With an understanding of the relationship between mortgage interest rates, capitalization rates and market rents, the cash value of real estate can be readily calculated. Today, I show you how.

Irvine Home Address … 1 WINTERSWEET Way Irvine, CA 92612

Resale Home Price …… $1,188,000

{book1}

I wanna be a billionaire so fricking bad

Buy all of the things I never had

Uh, I wanna be on the cover of Forbes magazine

Smiling next to Oprah and the Queen

I swear the world better prepare

For when I’m a billionaire

Travie McCoy — Billionaire

Most people purchase real estate in California because they believe they will get rich. Few want to spend money to provide a home for their family as most expect their home to provide money for the family. Houses are the new wage earners, not through rental cashflow but through appreciation. Life doesn't work that way. Real estate can be a profitable cashflow investment, and it can make people rich — not through speculation on buying and selling, but through owning for positive cashflow.

Cash value of real property

Establishing the cash value of real property requires an understanding of risk and relative rates of investment return. Today, we will review these basics and apply a little simple math to show how to value real estate based on its cashflow value.

Cashflow investment is very different than speculation. The value obtained from owning a cashflow investment does not come from the change in the assets resale price; the value comes from the cash the investment provides while it is owned. In contrast, a speculative investment derives its value from the change in resale price that presumably goes up. Sometimes speculative investments provide cashflow, but in the case of California real estate, speculative investments often have a strongly negative cashflow because people over pay and over leverage themselves in order to speculate.

Since a cashflow investment relies on positive cashflow to derive value, the investment is best analyzed with an assumed permanent holding period. Appreciation or depreciation is not considered as it is not important to the investment's performance. Potential changes in asset value may be important if the investor needs to liquidate for other reasons, but a resale value at a later date is not a major consideration in analyzing the investment.

Also, since a cashflow investment needs positive cashflow to warrant consideration, the investment must perform immediately upon purchase. Once cashflow investors begin projecting future increases in rents to justify a purchase price, they are entering the fantasy world of speculation and failing to make a wise cashflow investment decision. Nearly everyone in California looks at property in this foolish way.

To properly analyze a rental real estate investment, the property must provide a minimum return in the first year of ownership without regard to future resale value. If rosy projections of the future occur, that is a bonus; if they don't the investment is still likely to perform as planned. That is low-risk investing.

Equity and Debt

If you analyze nearly any property in coastal California, the capitalization rate (the measure of cash return) is very low, generally between 3% and 4%. With mortgage interest rates at 5%, such low capitalization rates are unwarranted. Why would anyone want to earn 3% in an equity position when they could invest in mortgage debt an earn 5%? Most do this because they expect rapid appreciation.

Equity should trade at a premium to debt. Just as a second mortgage carries a higher interest rate than a first mortgage, equity should carry a higher cap rate than debt because equity is a subordinate claim to real estate. Landlords must pay the mortgage before they pay themselves. If the mortgage is greater than the rent, the landlord loses money. Similarly, if the landlord sells a rental property, the debt is paid first, and any remainder is paid to the landlord. Given the subordinate position and the associated risk, smart equity demands a premium for subordination. One of the surest signs of overvalued real estate is cap rates that are lower than mortgage interest rates.

Of course, California speculators do not see it this way. Fools believe prices rise very quickly and go up forever, and they see debt as a tool that positions them to capture this appreciation. It works well during market rallies, but it is devastating when prices crumble — and prices do crumble because appreciation in excess of wage growth is not sustainable. Speculators chasing the dream of appreciation pay too much for real estate, and in doing so, they push cap rates down well below the cost of debt.

Advantages of equity

There are two main advantages of taking an equity position in real estate versus a debt position:

1. Equity returns are perpetual because it is ownership. Debt can be paid off and retired whereas equity can be kept forever and passed on through multiple generations.
2. Equity returns rise as rents increase with wage inflation whereas prudent debt is fixed. Adjustable rate debt may go up or down with interest rates, but it will never see steady growth like an equity position.

California speculators believe these advantages warrant paying a large premium to own real estate; however, overpaying for real estate reduces the return and negates much of the advantage of ownership. Premiums are not infinite.

