Hedge funds are forming to buy auction properties and flip them. Individuals investors are being crowded out by an increasingly professional group.
Irvine Home Address … 52 CAPE COD Irvine, CA 92620
Resale Home Price …… $949,500
That ain't workin' that's the way you do it
Money for nothin' and your chicks for free
Now that ain't workin' that's the way you do it
Lemme tell ya them guys ain't dumb
Dire Straits — Money For Nothing
When the housing crash first began, there were few funds organized to take advantage of it. As the need for more liquidity at the auction site grew, so did the discounts which enticed more bidders. At first, these were mostly wealthy individuals, but now, the hedge funds have moved in to the auction market.
Squeezing out amateurs, private equity funds and wealthy individuals are buying distressed properties at public auctions, refurbishing them and selling them for quick profits.
By Walter Hamilton and Alejandro Lazo
Los Angeles Times
August 20, 2010
Hoping there are big profits to be made in the aftermath of California's housing collapse, professional investors are flocking to the business of buying foreclosed homes at distressed prices.
The investors, primarily private equity funds and groups of wealthy individuals, purchase the homes at public auctions, which are held daily on the steps of local courthouses. They refurbish the properties and try to sell them for quick profits.
Not long ago, the typical home flipper was an amateur tapping a home equity line or savings for an investment property. But professionals have rushed in, partly because of sparse investment opportunities elsewhere.
There are huge differences between the amateur flipper of the bubble and the professional flipper of the bust. Amateurs used leverage to buy resale properties. Professionals use cash to buy auction properties. Amateurs made money because the frenzy drove prices higher. Professionals make money because they buy at a discount and resell at whatever price the market will bear. Amateurs can only make money when the market rallies. Professionals make money in any market where they can reasonably forecast prices 90 days out.
"In crisis there's opportunity," said Rick Hudson, president of investment firm Prosperity Group Real Estate in Irvine. "Right now there's huge opportunity with flipping houses."
Closely watched gauges of professional buying have surged over the last two years.
The number of homes sold at foreclosure auctions statewide increased to 4,336 in April, from 884 in January 2009, according to research firm ForeclosureRadar. It eased back to 3,483 in July as banks offered fewer properties for sale. The auctions are dominated by professional investors who shop with cash (although not usually with actual greenbacks, for practical reasons).
Another measure, the percentage of all homes sold to absentee buyers, paints a similar picture. In the hard-hit Inland Empire, for instance, 30% of all homes sold in April went to absentee buyers — up from 19% at the end of 2008 and the highest level in at least seven years, according to San Diego research firm MDA DataQuick. It was at 28.2% in July.
The binge of professional buying has helped spark a nascent housing recovery in Southern California because investors have cut significantly into the glut of foreclosed properties after the subprime mortgage meltdown.
Professional flippers have not stabilized the market. If anything, the continued activity of flippers adds more supply to the market and keeps appreciation in check. Auction flippers are merely a conduit between the two markets.
The main reason funds are forming to buy these properties is because there is a huge need for liquidity at the auction site. The banks have far too many delinquent borrowers, and there is not enough cash at the auction site to absorb the inventory of these foreclosures.
Banks gauge the liquidity at the site through dropped bids. Not every dropped bid gets purchased by an investor. It is quite common for a lender to drop their bid 20% below resale value and no third party steps forward to purchase the discounted property. When banks see their dropped bids are not being purchased, they don't bring more properties to auction because it will become another REO.
The reason you are seeing articles like this one is because the banks want more liquidity at the auction site. By telling the investment world about this opportunity through articles like this one, lenders hope more funds will form to absorb their massive shadow inventory.
Home sales in the six-county region rose 7.2% in June from May and 2.6% from a year earlier, according to MDA DataQuick. In July, overall sales tumbled primarily because of the expiration of federal tax credits, falling 20.6% from the month before in Los Angeles, Orange, Riverside, San Bernardino, San Diego and Ventura counties. But the region's median home price of $295,000 was off only 1.7% from June.
