Investing In Real Estate
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Praise for Gary Eldred
“Donald Trump and I have created Trump University to offer the
highest quality, success-driven education available. Our one goal is to
help professionals build their careers, businesses, and wealth. That’s
why we selected Gary Eldred to help us develop our first courses in
real estate investing. His books stand out for their knowledge-packed
content and success-driven advice.”
—Michael W. Sexton, CEO
Trump University
“Gary has established himself as a wise and insightful real estate
author. His teachings educate and inspire.”
—Mark Victor Hansen, Coauthor,
Chicken Soup for the Soul
“I just finished reading your book, Investing in Real Estate, Fourth Edi-
tion. This is the best real estate investment book that I have read so far.
Thanks for sharing your knowledge about real estate investment.”
—Gwan Kang
“I really enjoyed your book, Investing in Real Estate. I believe it’s one
of the most well-written books on real estate investing currently on
the market.”
—Josh Lowry
Bellevue, WA
President of Lowry Properties
“I just purchased about $140 worth of books on real estate and yours
is the first one I finished reading because of the high reviews it got.
I certainly wasn’t let down. Your book has shed light on so many
things that I didn’t even consider. Your writing style is excellent.
Thanks again.”
—Rick Reumann
“I am currently enjoying and learning a lot from your book, Investing
in Real Estate. Indeed it’s a powerful book.”
—Douglas M. Mutavi
“Thanks so much for your valuable book. I read it cover to cover.
I’m a tough audience, but you’ve made a fan here. Your writing is
coherent, simple, and clean. You are generous to offer the benefits of
your years of experience to those starting out in this venture.”
—Lara Ewing
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INVESTING
in
Sixth Edition
GARY W. ELDRED,PhD
John Wiley & Sons, Inc.
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Copyright
C
2009 by Gary W. Eldred, PhD. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
No part of this publication may be reproduced, stored in a retrieval system, or
transmitted in any form or by any means, electronic, mechanical, photocopying,
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Library of Congress Cataloging-in-Publication Data:
Eldred, Gary W.
Investing in real estate / Gary W. Eldred.—6th ed.
p. cm.
Includes index.
Rev. ed. of: Investing in real estate / Andrew J. McLean and Gary W. Eldred.
5th ed. 2006.
ISBN 978-0-470-49926-9
1. Real estate investment—United States. I. McLean, Andrew James.
Investing in real estate. II. Title.
HD255.M374 2009
332.63
24—dc22
2009023124
Printed in the United States of America.
10987654321
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CONTENTS
Prologue: Invest in Real Estate Now! xix
Acknowledgments xxvii
1 WHY INVESTING IN REAL ESTATE PROVIDES
YOU THE BEST ROUTE TO A PROSPEROUS
FUTURE 1
22 Sources of Returns from Investment Property 3
Will the Property Experience Price Gains from Appreciation? 4
Will You Gain Price Increases from Inflation? 5
Earn Good Returns from Cash Flows 6
Magnify Your Price Gains with Leverage 6
Magnify Returns from Cash Flows with Leverage 7
Build Wealth through Amortization 7
Over Time, Returns from Rents Go Up 8
Refinance to Increase Cash Flows 9
Refinance to Pocket Cash 10
Buy at a Below-Market Price 10
Sell at an Above-Market-Value Price 10
Create Property Value Through Smarter Management 11
Create Value with a Savvy Market Strategy 11
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Create Value: Improve the Location 12
Convert from Unit Rentals to Unit Ownership 12
Convert from Lower-Value Use to Higher-Value Use 12
Subdivide Your Bundle of Property Rights 13
Subdivide the Physical Property (Space) 14
Create Plottage (or Assemblage) Value 14
Obtain Development/Redevelopment Rights 15
Tax Shelter Your Property Income and Capital Gains 15
Diversify Away from Financial Assets 16
Is Property Always Best? 16
2 FINANCING: BORROW SMART, BUILD WEALTH 18
The Birth of “Nothing Down” 18
Should You Invest with Little or No Cash or Credit? 19
What’s Wrong with “No Cash, No Credit, No Problem”? 20
Leverage: Pros and Cons 22
What Are Your Risk-Return Objectives? 27
Maximize Leverage with Owner-Occupancy Financing 28
Owner-Occupied Buying Strategies 28
Current Homeowners, Too, Can Use This Method 29
Why One Year? 29
Where Can You Find High-LTV Owner-Occupied
Mortgages? 30
What Are the Loan Limits? 30
High Leverage for Investor-Owner Financing 32
High Leverage versus Low (or No) Down Payment 32
Creative Finance Revisited 32
Are High-Leverage Creative-Finance Deals Really Possible? 38
What Underwriting Standards Do Lenders Apply? 39
Collateral 40
Loan-to-Value Ratios 40
Recourse to Other Assets/Income 41
Amount and Source of Down Payment and Reserves 41
Capacity (Monthly Income) 42
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CONTENTS vii
Credit History (Credibility!) 43
Character and Competency 44
Compensating Factors 45
Automated Underwriting (AUS) 46
3 APPRAISAL: HOW TO DISCOVER GOOD VALUE 47
Make Money When You Buy, Not Just When You Sell 48
What Is Market Value? 48
Sales Price Doesn’t Necessarily Equal Market Value 49
Sound Underwriting Requires Lenders to Loan Only
Against Market Value 50
How to Estimate Market Value 51
Property Description 52
Identify the Subject Property 52
Neighborhood 52
Site (Lot) Characteristics 59
Improvements 60
The Cost Approach 61
Calculate Cost to Build New 61
Deduct Depreciation 61
Lot Value 62
Estimate Market Value (Cost Approach) 63
The Comparable Sales Approach 64
Select Comparable Properties 64
Approximate Value Range—Subject Property 65
