Archive for July, 2008

I’m confused. I really am.

I’ve been getting a rash of grief lately from the Chicken Little crowd here over my bullishness about buying suburban rental homes here in Metro Detroit.

They’re running up and down the street like little girls with their dresses up over their heads screaming “The Sky is Falling. They Sky is Falling!”.

I suppose that it’s easy to do when you put your brain in neutral. That protects you from the facts I guess.

The point that I’m trying to make (again and again) is that this area will rebound. It survived a much worse situation back in the 70’s and 80’s, and Michigan rebounded to lead the nation in growth and had the lowest unemployment rate of any state in the 90’s. It’ll be back.

But those that can’t learn from the past will never be convinced, and they’ll continue to scream their overreactions from the rooftops.

But from a real estate perspective, and in particular rental real estate, the proof, as usual, is in the math.

Chicken Littles – stop reading here – facts to follow.

First – you should understand that the premise of holding rental properties is that they are long-term investments. Like 15-20 years long.

So unlike the people that are in and out of the market every week, people that invest in rental properties buy. Then they hold. That’s it. It’s not sexy. It’s not complex.

And second, you should understand the math.

I’ll use the last rental property that I bought as an example.

I bought it for $69,250. It needed no rehab and all the mechanical systems (furnace, a/c, electrical, plumbing, etc) are in bullet proof condition. My experience with other properties in this condition over the last several years indicates that annual repairs and maintenance will be insignificant.

I rented it for $1000 per month BEFORE I closed on it (slightly below market to what I call a “permanent renter” – more on that later in another post). My principal, interest, taxes, and insurance come to $825 per month, so there’s $175 per month in cash flow to either put in my pocket or use on maintenance.

My point is – this property cash flows nicely at that price.

So let’s suspend all reality and common sense for a moment and listen to the Chicken Littles and suppose that housing prices fall an additional 20% across the board here. Fine.

So the value of this rental home falls from $69,250 to $55,400.

Time to jump off the roof, right?

Maybe for the Chicken Littles, because they’re focused on the short-term and can’t see beyond what’s right in front of them.

 I however,  don’t care.

Well why not? I’ve just lost 20% of the value of my asset, haven’t I?

Because the house cash flows where I bought it. So a reduction in the property value has ZERO impact on my profitability!

I even have room to lower the rent if the rental market drops, so only a total and complete collapse of the rental market here will impact me. Is that likely? No – because as the housing market has collapsed here the rental market has strengthened, and rents are rising.

So I’m simply at a loss why this is so hard to understand.

I hope this clarifies things. For most I’m sure that it did.

For the Chicken Little crowd though, I’m sure that it didn’t get through, because they always base their overreactions on never-seen and not possible Armageddon Scenarios.

So once and for all - shut up Chicken Littles. The sky is NOT falling!

Why not try being part of the solution for a change instead of exacerbating the problem?

Commercial lenders are suffering in this economy as well – just not as publicly it appears.

Last month one of the most prolific Hard Money Lenders on the Commercial Real Estate side of the house killed himself. A Hard Money Lender lends money to real estate investors for very short time frames at astronomically high interest rates – and some investors hyperventilate at the chance to borrow.

It looks like he got overexposed to the overheated Phoenix real estate market.

The market softened significantly, which caused his borrowers to begin defaulting on their notes. At the same time, his investors started to get appropriately gun-shy about the market, and they stopped investing. Which meant that he had to cover the interest payments on the defaulted loans.

He then committed the cardinal sin in real estate.

After offering his initial investors first lien position on properties, in his haste to attract new money, he gave new investors the coveted first lien position and basically displaced the prior investors.

First lien position gives someone first claim on the property in the event of a default. It’s the least risky debt-based way to own real estate, and therefore gets a lower return on investment. In contrast, second lien position can earn rates of return up to double that of first position due to the additional risk.

You can imagine how his initial investors reacted! Although he may be better off this way, because when his investors found out that they had been displaced, they would have beaten him senseless with baseball bats a la Robert De Niro as Al Capone in the Untouchables.

And his company filed for bankruptcy three weeks later.

Yep. After all the drama. All the back and forth. All the ups and downs.

My first apartment deal is DEAD.

Call it doctor: time of death Thursday July 10, 5pm eastern.

The cause of death is what’s ridiculous. Again, to recap (please indulge me if you’ve seen this before) Mr Seller and I agreed to terms last April 15th. He produced all of the required due diligence documents up front, except for his 2007 Tax Returns and a year-to-date income or operating statement, which he committed to getting me during the first week of May. (These two items, by the way, are required by every commercial lender and were required if I wanted to get financed, which I did)

So I’ve been waiting for two months. Ready to proceed at a moment’s notice, if he would simply provide – literally – 2 pages of information.

