Buying a rental property at trustee sale is not as risky and as speculative as many believe. With proper analysis and an accurate estimation of value, this can be a relatively low-risk way to obtain stable cashflow.
Irvine Home Address … 203 Briarwood, Irvine, CA 92604
Resale Home Price …… $299,000
Came to my door
When I was down on my luck
In the shape
Of an old friend
With a plan, guaranteed
He showed me the papers
As he walked me to his car
You could wear this style
If you follow my advice
Bobby McFerrin — Opportunity
The common perception of me is that of a housing bear. It is true that I believe resale prices will fall as foreclosures wash though the market, but I also see good reasons to own real estate — I mean really own it when you don't have any debt. It isn't necessary to time the bottom tick of the real estate market to invest wisely and profitably. Your goal should be to obtain the most cashflow for the money regardless of resale price. If prices drop further, that creates additional opportunity to get even greater returns.
The people buying with an eye toward positive cashflow are the ones who stabilize the market. They always are because they are the only ones who will buy when prices are going down.
The fake appreciation engineered by the Federal Reserve and our various tax incentive programs has created a low-volume plateau that is about to crumble under the weight of higher interest rates, high unemployment and large numbers of foreclosures. When the public stops believing HELOC riches are right around the corner, the bubble will continue to deflate until cashflow investors set a durable bottom.
There are abundant opportunities to acquire cashflow properties in many markets, and trustee sales offer a unique opportunity to obtain a solid portfolio of properties pruned of weeds that do not perform as expected.
Back in January, I went through the basics of Trustee Sales:
Over the next couple of weeks, we are going to explore the various ways you can participate in the clean up from the Great Housing Bubble:
Foreclosure 201: Buying a Rental at Trustee Sale
Foreclosure 201: Flipping Trustee Sale Houses on Speculation
Foreclosure 201: Flipping Trustee Sale Houses to a Buyer in Escrow
Foreclosure 201: Buying Trustee Sale Properties Using Conventional Financing
Investment portfolio real estate
Diversification protects investors from price volatility in any one asset class. Real Estate is typically the largest portion of a retirees net worth, and in many cases, it is the only asset they have. Mortgage equity withdrawal is particularly problematic for those approaching retirement because it allows consumption of what used to be a forced-savings account. Californians emptied their housing piggy banks, and they are broke. Foolish borrowers cannot easily access their IRAs and 401Ks for spending money leaving these investment vehicles as the only retirement savings reservoir outside of Social Security most retirees have — assuming borrowers did not deplete their retirement accounts attempting to save their homes.
Working-class owners should diversify into stocks, bonds and other investment classes before looking to acquire cashflow-positive real estate. However, once equity in the family home represents less than a third of total net worth, families should diversify into cashflow investment properties to maintain a real estate exposure between 25% an 50% of total investments. Note that real estate investment trusts, which are a security like stocks, provide real estate exposure and cashflow and these holdings should be considered the same as holding real estate directly.
The size of the portfolio and the allocation to real estate establish an investment budget. The next task is to determine how and where to deploy capital in a way that balances risk and return.
Capitalization rates and opportunity costs
Investors review of the risks and returns of any asset class, and savvy investors realize that every investment creates an opportunity cost because the capital deployed in one investment could have gone to another. Opportunity costs drive all current investment choices; when asset prices are high and returns are low, investors seek other assets where prices are low and returns are high. During the bubble disciplined cashflow investors were not adding to their portfolio of real estate, and many investors liquidated when prices were too high. Now that prices are softening, cashflow investors are finding opportunities once again.
I described cashflow investment in greater depth in the post IHB Investor Reports:
One key concept for Investment Value of Residential Real Estate is capitalization rate. The Capitalization (cap) Rate is the (yearly) Net Operating Income divided by Asking Price (assumed purchase price). It is the simplest measure of an investment’s financial performance, and it provides a convenient comparison to competing investment alternatives. A cap rate is like an interest rate on a checking account, a mutual fund return, or a bond yield. Cap rates change over time to reflect the perception of risk in real estate as compared to other investments.
The cap rate is inversely related to price; in other words, high cap rates are synonymous with low prices and visa versa. The cap rate an investor will accept varies from person to person. There is no single appropriate rate to apply to value.
Historically, cap rates on investment real estate are 10% to 12%, but in our era of cheap money and sub-5% interest rates, cap rates of 5%-6% are common today. The spread premium between real estate cashflow and savings account interest compensates holders of real estate for the additional risk. The current spread is very small, which reflects a lack of viable alternative investments and residual kool aid intoxication (people are overpaying).