The equity premium

When I say that equity carries a premium to debt, it is easy to get confused about what that means for pricing. For capitalization rates to exceed the cost of debt, prices must be low. Obtaining an equity premium means paying less for a property, not paying more. The relationship between the amount invested and the return on that investment is inverse; In other words, the more you pay, the worse your return and the lower your cap rate.

As a general rule, equity should trade at a 20% to 40% premium to debt. For instance, at 5% interest rates, capitalization rates should be between 6% and 7%:

5% x 120% = 6%

5% x 140% = 7%

Last week I profiled a cashflow property in Corona. The capitalization rate exceeded the mortgage interest rate and fell within the parameters listed above. That property is an excellent cashflow investment.

Cash value of real estate based on mortgage interest rates and monthly rent

Based on the relationship between debt and equity explained above, it is possible to produce a simple spreadsheet that relates mortgage interest rates and monthly debt to arrive at a properties cashflow value.

The table below is loaded with information. The two assumptions are the expense ratio which is how much of the income goes toward taxes, insurance, upkeep, and other expenses, and the other assumption is the equity premium I described above.

The first four lines show the calculation of net operating income from monthly rent. I have selected rents showing a range typical across properties here in Irvine. The columns to the right show the capitalization rate based on the mortgage rate as I described above.

The table itself shows the resulting cashflow value when you divide net operating income by the capitalization rate.

I imagine many who view these numbers in Irvine think they are rather quaint but completely meaningless. However, when you look at properties where values are not inflated — like the property in Corona — the numbers illustrate a basic truth about bottoming values in a real estate market. Once the equity premium over debt reaches a viable threshold, money is attracted to a market and prices are stabilized. Large swaths of Riverside County, most of Las Vegas, and much of the Phoenix markets are at prices consistent with positive cashflow valuations. In short, they are as cheap as they need to be for cashflow investors to come in an clean up the mess.

This doesn't mean we are at the bottom in some of these markets because the huge supply of current and future foreclosures will continue to put pressure on prices, but cashflow investors will buy anyway because to them, if prices fall more, it is more reason to buy. Cashflow opportunities as good as what is currently available in Las Vegas are very rare, and cashflow investors are buying everything available.

I am very bullish on Las Vegas, not because prices will rise any time soon, but because prices are very attractive on a cashflow basis.

Today's featured property

Today's featured property clearly illustrates how clueless speculators are to cashflow values here in Irvine. The property is being marketed as a cashflow property. It is occupied by 6 students.

First, I believe marketing this property as a multi-family property in a single family neighborhood is against code, and since this property is in my neighborhood, I plan to forward this listing to code enforcement and see if they will do something about it.

Second, for this property to be worth almost $1.2M, these six students must be paying a combined $12,000 a month rent. I would be surprised if they pay half that amount. It would take a very foolish investor to pay double the cashflow value for a property that is not zoned for the occupation necessary to obtain the value. On a cashflow basis, this property is not worth what the owner paid for it, yet this guy plans to make almost $500K. If buyers in Irvine are that stupid, everyone should quit their jobs and start doing illegal rental conversions.

This is one of the dumbest ideas I have seen. Perhaps the guys who remodeled the monstrosity at 2 Angell can go this route to get out from under their albatross. If this guy gets $1.2M, anything is possible.

Irvine Home Address … 1 WINTERSWEET Way Irvine, CA 92612

Resale Home Price … $1,188,000

Home Purchase Price … $700,000

Home Purchase Date …. 4/25/2009

Net Gain (Loss) ………. $416,720

Percent Change ………. 69.7%

Annual Appreciation … 49.8%

Cost of Ownership

————————————————-

$1,188,000 ………. Asking Price

$237,600 ………. 20% Down Conventional

5.07% …………… Mortgage Interest Rate

$950,400 ………. 30-Year Mortgage

$247,951 ………. Income Requirement

$5,143 ………. Monthly Mortgage Payment

$1030 ………. Property Tax

$0 ………. Special Taxes and Levies (Mello Roos)

$99 ………. Homeowners Insurance

$180 ………. Homeowners Association Fees

============================================

$6,451 ………. Monthly Cash Outlays

-$1413 ………. Tax Savings (% of Interest and Property Tax)