Adjust for Differences 65
Explain the Adjustments 66
The Income Approach 67
Income Capitalization 69
Net Operating Income 69
Estimate Capitalization Rates (R) 72
Compare Cap Rates 72
The Paradox of Risk and Appreciation Potential 73
Compare Relative Prices and Values 74
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viii CONTENTS
Valuation Methods: Summing Up 74
Appraisal Limiting Conditions 75
Valuation versus Investment Analysis 76
4 MAXIMIZE CASH FLOWS AND GROW
YOUR EQUITY 77
Will the Property Yield Good Cash Flows? 77
Arrange Alternative Terms of Financing 79
Decrease (or Increase) Your Down Payment 80
Buy at a Bargain Price 82
Should You Ever Pay More than Market Value for a
Property? 83
The Debt Coverage Ratio 84
Numbers Change, Principles Remain 85
Will the Property Yield Profitable Increases in Price? 85
Low-Involvement versus High-Involvement Investing 86
Compare Relative Prices of Neighborhoods (Cities) 87
Undervalued Neighborhoods and Cities 88
Beverly Hills versus Watts (South Central Los Angeles) 88
Demographics 89
Accessibility (Convenience) 90
Improved (Increased) Transportation Routes 90
Jobs 91
Taxes, Services, and Fiscal Solvency 91
New Construction, Renovation, and Remodeling 91
Land-Use Laws 92
Pride of Place 93
Sales and Rental Trends 93
Summing Up 95
5 HOW TO FIND BARGAIN-PRICED PROPERTIES 96
Why Properties Sell for Less (or More) Than Market Value 96
Owners in Distress 97
The “Grass-Is-Greener” Sellers 97
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CONTENTS ix
Stage-of-Life Sellers 98
Seller Ignorance 99
Prepare Screening Criteria 100
Bargain Sellers 101
Networking/Get the Word Out 102
Newspapers and Other Publications 102
Cold Call Owners 103
Agent Services 105
Internet Listings 107
Seller Disclosures 107
The Disclosure Revolution 108
Income Properties 108
Summary 109
6 PROFIT WITH FORECLOSURES 110
The Foreclosure Process 110
Lender Tries to Resolve Problem 111
Filing Legal Notice 111
The Foreclosure Sale 112
REOs 112
Buy Preforeclosures from Distressed Owners 112
Approach Owners with Empathy 113
The Difficulties of Dealing Profitably with Owners in
Default 113
Prequalify Homeowners and Properties 115
Finding Homeowners in Default (Prefiling) 117
Networking 117
Mortgage Collections Personnel 117
Drive Neighborhoods 117
Find Homeowners (Postfiling) 118
Cultivate a Relationship with Property Owners 118
Two More Issues 119
Vacant Houses 120
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Satisfy Lenders and Lien Holders 121
All Parties Are Better Off 123
Win by Losing Less 123
Profit from the Foreclosure Auction 124
Why Foreclosures Sell for Less than Market Value 124
Make the Adverse Sales Efforts Work for You 125
How to Arrange Financing 126
The Foreclosure Sale: Summing Up 127
7 PROFIT FROM REOs AND OTHER
BARGAIN SALES 128
Bad News For Sellers/Builders, Good News For You 128
How to Find REOs 129
Follow Up with Lenders after Foreclosure Sales 129
Locate Specialty Realtors 130
HUD Homes and Other HUD Properties 131
Homeowners versus Investors 132
“As-Is” Condition 132
Potential Conflict of Interest 133
Buyer Incentives 133
The Bid Package 134
Department of Veterans Affairs (REOs) 134
Big Advantages for Investors 135
Fannie Mae and Freddie Mac REOs 136
Agent Listings 136
Investors Invited 137
Federal Government Auctions 137
Buy from Foreclosure Speculators 138
Probate and Estate Sales 138
Probate 138
Estate Sales 139
Private Auctions 139
How to Find Auctions 141
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8 QUICK PROFITS THROUGH FIX AND FLIP 142
Fix, Flip, Profit! 142
Look for “Fixers” 143
The Browns Create Value in a Down Market 144
Research, Research, Research 145
Improvement Possibilities 146
Thoroughly Clean the Property 146
Add Pizzazz with Color Schemes, Decorating Patterns,
and Fixtures 147
Create Usable Space 147
Create a View 148
Capitalize on Owner Nearsightedness 148
Eliminate a Negative View 149
Enhance the Unit’s Natural Light 149
Reduce Noise 150
Required Repairs and Improvements 150
Plumbing 151
Electrical System 151
Heating and Air-Conditioning 151
Windows 152
Appliances 152
Walls and Ceilings 152
Doors and Locks 152
Landscaping 152
Storage Areas 153
Clean Well 153
Safety and Health 153
Roofs 153
Improvements and Alterations 154
You Can Improve Everything about a Property—Including
Its Location 154
The South Beach Example: From Derelicts to Fashion
Models 154
Community Action and Community Spirit Make a
Difference 155
Neighborhoods Offer Potential 156
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What Types of Improvements Pay the Greatest Returns? 157
How Much Should You Budget for Improvements? 157
Beware of Overimprovement 158
Other Benefits 158
No-No Improvements 159
Budgeting for Resale Profits 159
Estimate the Sales Price First 159
Estimate Costs 160
Future Sales Price Less Costs and Profit Equals
Acquisition Price 160
Comply with Laws and Regulations 162
Should You Buy a “Fixer”? 162
Too Little Time? 163
Put Your Creativity to Work 163
9 MORE TECHNIQUES FOR HIGH YIELDS
AND QUICK PROFITS 165
Lease Options 165
Here’s How Lease Options Work 165
Benefits to Tenant-Buyers (An Eager Market) 166
Benefits to Investors 167
The Lease Option Sandwich 168
How to Find Lease Option Buyers and Sellers 169
A Creative Beginning with Lease Options
(for Investors) 170
Lease Purchase Agreements 170
“Seems” More Definite 171
Amount of the Earnest Money Deposit 171
Contingency Clauses 171
Conversions 172
Condominium Conversion 172
Tenants in Common 174
Convert Apartments to Office Space 175
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Master Leases 176
Assignments: Flipping Purchase Contracts 178
Summary 179
10 NEGOTIATE A WIN-WIN AGREEMENT 180
Win-Win Principles 181
The Purchase Contract 183