Cash-on-cash returns and leverage
The cash-on-cash return is of greater interest to the typical leveraged investor as described in IHB Investor Reports:
The Cash-On-Cash Return is similar to a capitalization rate in that it shows a return on investment, but it is measured by comparing the Total Profit and Loss after Expenses, Debt and Taxes to the Total Cash Costs. This is the important rate of return for investors who are not purchasing with all cash. As long as debt is less expensive than the cap rate, the cash-on-cash returns can be magnified by increasing debt. This is an appropriate use of leverage to increase investment returns—to a point.
The over-use of leverage is biggest mistake made by speculators who think they are investors. Leverage (debt) magnifies the capitalization rate. For example, if a property had a 10% cap rate, the application of 5% debt results in a cash-on-cash return much greater than 10%. For this reason, many naively assume that more leverage must be better; on paper it certainly looks that way. However, leverage cuts both ways, and if rents or property values decline, the magic of leverage can drive stellar returns into a black hole.
Judicious use of leverage can increase returns, but the investment goal is to eliminate debt and own cashflow properties with no debt at all, particularly for retirement. Retirees gain little benefit from assets that fail to deliver cashflow.
Cashflow investing versus speculation
Many people who label themselves investors are really speculators. I detailed many of the differences in the post Speculation or Investment. Speculators and investors differ greatly on their use of debt.
Speculators are only interested in assuming a position in a financial market with hope they can exit that position later at a higher price and make a profit. Speculators will maximize debt and minimize debt-service payments because debt is merely a means to the end of taking a position in the market. Resale price is everything to a speculator.
Investors also take positions in a financial market, but they look for low prices which increase their rate of return on a cashflow basis. Investors will minimize debt and maximize debt-service payments in order to retire debt and maximize investment cashflow. Resale price is irrelevant to an investor who need never sell to obtain maximum value from the investment.
Note: take a moment to watch this informative video. Take special note of the cashflow return on investment Bruce Norris is getting in Riverside County (about 40 seconds in).
Advantages of trustee sale purchases
Trustee sale purchases represent the best method for sophisticated investors to acquire cashflow real estate. The first advantage is obvious; the property is acquired at a lower price, which increases the cap rate, and if low-cost debt is used, the lower price increases the cash-on-cash return. The second advantage is not so obvious; if the property does not perform as projected, if purchased properly it can be sold for a profit, and capital is released to pursue other investments.
These two advantages suggest a method for acquiring, evaluating, and operating a rental property portfolio that retains only the best performing properties.
Procedure for acquiring, evaluating, and operating rental property
The procedure Ideal Home Brokers recommends is as follows:
- Establish ownership parameters and scan for targets.
- Select and bid on best candidates.
- Acquire property at trustee sale.
- Prepare property for occupancy.
- Offer for rent at rate consistent with financial projections for market rents for 30 days.
- After 30 days, offer for rent at the proforma price and for sale at a decreasing price until it is rented or sold.
- If rented, place new debt on the property (this may require "seasoning" the property by holding for 90 days) if this fits within a larger strategy and only if the interest rate is lower than the capitalization rate.
The first four steps are similar for any acquisition, but steps five, six and seven are unique to this opportunity. Since the property is generally acquired at auction for a price below resale, if the property does not perform as expected, there is little reason to keep it. The property should be offered for rent at or slightly above the projected rental rate, and if it fails to rent for that amount in a timely manner, the property should be disposed of.
Current returns favor flipping
Cashflow properties rarely offer investors rates of return exceeding 20%, and in today's market, 5% is far more common. So why not flip the property and make more than 5% in 120 days? Why not take that capital and flip in and out of two or three properties a year and make more than a 20% rate of return?
The only reason is lack of opportunity, and for the next three to five years, there will be no shortage of flip opportunities as California turns over a significant percentage of its housing stock. Perhaps after this debacle is truly behind us and we have mopped up the foreclosures, keeping money tied up in long-term hold properties is warranted, but until the foreclosure wave recedes, investors with the cash to play in this market should consider doing so.
Flipping houses is the subject for next week.
IHB Property Evaluation Reports
To help buyers and investors, we designed the IHB Fundamental Value Reports, to have some consistency in format and information. The differences in the reports are primarily in the information they present because different audiences have different needs and wants. They all pull from the same basic data. Everything is transaparent. The report for Trustee Sales used as rentals is the most complex of the group, so bear with me as we delve into the details.
The cover page has pictures if they are available. The vast majority of foreclosures never hit the MLS, and often all we can get is a picture of the front elevation and perhaps a floorplan. We advise owners to budget for complete renovations. If they do not need to spend the renovation money, they should consider it a savings.