-$1127 ………. Equity Hidden in Payment

$471 ………. Lost Income to Down Payment (net of taxes)

$149 ………. Maintenance and Replacement Reserves

============================================

$4,531 ………. Monthly Cost of Ownership

Cash Acquisition Demands

——————————————————————————

$11,880 ………. Furnishing and Move In @1%

$11,880 ………. Closing Costs @1%

$9,504 ………… Interest Points @1% of Loan

$237,600 ………. Down Payment

============================================

$270,864 ………. Total Cash Costs

$69,400 ………… Emergency Cash Reserves

============================================

$340,264 ………. Total Savings Needed

Property Details for 1 WINTERSWEET Way Irvine, CA 92612

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Beds: 4

Baths: 2 full 1 part baths

Home size: 2,500 sq ft

($475 / sq ft)

Lot Size: 3,840 sq ft

Year Built: 1966

Days on Market: 15

Listing Updated: 40291

MLS Number: H10044068

Property Type: Single Family, Residential

Tract: Shdc

——————————————————————————

6 suites fully rented to UCI students. Beautiful home in the heart of Irvine University Park is surrounded by acres of parks, trees, and greenbelt – a tremendous health benefit for residents. Corner lot in a cul-de-sac. Total living area 3327 sq ft. profile only shows 2500 sq ft. Previous owner added 549 sq ft and current owner added 278 sq ft (both has permits please verify with city). Major remolded on 2008 likes new house. Owner occupy or investment.

Lenders have limited options for dealing with delinquency. So far lenders are holding current price levels by keeping properties from the market.

Irvine Home Address … 7 Capobella Irvine, CA 92614

Resale Home Price …… $675,000

{book1}

Ring, ring, ring goes the telephone

The lights are on but there's no-one home

Tick tick tock it's a quarter to two

And I'm done

I'm hangin' up on you

I can't keep on waiting for you

I know that you're still hesitating

Don't cry for me

'cause I'll find my way

You'll wake up one day

But it'll be too late

Madonna — Hung Up

Borrowers are done paying, and their hanging up on lenders. The lenders are still hesitating, waiting for borrowers to pay. Lenders will wake up one day and start the foreclosure process in earnest. Will it be too late?

The Lender Decision Tree

When lenders make loans, they far prefer borrowers to repay those loans; in fact, their entire business plan relies on it. As long as borrowers are current with their payments, lenders are happy and making money. When borrowers don't make their payments, the end result is a distressed sale. If there are enough of these, market prices are reduced dramatically which causes significant lender losses.

Below is the lender decision tree for delinquent borrowers. Today we will explore this diagram in some detail and discuss the ramifications of the decisions lenders make.

Loan Modifications

Once a borrower stops paying on the loan, the first step in the process is to attempt a loan modification. Many borrowers are using this step as a place to game the system for more time in the property. If the loan modification is successful, then the borrower is made current and everyone is happy. Very few loan modfications are successful mostly because it isn't in a borrower's best financial interest to get temporary relief and sustain the huge debt. Loan modifications are the first step in the amend-pretend-extend dance.

Short Sale

The next option is a short sale. This process generally goes nowhere because Banks Refuse to Recognize HELOC and Second Mortgage Losses. To give a sense of scale of this problem, consider this: "Together with Citigroup the banks hold about 42 percent of the $1.1 trillion in second-home liens. Unlike first mortgages, they are typically not bundled and sold off to investors but kept on the banks' books. The biggest home-equity lender in the U.S. is Bank of America, holding some $138 billion in such loans. Wells Fargo has about $123.8 billion of home-equity loans." These loans are all going to go bad, and it will decimate the banking industry when these losses are finally recognized.

Short sales are not going to be the final resolution of this problem for one main reason: many distressed sellers do not bother to attempt a short sale. First, for those with non-recourse loans, they are foolish to attempt a short sale because buried in the terms of the sale is the abandonment of their non-recourse status. Plus, why would they go through the hassle? The magnitude of the loss doesn't impact the borrower, so there is little incentive for them to participate in the short sale process. Once they decide they are not going to sell and obtain any equity, most people stop paying and stop responding to lender inquiries. If borrowers don't care enough about the property to communicate with the bank, they certainly are not going to get involved in a short sale process.

