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...

#10 - More than One...

Number 10 is actually more than a "technique", it is a series of techniques that are lumped together under the label, "Foreclosure Strategies". Not to be confused with being a Maryland Foreclosure Consultant (Strategy #5). A Maryland Foreclosure Consultant is a bird dog , who operates within the Maryland law (f/k/a SB-761) and would assist both home homeowners and investors dealing with properties going through the foreclosure process.

Within the "bucket" of foreclosure strategies you have post-foreclosure techniques and "pre-foreclosure" techniques. A post-foreclosure technique is simply to acquire the real estate once it moves from the "foreclosure" side of the house to the REO (Real Estate Owned) side of the house of most large lenders. Many lenders will outsource the management of properties once they become REO to an outside (or captive) firm called an asset manager. Typically the asset manager will be required to hire a real estate agency to "widely market" the property. So, if you have a good Realtor(r) on your team, you should not be missing out on anything if you work this niche.

Pre-foreclosure strategies include such techniques as taking over the payments subject-2, or using lease/options whereby the homeowner moves out and leases the house to you and you then make up back payments and send in payments. Most investors I know who do pre-foreclosure investing do not like to use lease./options because of the continued problems the prior homeowner can get in to that may attach to the property. They much prefer using Subject-2 (please see my comments on using Sub-2 in the prior post).

In addition to the strategies for getting the deed, there are also strategies for reducing the amount of the indebtedness to the lender through something call a "Short Sale". In a short-sale, the investor convinces the lender to take a payoff for less than the book value of the loan. Say a loan is $100,000 and the borrower has fallen seriously behind to the point the lender is now ready to foreclose. Because of the fees, penalties and charges, the lender is now owed $110,000. Rather than foreclosing and hoping to recover $110,000 through the foreclosure and resale process, the lender may in fact accept a pay-off figure of something remarkably less, say $65,000 or $70,000. Why?

Maybe the market has gotten soft, and the lender realizes that it have a significant holding period while waiting for a new buyer to come along. Or maybe the current owner has thrown himself/herself a "getting out of Dodge" party and one of the party (parting) games was to get all of their "Iron Man" friends to come to the house and see who could throw the biggest appliances out the second floor window - without opening the window. Another variation of this game is to not use a window at all, but see if you can in fact throw them through the wall and out onto the back yard. Or, quite possibly after a further review, the lender determines that the original loan was made under fraudulent terms and the property was never worth any where close to what the loan is.

Bottom line: every foreclosure has a real and hidden cost, and foreclosure us the VERY LAST THING most lenders want to have to do. There is the real cost of attorney's and court fees, as well as other professionals involved in a foreclosure and resale, as well as the "hidden cost" of what happens to a piece of real estate that sits empty. Therefore, it is often times in the lenders best interest to discount the amount of the mortgage and accept a discounted payoff, rather than going down the foreclosure path.

There is one exception to this philosophy of lenders not wanting to foreclose and that is of course in situations where the asset is worth more than the mortgage, Often times a lender will then sell the delinquent note at a discounted amount. The major difference is of course when the lender sells a note, it will no longer be the lender, and it has in fact transferred this "problem loan" another lender in exchange for cash. The new lender will be picking up a note, normally at a steep discount to the loans book value, and in many cases at a value way below what the asset would sell for, once fixed up.

This of course, leads us to strategy #11...

Sherman Ragland - Thank you for reading...