The basic property information is present: address, beds, baths, and so on. The scheduled date of the Trustee Sale (subject to postponement), and the published opening bid are presented for reference; however, the published bid is often meaningless as these bids are frequently dropped at the last minute.
The maximum bid amount is our recommended amount. The financial performance of the investment is calculated based on this price. If we obtain price improvement at auction, the performance of the investment is improved.
Of course, this brings up the key conflict of interest between investors and the IHB as service providers. Investors want to get the best possible deal — which means bidding less — and we do not want to research hundreds of properties and go to countless auctions and not buy anything. Our solution is standardization. The maximum bid price is set to an amount that allows the investor to get out unscathed (and usually make a profit) if the investment does not cashflow as planned. If an investor wants to guarantee price improvement by lowering the maximum bid amount, then we charge a fee to attend the auction.
The most important items are bold faced: the final bid decision deadline and the sale day cash requirement. If a buyer is interested in a property, we don't want to wait until the last minute to finalize our research and and gather the necessary cashier's checks. In an investor missed the deadline or fails to come up with the cash, they missed the deal.
We provide our opinion of the likelihood of success given the foreclosure market comps, and we provide a breakdown of the total cost as well as the equity obtained on auction day.
The next two numbers are the net income and the capitalization rate. The net income is annualized from the positive cashflow detailed on page two. When this annualized net income is divided by the total trustee sale cost (also detailed on page 2), the result is the capitalization rate.
The final three numbers are of great interest to cashflow investors who plan to obtain cash-out refinancing to free up capital to acquire other properties. This spreadsheet calculates the maximum cashflow-positive loan the property will support (within other limits). The remainder is capital investment after financing. The cashflow after financing is divided by the capital required to obtain that cashflow to measure the cash-on-cash return.
Let me be clear: this is still an all-cash deal to get the property at auction. The cash-out refinancing comes later, probably after three to six months of seasoning.
I recognize this sounds antithetical to my mantra of eliminating debt, but debt does have its uses. Debt is very dangerous if too much is used, or if it is considered a permanent part of the plan. Debt used in acquisition, which this debt is indirectly used for, is not an inherently bad use of debt. As long as there is a plan for consistent reduction and final elimination of this debt, it is useful. As long as the investor keeps debt elimination as the goal, using debt to obtain cashflow-positive property is beneficial, and for many would-be landlords, essential.
The second page provides the detail for the summary numbers on page 1. The sale day cash requirement is the sum of the maximum bid amount and the trustee sale fees. The total trustee sale cost includes renovation and improvements, property taxes (both back and current), an allowance for tenant move out and cash-for-keys if necessary, and transer taxes due. The cost of ownership includes the standard costs minus any financing costs as this is an all-cash deal.
The rental income is derived from comparables found in the MLS. An allowance for vacancy and collection loss is provided. Realistically, tenant turnover will cause the loss of one month's rent once every two years or so. In fringe markets, this number may be higher. Wise landlords set aside this money in a cash account to cover the missing payment when it occurs. The net monthly rental income is the gross rent minus the vacancy and collection loss.
The operating expenses are typical of a rental including a property management fee. These fees can be as low as 3% and as high as 12% depending on where the property is located. Six percent is relatively common in Southern California.
Net Operating Income is the monthly cash expenses is subtracted from monthly rental income. This is the stable cashflow capable of covering a mortgage payment. This is where the magic of this spreadsheet comes in.
Jump ahead to lines 28 and 29. These are the two limiting factors when considering cash-out refinancing. Line 28 has the maximum loan amount the lender will allow. In the example above, it is assumed the most a lender will allow on a cash-out refinance is 80%. During the bubble — and during the Saving and Loan disaster — lenders were willing to go much higher than 80%. This number is totally dependent upon lender standards.
Line 29 is the maximum cashflow positive loan the property will support. In Irvine, it is very rare to get properties where the cashflow justifies a loan greater than 80% loan-to-value. If I were to model the property Bruce Norris bought in the video above, the maximum cashflow positive loan would likely exceed 100%.
Note: The Savings and Loan fiasco of the late 80s and early 90s was caused by the phenomenon illustrated here. Lenders in the S&L era would provide cash-out refinancing in excess of 100% for nothing more than an aggressive proforma. Basically, you could walk into an S&L loan department with a spreadsheet like mine that projected a cashflow that justified loan of 120% of the development cost, and the lender would give you the money. There were deal makers all over California and Texas drawing up proformas and walking out of banks with millions of dollars. As one might imagine, there was fraud and theft on a grand scale. It has only since been eclipsed by the Great Housing Bubble.
On most properties in Irvine, the actual monthly cashflow will be zeroed out by the loan. The actual profit and loss is captured in the amortization on the loan. This is a viable way to acquire and pay off real estate.