If a short sale does go through, it is still a distressed sale. It is a sale that probably would not be occurring in the market if the borrower were not in distress. These should be inventory added to the organic inventory of people moving for other reasons. One of the side effects of having 11.2 million properties underwater is that about 25% of our organic sales inventory is removed from the market. People are trapped in their homes.

Squatting and shadow inventory

Once loan modifications and short sales have failed, the only options available to lenders are within the foreclosure process. At this point, borrowers are not making payments, and contractually, lenders have the right to force the sale of the property at public auction. Prior to the Great Housing Bubble, it was inconceivable that lenders would allow borrowers to squat in houses once it became obvious they were not going to repay the loan. Now that over 10% of loans in the United States are delinquent, lender are overwhelmed by the volume. And since lenders know that foreclosing on all those people will cause them catastrophic losses on their second-home lien portfolios in addition to crushing home prices, they are choosing not to do anything. More than one-third of all delinquent borrowers have been delinquent for more than a year. Squatters are everywhere.

The reason lenders are allowing widespread squatting are twofold:

1. Lenders hope that people in this category will cure their loans with a loan modification. Nobody believes this is the cure to the problem, not even the lenders.
2. The government benefits by having fewer homeless and no rioting in the streets. The twenty-first century's version of squatter's rights is allowing delinquent homeowners to stay in their homes. It prevents Hoovervilles and provides significant economic stimulus through the temporary elimination of housing expenses. Too bad it totally screws renters who don't enjoy such benefits.

Shadow inventory is foreclosure's purgatory. It prepares delinquent borrowers for the singularity of trustee sale.

Pre-Foreclosure Inventory

Once lenders finally serve notice on the squatters, these properties show up as pre-foreclosure inventory and we can see them on ForeclosureRadar.com. Although the amend-pretend-extend dance is primarily keeping people in shadow inventory, a huge number of properties are bottlenecking in pre-foreclosure.

We have been watching the foreclosure market very closely. Ordinarily, very little inventory exists here because once the process is started, it tends to move forward in an orderly process and is resolved in about five months. Not anymore.

I took a survey of properties scheduled for sale during the first four months of 2010. The dancing is evident. Over 50% of scheduled trustee sales are postponed, some of them are postponed many times. Over 25% are cancelled, presumably due to a loan modification. This is the outcome lenders are dancing to obtain. Less than 25% go to auction on any given day with lenders taking 10% to 15% and third parties getting 5% to 10%. It is the postponements that are most telling.

An IHB reader has contacted me about a property that has been scheduled for trustee sale for over six months. Every two weeks, the sale is postponed for another two weeks. The first mortgage on this property has not been paid since 2008, and the borrower is making no effort to pay. The one and only reason for this postponement is because the lender is unwilling to take the loss. This is happening all over, and the postponement numbers above are testament to this phenomenon.

Unfortunately, due to the endless postponements, we have been unable to put any owner-occupants into any foreclosure properties. For any given property, there is a 93% chance that the auction will be postponed, canceled, or sold back to the bank. This makes a nearly impossible environment to work with families. We will let everyone know when this changes, but for now, that is what we are up against in the foreclosure market. The dance goes on for the sake of those cancellations as lenders hope those loan modifications are successful. Most end up re-defaulting and accumulate in shadow inventory or back here on the path to foreclosure.

Keep in mind that these pre-foreclosure inventory numbers are the visible inventory. Shadow inventory is four times as large.

Limited Inventory

On any given day, less than 25% is released to the public. The effect is to restrict local inventories and cause competition among would-be buyers. Ask anyone active in the market today, and they will tell you that the competition is fierce because so little of the MLS inventory can actually transact. The few reasonably priced properties usually offered by lender REO departments get much attention. Buyers often have to bid over ask and accept onerous terms. Many sellers offer at WTF prices nobody can afford, so they are effectively out of the market. Many properties are short sales that linger for months with twenty offers waiting for the second lien holder to accept a loss. When it doesn't happen, the property heads to foreclosure.