Names of the Parties 184
Site Description 184
Building Description 184
Personal Property 185
Price and Financing 185
Earnest Money Deposit 186
Quality of Title 187
Property Condition 187
Preclosing Property Damage (Casualty Clause) 188
Closing (Settlement) Costs 189
Closing and Possession Dates 189
Leases 190
Contingency Clauses 191
Assignment and Inspection 192
Public Records 193
Systems and Appliances 193
Environmental Hazards 193
No Representations 194
Default Clause 194
Summary 197
11 MANAGE YOUR PROPERTIES TO INCREASE
THEIR VALUE 199
The 10:1 Rule (More or Less) 199
Think First 200
Know Yourself 201
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xiv CONTENTS
Know Your Finances 201
Know Your Capabilities 202
Smart Strategic Decisions 202
Local Markets Require Tailored Strategies 203
Craig Wilson’s Profit-Boosting Market Strategy 203
How Craig Wilson Used Market Information to Enhance
the Profitability of His Property 206
Results 210
Cut Operating Expenses 210
Energy Audits 210
Property Insurance 211
Maintenance and Repair Costs 214
Property Taxes and Income Taxes 214
Increasing Value: Final Words 215
12 DEVELOP THE BEST LEASE 216
The Mythical “Standard” Lease 216
Your Market Strategy 216
Search for Competitive Advantage 218
Craft Your Rental Agreement 219
Names and Signatures 219
Joint and Several Liability 219
Guests 220
Length of Tenancy 220
Holdover Tenants (Mutual Agreement) 220
Holdover Tenants (without Permission) 221
Property Description 221
Inventory and Describe Personal Property 221
Rental Amounts 222
Late Fees and Discounts 222
Multiple Late Payments 222
Bounced Check Fees and Termination 223
Tenant “Improvements” 223
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Owner Access 223
Quiet Enjoyment 224
Noxious Odors 224
Disturbing External Influences 224
Tenant Insurance 225
Sublet and Assignment 225
Pets 226
Security Deposits 226
Yard Care 228
Parking, Number, and Type of Vehicles 228
Repairs 228
Roaches, Fleas, Ants 229
Neat and Clean 229
Rules and Regulations 229
Wear and Tear 230
Lawful Use of Premises 230
Notice 230
Failure to Deliver 231
Utilities, Property Taxes, Association Fees 231
Liquid-Filled Furniture 231
Abandonment of Property 232
Non-waivers 232
Breach of Lease (or House Rules) 232
No Representations (Full Agreement) 233
Arbitration 233
Attorney Fees (Who Pays?) 234
Written Notice to Remedy 235
Tenants Rights Laws 235
Tenant Selection 235
Property Operations 237
Evictions 237
Landlording: Pros and Cons 238
Possibilities, Not Probabilities 238
Professional Property Managers 238
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13 CREATE SALES PROMOTIONS THAT
REALLY SELL 240
Design a Winning Value Proposition 240
Yet Generic Prevails 240
USP versus WVP 241
Craft Your Selling Message 243
Use a Grabber Headline/Lead 244
Reinforce and Elaborate 244
Add Hot Buttons 244
Establish Credibility 245
Compare to Substitutes 245
Evoke Emotional Appeal 245
Reduce Perceived Risks 245
Make It Easy for Prospects to Respond 245
Follow Up with Your Prospects 247
Reach Potential Buyers 247
For Sale Signs 247
Flyers/Brochures 248
Networking (Word of Mouth) 249
Web Sites/Links 249
Sales Agents 249
Should You Employ a Realty Agent? 249
Services to Sellers 250
Services to Buyers 251
Co-Op Sales 252
Listing Contracts 252
14 PAY LESS TAX 255
The Risks of Change and Complexity 255
Homeowner Tax Savings 256
Capital Gains without Taxes 256
Rules for Vacation Homes 257
Mortgage Interest Deductions 258
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Credit Card Interest 258
Rules for Your Home Office 259
Depreciation Expense 259
Land Value Is Not Depreciable 259
Land Values Vary Widely 260
After-Tax Cash Flows 260
Passive Loss Rules 261
Taxpayers in the Real Property Business (No Passive
Loss Rules) 262
Alternative Minimum Tax 262
Capital Gains 263
A Simplified Example 263
The Installment Sale 264
What’s the Bottom Line for Sellers? 265
Implications for Buyers 265
Tax-Free Exchanges 265
Exchanges Don’t Necessarily Involve Two-Way Trades 266
The Three-Party Exchange 266
Exchanges Are Complex but Easy 266
Are Tax-Free Exchanges Really Tax Free? 268
Section 1031 Exchange Rules 268
Reporting Rental Income and Deductions 269
Tax Credits 271
Complexity, Tax Returns, and Audits 272
Use a Tax Pro 275
Property Taxes 276
Summary 278
15 MORE IDEAS FOR PROFITABLE INVESTING 280
Lower-Priced Areas 281
What about Property Management? 283
Tenant-Assisted Management 283
Property Management Companies 283
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Emerging Growth Areas 284
The Creative Class 284
Implications for Investing in Real Estate 284
Right Place, Right Time 285
Emerging Retirement/Second-Home Areas 285
Which Cities and Areas? 286
Income Investing 286
Commercial Properties 286
Property Management 287
The Upside and Downside 287
Opportunity for High Reward 287
Commercial Leases Create (or Destroy) Value 289
Triple Net (NNN) 290
Self-Storage 291
Mobile Home Parks 292
Profitable Possibilities with Zoning 294
Tax Liens/Tax Deeds 294
Localities Differ 294
Are Tax Liens/Tax Deeds an Easy Way to Make
Big Profits? 295
Discounted Paper 295
What Is Discounted Paper? 295
Here’s How It Works 296
Broker the Note 296
Do Such Deals Really Occur? 296
Due Diligence Issues 296
Should You Form an LLC? 297
Different Strokes for Different Folks 297
Insufficient Court Rulings 297
One Size Doesn’t Fit All 298
16 AN INCOME FOR LIFE 299
Less Risk 301
Personal Opportunity 301
Index 304
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Prologue
INVEST IN REAL ESTATE NOW!
N
early everywhere I speak these days, someone from the audience
asks, “Do you feel the real estate market will drop further? Have
we reached bottom yet? When do you think property prices will
fully recover?”
