Let me paint you a picture.
Back in 1991 commercial (along with residential) real estate plunged. Truth be told, the US real estate market had topped in 1988, but it wasn’t until 1991 that all of the bad loans came home to roost. The savings and loans intuitions were bankrupt to the tune of one trillion dollars. Citibank was on the verge of insolvency, and New York City was being abandoned by such stalwart corporate tenants as Exxon Mobil.
In short, much of the country had lost faith in the economy and real estate prices plummeted. During this period I was fortunate enough to be cash rich. I had many investment opportunities thrown my way, from restaurants to nightclubs as well as real estate.
While the nightclub and restaurant business seemed like a great way to meet girls, it didn’t seem like a great business unless you could dedicate yourself to it full time. Real estate, on the other hand, seemed like a winner. I remember growing up with my father telling me “Bricks and mortar son. Put your money in bricks and mortar”
My father had taken his own advice in the late 1970’s and early 1980’s, and had collected himself a respectable fortune by buying, renting and flipping real estate. But, like many investors, he became over leveraged, took too many risks, and lost every cent he had when real estate went sour in the late 80’s.
It was a sobering moment in my childhood, and one that I don’t think my father ever got over.
I’ve always had a very simple rule when investing - even when I bought my very first shares of British Gas at the age of 15. If I can’t understand a business, I can’t put my money in it.
That’s why I didn’t buy in 1991. I simply didn’t understand real estate. I didn’t know how to value it, I didn’t know how to buy it, there were so many variables that it made my head spin. I also knew that I didn’t want to be a landlord. I was a man on the town and dealing with tenant issues and leaky faucets seemed like too much work. Especially when viewed against the money I was making in the market.
Over the last sixteen years I have learned much more. The beauty of real estate is the LEVERAGE, the bloody LEVERAGE is MAGNIFICENT!! It allows the smart buyer to propel themselves into an economic band that they could only dream about.
Unlike other financial assets you don’t get margin calls on your homes when they fluctuate in value. So long as you keep paying your mortgage, the bank doesn’t care if the home value goes to zero. They will never call you and say “Mr. Tiwari we noticed that you home value went down 30% - we want more collateral”.
This is so powerful.
So how do we make money from this?
The first question a smart investor will want to ask themselves is have we reached the bottom in real estate prices? I can unequivocally say that home prices have not yet bottomed. Depending on the area, we could be looking at another 8% down this year, with another 8% down next year.
I live in North Eastern Pennsylvania, and I’m seeing 10 year old, 1,500 square foot, 3 BR homes that were $115,000 last year now selling for $75,000 in foreclosure. That’s a 34% decline before negotiations!
In fact, almost every listing I’ve pulled up recently is a bank foreclosure. After speaking to many agents in my area, I’ve found out that the majority of loans processed over the last couple of years were subprime adjustable rate mortgages.
One agent put it quite succinctly “How could a person with a $50,000 income think that they could afford a half a million dollar house”.
To make matters worse, investors can no longer buy a property cheap, rehab it and refinance it at the higher value. The rules have changed. Let me give you an example: let’s say the banks desperate and we buy our 3Br house, not for $75,000, but for $40,000. After some cosmetics, etc, we’ve spent $5,000 sprucing the place up, so our cost basis in the house is now $45,000.
Well, if you are a smart real estate person you will refinance your cash out and go chase the next real estate deal.
Hold on, not so fast. The banks finally wised up. The only buyers of mortgages right now are Fannie Mae and Freddie Mac, the CDO (secondary mortgage) market is long dead and buried. Freddie and Fannie now say that you can only refinance out 90% of the home’s value. (No more 100% cash outs allowed)
Ok, no problem, 90% of $75,000 is $67,500 that means we get to pocket $22,500 ($75,000 minus what you paid for the house $45,000).
Fannie and Freddie are now insisting that all loans be “seasoned”. That means that for the first 12 months of the loan you can only refinance out based on what you paid for the property (including repairs)! So instead of doing a REFI at $75,000, you could only do it at $45,000.
I could buy a $1,000,000 home for a dollar, but I’d still have to wait a year before I could REFI out my equity.
This decision was squarely aimed at the small investor market and has essentially shut that market down. There are just not too many people that can have their equity tied up for 12 months at a time. It’s really put a crimp in the real estate roll up strategy of buying, rehabbing, refinancing, buying, rehabbing, refinancing.
The good news is that these restrictive lending practices have removed many buyers from the market. This is making the banks that hold all of this foreclosed real estate much more receptive to low ball offers.
But how much should an investor offer, especially if we haven’t hit bottom yet?
Here’s the model I am using.