The financing section details how the maximum loan is calculated and the remaining capital the investor must leave in the property to remain cashflow neutral.
Page three shows the various comparable ranges and cashflow values with a summary chart.
Page 4 has comparables and notes.
When people think about buying foreclosures at auction, the whole activity seems extremely risky and speculative. I hope I have demonstrated today that investing in this market with limited risk is easier than most imagine.
The most important part of this process is selecting the right comparables. The spreadsheet will do the math quickly and accurately, but if the data is bad, or if the proper adjustments to the data are not made, the whole deal falls apart. If the comps are too high, there is a chance the investor will overpay. If the comps are too low, the investor will be outbid.
For instance, when I ran the report for this property, my maximum bid amount was under the amount the buyer ultimately paid. Based on his current asking price and the previous reductions, it appears this buyer was too aggressive in his valuations, and he overpaid. That is the random nature of this market. There is no way to know if someone with aggressive assumptions is going to compete with you at auction, and that includes the lenders and their willingness to drop bids.
Knowing the market where you are buying is the key. Many of the investors that have contacted us are already expert in the valuations and rents in a given market area. These are the clients most likely to have a positive result. We assist in the research, analysis and acquisition, but ultimately it is the investor who must decide if the deal is right for them.
Irvine Home Address … 203 Briarwood, Irvine, CA 92604
Resale Home Price … $299,000
Home Purchase Price … $257,800
Home Purchase Date …. 1/12/2010
Net Gain (Loss) ………. $23,260
Percent Change ………. 16.0%
Annual Appreciation … 45.3%
Cost of Ownership
$299,000 ………. Asking Price
$10,465 ………. 3.5% Down FHA Financing
5.19% …………… Mortgage Interest Rate
$288,535 ………. 30-Year Mortgage
$63,257 ………. Income Requirement
$1,583 ………. Monthly Mortgage Payment
$259 ………. Property Tax
$12 ………. Special Taxes and Levies (Mello Roos)
$25 ………. Homeowners Insurance
$328 ………. Homeowners Association Fees
$2,206 ………. Monthly Cash Outlays
-$151 ………. Tax Savings (% of Interest and Property Tax)
-$335 ………. Equity Hidden in Payment
$21 ………. Lost Income to Down Payment (net of taxes)
$37 ………. Maintenance and Replacement Reserves
$1,780 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$2,990 ………. Furnishing and Move In @1%
$2,990 ………. Closing Costs @1%
$2,885 ………… Interest Points
$10,465 ………. Down Payment
$19,330 ………. Total Cash Costs
$27,200 ………… Emergency Cash Reserves
$46,530 ………. Total Savings Needed
Baths: 1 bath
Home size: 1,000 sq ft
($299 / sq ft)
Lot Size: n/a
Year Built: 1978
Days on Market: 74
MLS Number: P720337
Property Type: Condominium, Residential
==== PRICE REDUCED FOR QUICK SALE ==== Private end unit overlooking greenbelt in beautiful, peaceful neighborhood of Irvine. This unit has been renovated with new paint throughout, new carpet, new baseboards around all rooms and brand new kitchen appliances. Tile entry opens to spacious living room. There is also a separate room for laundry.
Property History for 203 BRIARWOOD
|Mar 20, 2010||Price Changed||$299,000|
|Mar 15, 2010||Price Changed||$306,000|
|Feb 23, 2010||Price Changed||$309,000|
|Feb 22, 2010||Price Changed||$314,900|
|Feb 12, 2010||Price Changed||$319,000|
|Feb 03, 2010||Listed||$324,900|
|Jan 27, 2010||Sold (Public Records)||$258,000|
One percent price reductions really don't seem like enough, do they?
The former owner of today's featured property was an ordinary HELOC abuser. She bought the place in 2003, and by 2006 she was in an Option ARM that finally blew up. There is no way to tell how long she was delinquent before they issued the notice of default, but the lender wasted no time in the foreclosure process:
Recording Date: 01/27/2010
Recording Date: 12/23/2009
Document Type: Notice of Sale
Recording Date: 09/18/2009
Document Type: Notice of Default
IHB Trustee Sale Services
The cleanup of this mess has been delayed 12 to 18 months by the various moratoria and lender delays, but they are finally moving to clean up this mess. This clean up will create opportunities everywhere.
There is no reason the prudent readers of this blog who carefully saved their money should not step in to profitably clean up the mess from the mass stupidity of lenders and borrowers. I will feel good about being an active part of the solution. Someone has to come forward and buy these properties. Those buyers will be compensated with steep discounts (otherwise they wouldn't bother).
Our service gives you this opportunity. Seize it.