The effect of these conditions is to create limited inventory for the lenders to sell their own properties at inflated prices. If inventory is restricted enough, lenders capture the most motivated buyers. That is the way monopolies, oligopolies and cartels operate. Unfortunately, since this is a cartel, and since there is a huge shadow inventory, each cartel member gains advantage over the others by releasing more inventory. Once the administrative roadblocks are removed, we should see more inventory that moves from shadow inventory to visible inventory and finally through foreclosure and on to the market.

Until the spigot of inventory is opened wider, the flow of properties will be slow, prices will remain inflated, and shadow inventory and squatting will continue unabated. The Ponzis inflated house prices with their quest for appreciation income, and now inflated prices are supported by allowing the Ponzis to squat in their castles of debt. What was the Ponzi economy is now the squatter economy.

Doubling the mortgage

Many Irvine home owners doubled their mortgage during the housing bubble. With free money readily available, many took it, and now they are losing their homes.

• Today's featured property was purchased on 4/21/1999 for $338,000. The owner used a $270,400 first mortgage and a $67,600 down payment.
• On 10/17/2000 he opened a HELOC for $55,000.
• On 9/4/2001 he refinanced with a $275,000 first mortgage and a $150,000 HELOC which he didn't use.
• On 2/1/2002 he refinanced the first mortgage for $286,500.
• On 10/4/2002 he refinanced with a $400,000 first mortgage and obtained a HELOC of $50,000.
• On 9/9/2003 he refinanced with Countrywide and got a $408,000 first mortgage and a $50,000 HELOC.
• On 4/22/2004 he refinanced with a $420,000 first mortgage.
• On 1/10/2006 he refinanced with a $525,000 Option ARM with a 1% teaser rate and obtained a $100,000 HELOC.
• Total property debt is $625,000
• Total mortgage equity withdrawal is $354,600.
• Total squatting time is at least 18 months.

Foreclosure Record

Recording Date: 08/07/2009

Document Type: Notice of Sale

Foreclosure Record

Recording Date: 03/17/2009

Document Type: Notice of Default

Irvine Home Address … 7 Capobella Irvine, CA 92614

Resale Home Price … $675,000

Home Purchase Price … $338,000

Home Purchase Date …. 4/21/1999

Net Gain (Loss) ………. $296,500

Percent Change ………. 99.7%

Annual Appreciation … 5.9%

Cost of Ownership

————————————————-

$675,000 ………. Asking Price

$135,000 ………. 20% Down Conventional

5.07% …………… Mortgage Interest Rate

$540,000 ………. 30-Year Mortgage

$140,881 ………. Income Requirement

$2,922 ………. Monthly Mortgage Payment

$585 ………. Property Tax

$67 ………. Special Taxes and Levies (Mello Roos)

$56 ………. Homeowners Insurance

$42 ………. Homeowners Association Fees

============================================

$3,672 ………. Monthly Cash Outlays

-$717 ………. Tax Savings (% of Interest and Property Tax)

-$640 ………. Equity Hidden in Payment

$268 ………. Lost Income to Down Payment (net of taxes)

$84 ………. Maintenance and Replacement Reserves

============================================

$2,667 ………. Monthly Cost of Ownership

Cash Acquisition Demands

——————————————————————————

$6,750 ………. Furnishing and Move In @1%

$6,750 ………. Closing Costs @1%

$5,400 ………… Interest Points @1% of Loan

$135,000 ………. Down Payment

============================================

$153,900 ………. Total Cash Costs

$40,800 ………… Emergency Cash Reserves

============================================

$194,700 ………. Total Savings Needed

Property Details for 7 Capobella Irvine, CA 92614

——————————————————————————

Beds:: 3

Baths:: 0002

Sq. Ft.:: 1908

$0,354

Lot Size:: 3,586 Sq. Ft.

Property Type:: Single Family Residential Detached

Stories:: 2

Year Built:: 1987

Community:: Biltmore

County:: Orange

On Redfin:: 237 days

——————————————————————————

As of 15th of March, 2010 this is a short sale. Subject to lender(s) approval of short sale. Upgrade home in Westpark in Irvine CA. This a lovely 2 story home with 3 bedrooms, 2.5 baths and 2 car garage. Tiled floors downstairs, fireplace, kitchen with TV room, refinished cabinets, granite counters and more. Call agent for details.

If you missed the 60 Minutes story on strategic default, you can find it here.

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