The fragile rebound in the broader market contrasts with the behind-the-scenes scramble at foreclosure auctions.
"There's a tremendous amount of capital that is desperate to just buy anything right now," said Gil Priel, principal of a real estate investment firm in Woodland Hills.
That is nonsense. This guy simply doesn't want other competitors at his auction site.
In some cases, well-financed newcomers are elbowing out smaller investors at auction sales.
"The people who want to go and buy a house to flip, and do one or two, are already exiting the market," said Jan Brzeski, who manages a residential investment fund at Standard Capital in Los Angeles.
That much is true: small investors are being crowded out.
I have watched the big fish at the Orange County auction site bid up small investors to prevent them from getting a good deal. The big fish didn't want these properties, but he reads the poker faces of the small investors and knows he can bid them higher. After one such incident, I heard him quip, "I would have taken the property." True enough, but he didn't want the property, he merely wanted the small investor not to make any money so he wouldn't come back and become a competitor.
The swarm of new investors, however, is making a treacherous and labor-intensive business even tougher.
Investors must do their homework on dozens of homes for every one they buy. Legal and other impediments usually prevent them from going into homes prior to buying them, leaving no way to gauge repair costs. And despite being foreclosed on, the original owners often still live in the houses. That forces buyers to pay them to leave, a dynamic known as cash-for-keys.
The influx of new players is pushing up auction prices and squeezing profits. The average discount at auctions — the difference between a home's sale price and its actual value — is 21.6%, down from 28% in January 2009, according to ForeclosureRadar.
Shall we shed a tear for the auction investor who only makes a 21.6% profit?
Last year, Chase Merritt, a Newport Beach private equity fund management firm, notched strong returns from auction sales, said Chad Horning, its chief executive. Chase Merritt bought a property in Costa Mesa in June 2009 for $315,500 and sold it 21/2 months later for $470,000. It bought a Mission Viejo home for $305,371 and sold it within two months for $375,000.
Chase Merritt launched its first foreclosure fund in May 2009 and has started two more funds since then. But "it's literally gone from a business that's very attractive, even lucrative, 12 to 18 months ago to something that almost doesn't make sense," Horning said.
"It's just like the housing bubble," he said. "It's almost like we're in a bubble at the courthouse steps."
Spoken like a man who doesn't want any more competitors…. Ask any auction buyer, and they will tell you that the margins are poor now compared to some past golden era. The truth is that margins are still pretty fat, and they want to keep them that way.
The scramble was on display recently at an auction at the Norwalk courthouse.
A semicircle of people crowded around auctioneer Elwood Brown. Most were clad in cargo shorts and flip-flops. A few sat in lawn chairs. But their laptops and cellphones, as well as the thousands of dollars' worth of cashier's checks they clutched, marked them as professional investors girding for battle.
Brown took a swig from his oversized water bottle and announced that bidding for a four-bedroom duplex in Hawthorne would start at $179,598.60.
The price shot up within seconds as two men and a woman raised one another's bids in $1,000 increments.
"It's at 229, Daryl," a man in a polo shirt and sunglasses whispered intently into his cellphone. "About to close. Do you want it?"
He increased his offer, but a rival bidder claimed the home a few seconds later for $237,000.
I have watched these guys on the phone at the auction site. I think they are crazy. Don't they know the most they are willing to pay in advance? Why would you be exercising discretion on the bid amount at the auction site? In my opinion, it is a recipe to overpay on emotion.
Competition at the auctions is brutal, said Bruce Norris of Norris Group, a real estate investment firm in Riverside.
Norris unwittingly bought a house that was the site of a gruesome double murder. No one else bid — a rare occurrence that showed others knew the history — leaving Norris with less cash to bid for other houses.
"It's a very lonely place out there," Norris said.
That's only one of many risks in the foreclosure business. People who've lost their homes through foreclosure sometimes vent their anger by smashing walls, knocking over water heaters or ripping out toilets.