When house prices are declining, comparable home sales are just are not a great guide to use. So when the agent tells you that so and so’s house sold for all this money, tell them to bugger off (in your head, it wouldn’t be polite to say that out loud!).
What I wanted to create was a value model that would protect me from making bad decisions. So let’s use a $100,000 house as an example.
Step 1. The first thing I do is give the house price a 16% haircut to account for this year's, and next year’s, projected drop. This will drop the price to $84,000.
Step 2. I’ve learned that if I’m going to make big money in real estate I have to buy below market price. If I bought it at $84,000, then I might as well wait until next year and buy it then.
No, I need to get it cheaper, so I give the reduced price another 20% haircut taking me to $67,200. I now know that I will never, ever pay more than $67,200 for this property.
Step 3. The first two steps alone have insulated me from a further 30% drop in real estate prices. My third step is to make sure that I have a positive cash flow of $300 - $400 a month.
That means that after paying the mortgage, taxes, home owner association dues, and insurance, the home is throwing off between $300 - $400 a month in free cash flow. Very often this will mean that I will have to adjust the price I am willing to pay for the house even lower.
I need that cash cushion in case the economy worsens and we get rampant job losses. I need to have the flexibility to be able to lower my rent if the economy falls off a cliff without running the risk of not being able to pay my mortgage.
This $300 – $400 a month cash cushion gives me huge piece of mind.
Step 4. Right now if you have a credit score above 720 you can get 10% down mortgages for about 6% with no points. So if you’ve got good credit the lenders are there. I know the lending market has dried up, but they have to lend to someone.
So let’s assume that the taxes are $1,800, community dues are $900, and insurance is $800 a year. That gives us total expenses of $3,500 a year which is $291 a month.
Three bedroom homes in my area rent for about $1,000 a month.
So how do we figure out how much we can pay?
Take the $1,000 a month in rent and minus out the monthly expenses of $291. That leaves us $709. From that number we need to deduct how much profit we want to make. Let’s say that we want a $400 positive cash flow so minus $400 from $709 and we get $309.
That $309 is what we have available to carry a mortgage.
A quick look at a mortgage factor table tells us that a 30 year fixed 6% mortgage costs $6 per thousand. So to get our offer price we divide $309 by 6 (mortgage payment money divided by mortgage factor rate) which equals 51.50. So if we want a $400 positive cash flow our total mortgage including closing costs cannot be more than $51,500.
Typical closing costs on a property at this price are around $4,000 so your offer on the home would be $47,500 and your total loan amount with closing costs would be $51,500. (The numbers are not completely accurate because you have to factor in your 10% down payment of $5,100, but the loan amount with closing costs will essentially be the same plus or minus a few dollars.)
Now if they laugh you out of the room with a $47,500 offer don’t burn your bridges. Be pleasant but firm, give them your card, and tell them to give you a call if they change their mind. Believe me - some of them will.
Alternatively, you can make a counter offer with a higher price. How much higher you ask? Well let’s do the math but this time we will settle for $300 a month in cash flow instead of $400.
Our rent is $1,000 a month, expenses are $291 a month and our profit allocation is $300 a month leaving $409 a month for debt service.
$409 a month will support a 30 year 6% loan of $68,000. That means that you can offer up to $64,000 plus $4,000 of closing costs for a total loan amount of $68,000.
But if you look up to step 2 you will see that this will take us above our highest number allowed which is $67,200. It’s only $800 more but I will still stick to it as my max number just to ingrain the importance of having buy-side discipline.
(Like the other example, the numbers are not completely accurate because you have to factor in your 10% down payment of $6,800, but the loan amount with closing costs will essentially be the same plus or minus a few dollars.)
Bringing it all together
The key for the first year is to acquire as much real estate as possible using this model. As you go into your 12th month of property ownership you can start refinancing out your investment capital to start the process all over again.
If you can do this over the next four years, you will watch your personal net worth sky rocket. After four years, this real estate bear market will be well and truly over. Those $50,000 to $70,000 homes that you bought will be worth $125,000 to $150,000. Three years after that they will be worth well into the $200’s, and you will have a multi-million dollar net worth and a six figure income to boot.
Is this easy? Heck no! It going to take hard work, guts, and determination. But for those of you with the aforementioned qualities, this is an incredible long term buying opportunity in real estate.
I know that many of you are big time real estate players, so I want to hear from you. Please share your real estate stories - where are you seeing the bargains? What negotiating ploys are you using and do we have any section 8 landlords that can share some of their tips too? Is section 8 (government paid low income housing) renting the nightmare most people think or can money be made there?
Tycoon is about empowering you to make more than your fair share. So step up and start sharing the knowledge, and you’ll be amazed by how many money making ideas you will pick up from your fellow tycoons!
Chief Investment Officer
ETF Master Trader