I answer, “I do not know. I really do not care. And neither should
you.”
Why do I give such seemingly flip answers? First, because they are
true. All investment pros encourage you to focus on your wealth-building
goals—not profit maximization per se. Waiting for the bottom merely gives
you an excuse to procrastinate. I’ve seen would-be investors make this
mistake a thousand times.
And second, because the questions are ill-formed. They miss iden-
tifying the multiple ways that you can profit with property. To invest
successfully in real estate, you need not, and should not, focus on pre-
dicting market valleys (or peaks). More productively, think in terms of
possibilities, probabilities, and strategy—not merely the lowest price.
WHAT ARE YOUR POSSIBILITIES?
If you asked financial journalists (or their quotable experts) whether you
should now invest in real estate, you would likely receive a variety of
answers. But nearly all of their answers would focus on one central point:
the expected direction of short-term price movements.
Journalists and their media molls love to play the game of short-
term forecasting. They do it with stocks, gold, commodities, interest rates,
and, for the past 10 years, properties. Are prices climbing? Buy. Are prices
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xx PROLOGUE
falling? Get out and go sit on the sidelines. As a result of their obsession
with short-term price movements, the media have distorted and confused
the idea of investing in real estate.
In contrast to media hype, the most experienced and successful real
estate investors do not weight their deal analysis with any significant
emphasis on short-term price forecasts. Instead, we typically look to an
investing horizon of three to 10 years (or longer). More important, we
realize that in addition to price increases, property provides us with many
possible sources of return. Here are some (but certainly not all) of these
profit possibilities.
♦ Earn price gains from appreciation.
♦ Earn price gains from inflation.
♦ Create unleveraged cash flows.
♦ Use leverage to magnify returns from price gains.
♦ Use leverage (financing) to magnify returns from cash flows.
♦ Grow equity gains through amortization.
♦ Refinance to increase cashflows
♦ Refinance to generate cash (lump sum).
♦ Buy at a below-market-value price.
♦ Sell at an above-market-value price.
♦ Create value through smarter management.
♦ Create value through savvy market strategy.
♦ Create value by improving the location.
♦ Subdivide your bundle of property rights.
♦ Subdivide the physical property.
♦ Create plottage (assemblage) value.
♦ Convert the use (e.g., residential to offices, retail to offices).
♦ Convert type of tenure (e.g., rental to ownership).
♦ Shelter income from taxes.
♦ Shelter capital gains from taxes.
♦ Create and sell development/redevelopment rights.
♦ Diversify away from stocks and bonds.
I explain each of these possible sources of return in Chapter 1 and
then illustrate and elaborate to varying degrees in the chapters that follow.
With this extensive range of possibilities in view, you can always find
profitable ways to invest in real estate.
Unlike investing (or speculating) in stocks, bonds, gold, or commodi-
ties, you can generate returns from properties through research, reasoning,
knowledge, and entrepreneurial talents. In contrast, when you buy stocks,
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PROLOGUE xxi
you had better pray that the market price goes up, because that’s your only
possibility to receive a reasonable return.
∗
WHAT ARE YOUR PROBABILITIES?
In the correction part of the real estate cycle, fear looms. Cash balances in
banks build up. Investors and savers join in a flight to quality. They will-
ingly accept certificates of deposit (CDs) that pay low-single-digit interest
rates. Investors think, “Who cares about return on capital? I just want to
feel confident that I receive a return of capital.
In his highly regarded book The Intelligent Investor, Benjamin Graham
created the parable of Mr. Market. Mr. Market represents that crowd men-
tality whose moods swing like a pendulum from irrational exuberance
to bewildered fear and confusion. Which market mood provides the best
investment opportunities/possibilities? Which market mood throws in-
vestors the highest amount of actual risk? Which market mood corre-
sponds to the least amount of actual risk?
Booms Increase Actual Risk
You know the answers. During the irrationally exuberant boom times, in-
vestors perceive little risk, but actual risks loom larger and larger as prices
climb higher and higher, income yields fall, and unsustainable amounts of
mortgage debt pile up.
In Las Vegas, so-called investors (actually speculators) believed that
flipping properties paved their way to wealth. Few perceived that their
property risks actually laid down poorer odds than the slots at Harrah’s.
And who but a fool (or Panglossian optimist) would borrow money to
play the slots? Yet Las Vegas property buyers loaded up with excessively
high loan-to-value (LTV) ratios of 90, 95, and 100 percent (or more). They
merely assumed that the future would continue to pay off as they had
experienced in the recent past.
On many of their properties, loan payments (principal, interest, taxes,
and insurance [PITI]) approached $2,000 a month. Potential rents for the
same properties would reach no more than $1,200 a month. When an
alligator is chewing your leg off, you are in a world of danger (and a
world of hurt). As I have written in nearly every one of my books, high
debt, low income yields, and exaggerated hopes for outsized continuing
∗
With property, I have earned per annum returns of 25 percent or more—without
a single dollar of price gain.
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xxii PROLOGUE
increases in price (for either stocks or properties) always trigger a reversal
of fortune. (See especially my Value Investing in Real Estate, John Wiley &
Sons, 2002.)
The speculative buying of Las Vegas houses serves as an outside-
the-norm example. Few other areas experienced such heightened frenzy
among both builders and buyers. Nevertheless, irrational exuberance
infested the moods and minds of property buyers throughout many
of the world’s principal cities (though during the boom of late, not
Dallas, Berlin, or Tokyo—each had suffered its own irrationally exuber-
ant property market 15 to 20 years back, and sat out this most recent
party). In nearly every instance, borrowed money fueled property prices
upward without commensurate growth in rent collections or personal
incomes.
Market Corrections Vanquish Market Risk
Within a few short years, many property markets have shifted from sell-
ers’ markets driven by loose lending and buoyant dreams of fast, easy
money to buyers’ markets sustained by stricter credit standards, record
numbers of foreclosures, a 25-year high in unemployment, and multiple
major banks taking hits for unprecedented amounts of losses. No wonder
fear and confusion have chased many potential property investors out of
the game.