"We've literally had people take $20,000 of cabinetry out and feel perfectly justified doing it," Norris said.
Aaron Norris stopped my on August 11, and relayed the following comment: "We’ve had to kick out the same “tenant” from two houses that we’ve purchased. Some will hop from house to house knowing they can draw up fake lease agreements and go for cash for keys."
They have seen everything.
The daily auction ritual begins each morning when banks signal which homes they are likely to dispose of that day. That sets off an early-hours scramble as would-be buyers speed through suburban neighborhoods to investigate the homes.
I have been asked on many occasions why banks don't announce their dropped bids in advance. It seems obvious that they would get more bids and a better recovery if they announced a dropped bid well in advance. I wish I had a good answer for that question. My guess is bureaucratic incompetence, but I honestly don't have a good answer. I do know that it costs them money, and it makes the job of finding deals much more difficult.
On a recent day, Norris steered his sport utility vehicle into the driveway of a 3,300-square-foot McMansion on a corner lot in Moreno Valley. The front lawn was brown and the backyard was littered with garbage. But the windows were intact and there was no visible damage — far better than many foreclosures.
Aiming for an all-important look inside, Norris rang the doorbell and delivered the bad news to the teenage boy who answered the door that the home was scheduled to be sold that day.
"Do you mind if I poke around a little bit to see what kind of condition it's in?" Norris asked, angling his body to get a glimpse of the living room.
Then another car sped up and a rival buyer hurried up the driveway. She studied the house for a few seconds and craned her neck over the wooden fence protecting the backyard.
"This is a dream compared to a lot of them," she said in a satisfied tone as she rushed back to her car.
In the end, no one bought the home. The sale was delayed after the owner filed for bankruptcy protection.
Norris was philosophical, knowing that there were plenty more foreclosures.
"If you miss one," he said, "oh well, tomorrow's another pile."
Yes, tomorrow's another pile. At our current rate of absorption, it will take another 18 months just to deal with the visible inventory and another 60 months to deal with the shadow inventory. The flipping funds will be busy for a while.
Private Placement Hedge Funds
The funds described in the article above are private placements, also known as hedge funds. These funds provide a mechanism for investors to pool their money to invest in opportunities that may be too large or too risky to purchase on their own. This makes them ideal for trustee sale flipping.
Smaller investors may have $25,000 to $100,000 available to invest, but with houses costing $200,000 or more, auction properties are out of their reach. However, if ten or more investors band together, they have sufficient buying power to be successful at auction. A wealthy individual takes significant risk investing in auction properties on their own. It is difficult to diversify into a large number of properties due to the high capital requirement. Pooling smaller investments into a large fund creates more investment opportunities and diversifies risks into a broader collection of properties.
Private Placements are typically open to what are termed "sophisticated" or "accredited" investors, and usually have some minimum threshold for investment. These aren't like mutual funds that take small contributions and are available to anyone.
Accredited investors are usually one of the following:
Either individually or with a spouse, a net worth (i.e., total assets in excess of total liabilities) currently exceeds $1,000,000;
A natural person who has an individual income in excess of $200,000, or $300,000 jointly with a spouse, in the last two years and reasonably expect an income in excess of $200,000, if an individual, or $300,000 if jointly with a spouse, in this year.
There are trusts and institutions that can also qualify as accredited investors.
Sophisticated investors are defined as:
not an accredited investor possessing such knowledge and experience in financial and business matters so as to be capable of evaluating the merits and risks of, and protecting personal interest in connection with investing in the Interests. The total investment in the Interest does not exceed 20% of the Investor’s net worth at the time of purchase of the Units (excluding personal residence(s), furnishings, and automobiles).
Private placements qualify under an exemption from SEC regulations, and as such, they must maintain fewer than 35 sophisticated investors to maintain their exemption. There is no limit to the number of accredited investors.
