create a negative amortization! In a negative amortization situation, the balance owed on the loan actually continues to increase, because the amount paid each month was not enough to satisfy the lender's need and to keep the monthly payments from going "sky-high" the lender simply keeps on tacking on the amount due to the mortgage principal, so you actually wind up owing more than you borrowed. In which case, the "L"erverage then actually begins to eat the "A"ppreciation and you have completely destroyed the underlying advantage that a real estate investment offered in the first place.

If any of this is new to you, then you may want to pick up a copy of this week's Business Week (September 11th, 2006). They do a wonderful job in 8 pages (with full color graphics) of explaining the hidden evils of adjustable rate and adjustable interest only mortgages then I can do in a daily blog entry.

RANT OVER...!

Sherman Ragland - Thank you for reading...