So here is the $64,000 question: How should you interpret these and
other dismal facts from the dismal science? Do lousy economic conditions
diminish your chance to build a prosperous and secure future by investing
in property? Or do they vanquish market risk?
To make this question of risk easier, first address the following 10
issues. When is the best time to acquire investment property:
1. (a) When builders are bringing to market near-record numbers
of new houses, condominiums, and condominium conversions,
or (b) when new housing starts have fallen to the lowest level
since before 1959?
2. (a) When buyers flock to open houses and beg sellers to accept
their above-asking-price bids, or (b) when investors and home
buyers remain relatively scarce?
3. (a) After economic recovery pushes interest rates higher, or
(b) when interest rates sit near the low end of the past 40 years?
4. (a) When inflation seems subdued (as occurred during the
past eight years), or (b) (as today) when massive amounts of
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PROLOGUE xxiii
government borrowing and huge increases in the money supply
seem sure to push inflation (and interest rates) to higher levels
within the coming decade?
5. (a) When properties sell for prices at a 20 to 50 percent premium
above their replacement costs, or (b) when you can buy properties
at a 20 to 50 percent discount below their replacement costs?
6. (a) When millions of home buyers overleverage to purchase
houses that they cannot afford, or (b) when stricter credit and
high unemployment lead many people to double up (or even
triple up) on their housing?
7. (a) When most sellers can hold out for top dollar, or (b) when
financial distress and more than one million foreclosures/REOs
create millions of desperately motivated sellers?
8. (a) When property prices sit in the clouds well above the level
that rents will support, or (b) when market values fall to the
point where income yields make sense and investors can reason-
ably expect to achieve positive cash flows—either immediately
or within a few years?
9. (a) When hundreds of thousands of new investors overleverage
themselves to buy rental properties that they do not know how
to manage, or (b) when those same starry-eyed investors rudely
awaken to the fact that successful investing requires reserves of
cash and credit, knowledge, thought, and an operating system
and strategy?
10. (a) When economic recovery and increasingly positive news pro-
pel millions of backbenchers into the game, or (b) now?
If you’ve answered (b) to each of these 10 issues, you display the
courage and foresight to become a great investor. You know that market
corrections vanquish risk and multiply your possibilities for profit.
Never Wait for Market Peaks or Bottoms
To invest successfully, never try to time a market bottom—or a market top.
Neither you, I, nor anyone else can develop that skill. Why? Because more
often than not, random events trigger short-term turns in markets. We
can tell when markets are becoming too pricey. We can tell when market
conditions greatly favor investors. But only by extraordinary luck can we
pick the one best time to sell or buy. (Just as importantly, the way you
negotiate a deal can create as much or more opportunity for you than the
market conditions themselves.)
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xxiv PROLOGUE
My Texas Example I owned properties in Texas in the early 1980s. By
mid-1984, I had sold all of them (at substantial gains). The market contin-
ued to go up. Property agents told me that I shouldn’t have sold. Later,
after the crash in 1985, they told me that I had sold too soon. What do you
think?
When do you replace the tires on your car? At the last possible
moment before they blow out? Or when you see the tread wearing down
and the risk of a blowout increasing? If you want to save your life, do not
try to run your tires until the last possible moment.
Likewise with property, when irrational exuberance fuels prices ever
higher and these prices are unsupported by rent levels or personal in-
come growth, risk builds excessively. Prudence sells to save profits. Only
fools hold on to capture the last dollar—or the last 1,000 miles from that
risky, worn tire. And only bigger fools believe that tires or booms will last
forever.
Look for Solid Value—Not Necessarily a Market Bottom or Market Boom
Today’s markets offer multiple low-risk, high-profit possibilities. Over
a time horizon of three to five years—if you follow the principles laid
out in this book—you will enjoy strong profits. I encourage you to get
in the game now. No one can predict the course of prices during the
next year or two. But today, you can certainly find solid values in most
markets.
In my experience, two major mistakes prevent people from profiting
with property: (1) They wait too long to exit an irrationally exuberant
market, and (2) they wait too long to take advantage of the possibilities
that are theirs for the taking.
DEVELOP AND EXECUTE YOUR STRATEGY NOW
As you read through the following pages, you will discover how property
provides at least 22 sources of financial returns. Plus, you will discover
multiple ways to harvest those returns.
Buying, improving, and holding income properties—especially
when you purchase them at bargain prices and finance with smart
leverage—offers the surest, safest, and, yes, even the quickest way to build
wealth. But even long-term investors such as myself will venture along
other avenues when clear opportunities arise.
In addition to the buy, improve, and hold approach, other tech-
niques include discounted paper, real estate investment trusts (REITs),
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PROLOGUE xxv
condominium conversions, fix and flip, adaptive reuse, tax liens, mobile
home parks, self-storage centers, lease options, triple net leases, and other
possibilities to profit through property.
If you want a secure future—a future free of financial worries, a life
that you can live as you would like to live—property, especially property in
today’s markets, provides a near-certain route to wealth. All that remains
is for you to choose, develop, and execute your own strategy now.
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xxvi
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ACKNOWLEDGMENTS
M
any people have contributed directly and indirectly to this sixth
edition of Investing in Real Estate. Because of their efforts, this
best-selling classic text on property investing has been made even
better.
Accordingly, I thank Donald Trump and Michael Sexton for inviting
me to work with Trump University to help create some of the best real
estate educational products and services available (e. g., Trump Univer-
sity books—all published by John Wiley & Sons—CDs, seminars, online
courses, webinars, and coaching programs). Working with the Trump team
and Trump University students has broadened and deepened my perspec-
tives on property investing as well as how to simply and effectively convey
that knowledge to property investors at all levels of experience.