And so I waited. And waited. And waited.

Until last Thursday. After trying to light a fire under him as I discussed in a prior post, I received a call from the selling broker. Apparently Mr Seller had had a brain fart and had thought up one whopper of an additional condition that he wanted to impose.

Mr Seller wanted an additional $10,000, non-refundable, earnest money deposit before he would release any more information, particularly the tax returns.

Huh?? But I’m not the one holding up the deal Sherlock.

So I gave Mr Seller until 5pm Thursday to pull his head out, or else the deal would die.

He didn’t. It did.

Do you know what the funny thing is? This was property named as part of a 1031 exchange for the seller. And in addition, Mr Seller, aka Mr Einstein, refinanced this property at the beginning of May in order to pull all of his cash out – in the middle of selling it!

Why do I call him Mr Einstein? Because he took on an adjustable-rate mortgage. But that’s not all – the genius took on a mortgage where the rate adjusts monthly! It was like he simply asked for the lowest closing cost commercial mortgage and signed whatever they put in front of him.

So not only is he losing out on his 1031 exchange, but his interest rate will move against him such that in October or November of this year he’ll be upside down on his payment.

Couldn’t happen to a nicer guy.

Off to continue my Apartment Quest!

I have thought for a long time that Star Trek is a metaphor for life.

Especially for work and business.

But as much as I try to explain it to my wife, I still usually get the blank stare (you know the one I’m talking about), even though I converted her into a STNG fan when we were courting way back in grad school in 1990. (She doesn’t like or get Monty Python either)

I have been mapping out my business over the last couple of weeks trying to decide what to outsource and in-source, and it hit me again how Star Trek is relevant. In particular I thought about the different management styles of Picard and Kirk. (I’m serious! Keep reading!)

You see, in my view Kirk represents the old way of managing. He was involved in every decision. He led every away mission. He did all the heavy lifting on the show, to the extent that the only way that missions succeeded were because of his own heroic effort.

That made for some great television, but it’s certainly not any way to run a business, because it’s not a practical, nor sustainable, business model.

Now contrast that with Picard’s style. He made a point to recruit the best people possible for his crew (as did Kirk), but Picard got out of their way and let them do their jobs. He delegated everything, pushed his people to do more and develop their own leadership skills. And he rarely, if ever, led any away missions. He led, and focused only the tasks that he needed to handle. And he knew the difference.

Could Spock, Chekov, Sulu, Scotty, and McCoy have rescued Kirk from the Borg like the NG crew did with Picard? I doubt it. They had little experience operating anywhere but under the direct control of Captain Kirk.

So I’m choosing to structure and run my business like Picard ran the Enterprise – by outsourcing everything except for the tasks that require my personal attention, and delegating wherever I can.

But without the accent.

GREAT.

I wrote a blog post a couple of days ago about Indymac shutting down it’s lending operations. Something about a Pig Through a Snake. Perhaps you read it – about capitalization issues taking down another lender – blah blah blah blah. It was mildly interesting but not earth shattering because, hey, it didn’t affect me!

Then late yesterday afternoon I finally received a call back from my intrepid commercial mortgage broker. I had called him to talk about changes in rates since we talked last week and also to discuss firming up the other terms since the balance of the due diligence was due from Mr Seller at 5pm yesterday.

What does he tell me? That oh by the way – that even through they had told me from the start that they were a direct lender, they had planned to use Indymac to fund my loan all along. And because Indy was basically out of business now we would have to start the process all over – from scratch. 

With a Fannie Mae loan. 

I looked for a window to leap from but I was on the first floor. Another three months of back-and-forth?? And that wasn’t all of it.

“Excuse me?” I asked him. “Didn’t you tell me that when we first started this odyssey that Fannie Mae loans were WAY more expensive in terms of costs and fees??” 

“Um, yes”, he tells me. “About $6,000 more than what you would have spent with Indymac”.

“Six THOUSAND more??  All because Mr Seller dragged his feet on the due diligence??”

No way, I said to myself. This has just become the seller’s problem. 

So I called the selling broker and countered for this and a couple of other expense items that were less than accurate. I gave him an additional 24 hours to sort it all out. (I may get my 11 cap rate after all!)

So this is finally going to come to a head later today. I never dreamed that it would be so difficult to spend a million dollars.

So again, stay tuned.