Private placements are limited to these special investment classes because they are risky. The SEC doesn't want to see grandma put her life's savings into a risky investment and lose it, so these regulations are designed to bar those who are not financially savvy from participating in them.
Expect to see more of these funds popping up over the next few years as the foreclosure crisis grinds on. There is a huge need for liquidity at the auctions, and hedge funds are just now starting to deliver the capital to where it is needed.
Renovation gone wrong
Today's featured property was the wrong project at the wrong time. The property was purchased near the peak on 3/21/2006 for $699,000. The owner used a $559,200 first mortgage, a $139,800 stand alone second, and a $0 down payment. No risk on his part.
The owner then formed an LLC and deeded the property to it. On 12/28/2006, he found a private party to loan him $1,000,000 to cover the original loan and renovation costs. Presumably the property renovation was complete at that time, but the bird's eye view shows the construction in progress, and based on the auction price, this renovation may have been only partially complete.
Recording Date: 01/19/2010
Document Type: Notice of Sale
Recording Date: 10/14/2009
Document Type: Notice of Default
According to ForeclosureRadar, this property sold for $400,727 at auction. If that is accurate, and if the property did not require major work to complete, the flipper is going to make a fortune. Since this auction was back in February, I suspect there was significant renovation work still to be completed.
The current asking price of $949,500 suggests this property is overbuilt for the neighborhood, but at $256/SF, it will likely find a buyer.
If you would like to learn how you can get involved with trustee sales, please contact me at email@example.com.
Irvine Home Address … 52 CAPE COD Irvine, CA 92620
Resale Home Price … $949,500
Home Purchase Price … $491,727
Home Purchase Date …. 2/9/2010
Net Gain (Loss) ………. $400,803
Percent Change ………. 81.5%
Annual Appreciation … 118.3%
Cost of Ownership
$949,500 ………. Asking Price
$189,900 ………. 20% Down Conventional
4.51% …………… Mortgage Interest Rate
$759,600 ………. 30-Year Mortgage
$185,784 ………. Income Requirement
$3,853 ………. Monthly Mortgage Payment
$823 ………. Property Tax
$0 ………. Special Taxes and Levies (Mello Roos)
$79 ………. Homeowners Insurance
$0 ………. Homeowners Association Fees
$4,755 ………. Monthly Cash Outlays
-$919 ………. Tax Savings (% of Interest and Property Tax)
-$998 ………. Equity Hidden in Payment
$318 ………. Lost Income to Down Payment (net of taxes)
$119 ………. Maintenance and Replacement Reserves
$3,274 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$9,495 ………. Furnishing and Move In @1%
$9,495 ………. Closing Costs @1%
$7,596 ………… Interest Points @1% of Loan
$189,900 ………. Down Payment
$216,486 ………. Total Cash Costs
$50,100 ………… Emergency Cash Reserves
$266,586 ………. Total Savings Needed
Baths: 3 full 1 part baths
Home size: 3,710 sq ft
($256 / sq ft)
Lot Size: 4,725 sq ft
Year Built: 2006
Days on Market: 42
Listing Updated: 40411
MLS Number: S624928
Property Type: Single Family, Residential
Fantastic custom home remodeled from the ground up! No Home Owner Association Dues! No Mello Roos! Located in the highly sought after, award winning Northwood High School District! Travertine and granite features accent the architectural beauty of this home. A gourmet kitchen offers new cabinetry with plenty of storage and a island. This open floor plan is perfect for entertaining while enjoying the ambiance of a fire in the fireplace on those cool evenings. This home has two master bedroom suites: a main floor master suite as well as another on the second floor with a private retreat and fireplace for those relaxing times. A walk-in closet and balcony overlooking a lovely, serene greenbelt are just two more of this home s special features! The second floor provides an open area perfect for study, den or media niche. The third floor offers a unique opportunity for the creative. . . a home theatre? a library? a music studio? or maybe a romantic hideaway?