I also express my appreciation to Dr. Malcolm Richards, dean of
the School of Business and Management at the American University
of Sharjah (AUS). In recognizing the critical need for real estate educa-
tion in the Middle East—and especially the hyper-growth Sharjah/Dubai
metroplex—Dean Richards carved out a rewarding position for me from
which I have added substantively to my knowledge and analytical abili-
ties as they apply to international property markets. Under Dean Richards,
the School of Business and Management of AUS has established itself as
the premier school for business education in the Middle East—and I am
pleased to have been able to participate in its development. My assistants
at AUS, Mohsen Mofid and Sadaf Ahmad Fasihnia, too, deserve recogni-
tion for their cheerful and competent assistance in all of my writing and
teaching activities. (Alas, both have now graduated and I will miss them
greatly.)
xxvii
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xxviii ACKNOWLEDGMENTS
My best-selling real estate titles—including Investing in Real Estate—
have been translated into numerous foreign languages such as Russian,
Indonesian, Vietnamese, and Chinese. Thanks go to the skillful translators
of these volumes and to my Asian property adviser, Sit Ming (Laura) Lee.
Last but far from least, I thank my supervising editor, Shannon Vargo;
senior production editor Linda Indig; and the entire staff at John Wiley &
Sons, with whom I always enjoy working. This edition of Investing in
Real Estate marks the 23rd manuscript that I have completed for this 200-
year-old company that represents the finest publishing traditions. I look
forward to completing many more.
Gary W. Eldred
Vancouver, Canada
August 2009
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1
WHY INVESTING IN REAL ESTATE
PROVIDES YOU THE BEST ROUTE
TO A PROSPEROUS FUTURE
“O
lder workers rush back into the jobs market as downturn
wrecks their retirement portfolios,” so headlined a recent
front-page article in the Financial Times (May 9, 2009). Other
major newspapers such as the Wall Street Journal,theNew York Times,and
Investor’s Business Daily have run similarly disconcerting articles.
The Financial Times article (and others similarly written) depart from
the mainstream media view that dominates. For the past 15 years, most
major media—and especially personal finance magazines such as Money,
Smart Money, and Kiplinger’s—have primarily served up inept mantras for
the masses disguised as financial wisdom. Such widely read magazines
and newspapers have published hundreds (quite likely thousands) of ar-
ticles that promise investors that they can achieve wealth without work,
effort, or thought.
Just keep pouring monthly payments into your IRAs, 403(b)s, and
401(k)s and you will enjoy financial security. “Over the long run stocks
outperform all other investments. Over the long run stocks will protect
you against inflation.”
Indeed, just as I was about to write this chapter, voil
´
a, my local
paper obliged with a perfect example. A reader, Nasir Iqbal, posted
this comment: “I don’t trust stocks. I think I will receive higher re-
turns with property. With property, I will feel financially secure when
I retire.”
1
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2 WHY INVESTING IN REAL ESTATE PROVIDES YOU THE BEST ROUTE
The journalist, Cleofe Maceda, responded as follows:
Is buying property the right way to secure your retirement?
Experts [sic] say people like Iqbal are better off looking into
other avenues for capital growth—which can reduce the long-
term risk of running out of income in retirement.
Maceda (the journalist writing the article) then quotes one of his
so-called experts,
The challenge with property is that you can only sell it for what
people are willing to pay. [Duh?] It can take two years or longer
to sell a property. There is no liquidity with property.
Continuing a bit further in this article, the journalist again quotes his
expert.
Stock markets offer the best possibility to beat inflation over
periods of five years or more. This is because shares produce
dividend income in addition to the ability to grow in price.
As to volatility—that other big issue that confronts investors—the
mantra persists. No need to worry about 30 to 50 percent drops in the
stock markets...
...that volatility can work for an investor’s advantage because
it allows them to maximize their buying power [i.e., when stock
prices fall, your $1,000 a month deposits (or whatever) buy more
shares].
In one short article, Maceda scores six out of six widely popularized,
yet false claims:
1. Stocks outperform all other assets.
2. Liquidity favors stocks.
3. Stocks pay you good income.
4. Stocks protect you against inflation.
5. Stocks reduce the risk of running out of money in retirement.
6. You don’t really lose when your stock portfolio crashes, you gain.
Evidently, Maceda—like a majority of journalists (and investors)—
prefers not to think for himself. He prefers not to look at the actual
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22 SOURCES OF RETURNS FROM INVESTMENT PROPERTY 3
historical record of stocks. He prefers to remain ignorant of property. Stand-
ing against conventional wisdom, the Financial Times (at least in the article
quoted) has captured the sad reality of stocks. Maceda only perpetuates
the mantra manufactured by Wall Street.
This chapter sets the record straight. It provides you (and Nasir Iqbal)
a more enlightened perspective on property, stocks, and several other asset
classes (bonds, annuities) that investors might turn to as they strive to build
wealth and achieve financial security.
22 SOURCES OF RETURNS FROM
INVESTMENT PROPERTY
When so-called experts compare property with stocks, they rarely get
their comparisons right. More often than not, they assume that property
yields only one source of return that counts: potential gains in price. For
example, in his acclaimed book, Winning the Loser’s Game, Charles Ellis
concludes that:
Owning residential real estate is not a great investment. Over
the past 20 years, home prices have risen less than the consumer
price index and have returned less than Treasury bills.
Leaving aside for a moment how and where Ellis came up with
his long-term house price figures—no statistics I have ever seen re-
port that housing, relative to incomes or consumer prices, has become
cheaper—Ellis (and other finance/economics types) err most egregiously
in how investors should measure the total potential returns that property
offers. Ellis omits at least 20 other sources of financial returns that investors
can earn from their portfolio of properties.
1
To evaluate property, certainly weigh the possibilities for price gains,
but go further. You can earn double-digit rates of return (and sometimes
much more) from your property investments—even without any gain
in price.
It’s up to you to decide which sources of returns best fit your in-
vestment goals—and correspondingly, for each property you evaluate,
which sources of return seem doable. Few properties present a full range
of possibilities. But to fully see potential, apply each test of possibility
1
His two-decade time horizon also fails as a representative period because it in-
cludes the late 1970s and the 1980s—treasuries paid record-high interest rates
during those years.
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4 WHY INVESTING IN REAL ESTATE PROVIDES YOU THE BEST ROUTE
to all properties you consider. Every property presents multiple sources
of returns.
Will the Property Experience Price Gains from Appreciation?
In everyday speech, most people do not differentiate price gains that result
from appreciation and those that result from inflation. Appreciation occurs
when demand grows faster than supply for a specific type of property
and/or location. Inflation tends to push prices up—even if demand and
supply remain in balance.
Homes in Central London, San Francisco’s Pacific Heights, and
Brooklyn’s Williamsburg neighborhood have experienced extraordinar-
ily high rates of appreciation during the past 15 to 20 years. And just since
1990, houses within a mile or so of the University of Florida campus have
tripled in market price—primarily because UF students and faculty alike
now strongly prefer “walk or bike to campus” locations.
Areas Differ in their Rate of Appreciation. Although properties lo-
cated in Pacific Heights and Williamsburg have jumped in value at rates
much greater than the rise in the Consumer Price Index (CPI), some
neighborhoods in Detroit have suffered major declines in value. Appre-
ciation does not occur randomly. You can forecast appreciation potential
using the right place, right time, right price methodology discussed in
Chapter 15.
Likewise, you need not get caught in the severe and long-term down-
drafts that plague cities and neighborhoods that lose their economic base
of jobs. Just as various socioeconomic factors point to right time, right
place, right price, similar indicators can signal wrong place, wrong time,
wrong price.
You Do Not Need Appreciation. Should you always invest in prop-
erties that are located in areas poised for above-average appreciation?
Not necessarily. Throughout the rest of this chapter, I show you many
ways to profit with property. Some investors own rental properties
in deteriorating areas—yet still have built up multimillion-dollar net
worths. My first properties did not gain much from price increases
(appreciation or inflation)—but they consistently cash flowed like a slot
machine payoff.
If you choose a fast money, flip and fix strategy, appreciation doesn’t
count for much either. Also, when you buy at a price 10 to 30 percent below
market value, you earn instant appreciation that is not related to market
temperature. Throw away the urge to believe that you can’t make good
money with property unless its market price appreciates.
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22 SOURCES OF RETURNS FROM INVESTMENT PROPERTY 5
Will You Gain Price Increases from Inflation?
In his book, Irrational Exuberance, the oft-quoted Yale economist, Robert
Shiller, concludes that houses perform poorly as investments. According
to his reckoning, since 1948, the real (inflation-adjusted) price growth in
housing has averaged around 1—at best 2—percent a year.
“Even if this $16,000 house sold in 2004,” says the eminent profes-
sor, “at a price of $360,000, it still does not imply great returns on this
investment ... a real (i.e., inflation-adjusted) annual rate of increase of a
little under 2 percent a year.”
Shiller Thinks Like an Economist, Not an Investor. Every investor
wants to protect his wealth from the corrosive power of unexpected infla-
tion. Even if we accept Shiller’s numbers—and I believe them reasonable,
though certainly not beyond critique—the data do show that property
has kept investors ahead of inflation in every decade throughout the past
75 years.
Not true for stocks (or bonds). Consider the most inflationary period
in U.S. history: 1966–1982. In 1966, the median price of a house equaled
$25,000; the Dow Jones Index hit 1,000. During the next 18 years the CPI
jumped from 100 to 300. In 1982, the median price of a house had risen
to $72,000; the DJIA closed the year at 780—below its nominal level of
18 years earlier.
Inflation Risk: Property Protects Better than Stocks. No one knows
what the future holds. Will the CPI once again start climbing at a steeper
pace? At the runaway rate the U.S. government prints money and floats
new debt, the odds point in that direction. During periods of accelerating
inflation, most people would rejoice at just staying even.
Imagine that in the early to mid-1960s you were a true blue “stocks
for retirement” kind of investor—and you were then age 45. In 1982, as
you approach age 65, your inflation-adjusted net worth sits at maybe
30 percent of the amount you had hoped and planned for. What do you
do? Stay on the job another 10 years? Sell the homestead and downsize?
Borrow money from a wealthy friend who invested in real estate?
Property Investors Do Not Buy Indexes and Averages. Economists
calculate in the netherland of aggregates and averages. Investors buy
specific properties according to their personal investment objectives. An
economist’s average does not capture the actual price gains (inflation plus
appreciation) that real investors earn.
No investor who intelligently chooses properties for their wealth-
building potential selects such properties randomly. Investors apply
some variant of right time, right place, right price methodologies (see
page 285). If you want to outperform the average price increases of real
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6 WHY INVESTING IN REAL ESTATE PROVIDES YOU THE BEST ROUTE
estate—even though the averages themselves look quite good—you cer-
tainly can.
Earn Good Returns from Cash Flows
Unlike the overwhelming majority stocks, income property typically yields
(unleveraged) cash flows of 5 to 12 percent.
2
If you own a $1,000,000
property free and clear of financing, you can pocket $50,000 to $120,000 a
year. If you owned a $1,000,000 portfolio of stocks, you might pocket cash
flows (dividend payments) of $15,000 to $30,000 a year.
Historically, the largest source of return for unleveraged properties
has come from cash flow. If you want to grow a passive, inflation-protected
stream of income, own income properties.
Economists and financial planners greatly embarrass themselves
when they sleight or ignore this critical source of return. Before Charles
Ellis, Robert Shiller, and others of their ilk again take up their pens to write
on real estate, they might set aside their misguided claims of expertise on
realty returns and first learn something about the actual practice of invest-
ing in real estate. If they did, they would also learn that nearly all property
investors magnify their returns with leverage.
Magnify Your Price Gains with Leverage
Know-nothing economists, financial analysts, and various media-anointed
experts claim that price gains from property provide real (inflation-
adjusted) returns of one to two percent a year. In doing so, they omit the
return-boosting power of OPM (other people’s money—typically, mort-
gage financing).
Low Rates of Price Gain Create Big Returns. Assume you acquire
a $100,000 property. You borrow $80,000 and place $20,000 down. During
the following five years, the CPI advances by 50 percent. Your property,
though, lagged the CPI. Its price only increased by 25 percent. Your real
wealth fell, right? No, it increased.
You now own a property worth $125,000, but your equity wealth—
your original $20,000 cash equity in the property—has grown to $45,000
(not counting mortgage amortization of principal). You have more than
doubled your money. To have stayed even with the CPI, your equity only
needed to grow to $30,000.
2
Yields in the U.K., Asia, and most of Europe often fall somewhat below those
available throughout the United States.
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22 SOURCES OF RETURNS FROM INVESTMENT PROPERTY 7
Acorns into Oak Trees. Real estate investing builds wealth because it
grows acorns (small down payments) into free and clear properties worth
many multiples of the original amount of invested cash. Let’s go back to
that Shiller example.
The homebuyer paid a price of $16,000 in 1948. Did that homebuyer
pay cash? Not likely. Ten to 20 percent down set the norm—say, 20 percent
or $3,600 (.2 × $16,000). At Shiller’s hypothetical 2004 value of $360,000,
the homebuyer multiplied his original investment 100 times over. Even
if we say the 2004 property value comes in at $180,000—the homeowner
enjoyed a 50-fold increase of his $3,600 down payment.
What about stock gains during that period of 1948 to 2004? In 1948 the
DJIA hovered around 200 (by the way, still about 40 percent below its 1929
peak of 360). In 2004, the DJIA stood at about 8,000—a 40-fold gain. Not
bad, but still less than the gains from property (and much, much less when
we bring cash flows into the comparison of returns). [Note: As I write
in mid-2009, the DJIA still sits around 8,000—whereas property prices
(in all but the most distressed areas) are still up from 2004 and way up
from 1998, which is the year that the DJIA first hit 8,000.]
Magnify Returns from Cash Flows with Leverage
Traditionally, investors not only magnify their equity gains from leverage,
they also magnify their rates of return from cash flows. You pay $1,000,000
cash for an apartment building that yields a net income (after all operating
expenses) of 7.5 percent (no financing). Not bad. But if you finance $800,000
of that $1,000,000 purchase price at, say, 30 years, 5.75 percent interest,
you invest just $200,000 in cash. Your net income equals $75,000 (.075 ×
1,000,000) and your annual mortgage payments (debt service) will total
around $56,000. You pocket $19,000 ($75,000 less $56,000). You’ve boosted
your cash flow return (called cash on cash) from 7.5 percent to 9.5 percent
(19,000 ÷ 200,000).
Build Wealth through Amortization
Assume for a moment that your $1,000,000 apartment building throws off
zero cash flows. You apply every dollar of net operating income to paying
down your mortgage balance of $800,000. After 20 years, you own the
property free and clear. This property experienced no gain in price. It’s
still worth $1,000,000.
No price gains from inflation, no price gains from appreciation, and
no money pocketed from cash flows. Quite unrealistic and pessimistic,
right? Yet, over a 20-year period, you grew your equity from $200,000 to
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8 WHY INVESTING IN REAL ESTATE PROVIDES YOU THE BEST ROUTE
$1,000,000—a five-fold gain, and annual compound growth rate of more
than 8 percent.
Your tenants just bought you a $1,000,000 property. That’s why I tell
my students, “Rent or buy?” asks the wrong question. All tenants buy—the
real question is one of ownership. If you rent, you still pay your landlord’s
mortgage. Your landlord reaps the rewards of ownership—while tenants
bear the cost. Seems to me a great deal for property investors.
Over Time, Returns from Rents Go Up
Most property owners raise their rents. Maybe not this year. Maybe not
next year. But over a period of five years or more, increasing rents yields
increasing cash flows. If you’ve selected a right time, right place, right price
location, demand will push rents up as more people want to live in the
neighborhood where your property is located. Or perhaps, as government
floods the economy with paper money, inflationary pressures force rents
up. Either way, you gain. In fact, you can gain even if your rent increases
fail to match the inflationary jumps in your expenses.
Let’s return to our apartment building example. Gross rent collections
equal $125,000; net operating income equals $75,000; mortgage payments
equal $56,000; your cash flow equals $19,000.
Gross rents $125,000
Vacancy and expenses 50,000
Net operating income 75,000
Annual mortgage payments 56,000
Cash flow 19,000
First, assume your rents and expenses each increase by 8 percent.
Here are the revised amounts:
Gross rents $135,000
Vacancy and expenses 54,000
Net operating income 81,000
Annual mortgage payments 56,000
Cash flow 25,000
An 8 percent increase in rents and expenses boosts your cash flow by
31 percent:
25,000 ÷ 19,000 = 1.31
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22 SOURCES OF RETURNS FROM INVESTMENT PROPERTY 9
If expenses had increased by 12 percent and rents stepped up mildly
by just 6 percent per annum (p.a.), you would still increase your cash flow:
Gross rents $132,500
Vacancy and expenses 56,000
Net operating income 76,500
Annual mortgage payments 56,000
Cash flow 20,500
20,500 ÷ 19,000 = 1.08
[Note: You can run multiple scenarios with these numbers and other
numbers presented throughout this chapter. No results are guaranteed.
Through your own market and entrepreneurial analysis, you will both
estimate and create the potential returns for the properties you buy.]
But I do encourage you to realistically envision the return pos-
sibilities that property investing offers. Then as you evaluate markets,
properties, and the economic outlook for your geographic areas of inter-
est, figure the probabilities. Which sources of return look most promis-
ing? Which sources of return seem remote? What risks could upset the
applecart?
Refinance to Increase Cash Flows
You increase your cash flows when you increase your rents (or decrease
your expenses). You also increase your cash flows when you refinance to
lower your annual mortgage payments. Today, a future refinancing at rates
lower than those currently available seems somewhat remote.
But who knows? From 1930 until the early 1950s, interest rates on
long-term mortgages ranged between 4.0 and 5.0 percent. A refi from a
6.5 percent, 30-year loan into a 4.5 percent, 30-year loan would not only
slice your mortgage payments by 20 percent, it would lift your cash flows
by an even greater percentage.
In some future time, we might again confront mortgage interest rates
of 8 to 10 percent. Under those market conditions, a later refinance at lower
interest rates becomes ever more likely.
(Note: Chapter 2 introduces a technique called a wraparound mort-
gage whereby investors can obtain the benefit of a lower-than-market inter-
est rate through seller financing. Wraparounds give buyers a reduced inter-
est rate and at the same time, from a seller’s perspective, the wraparound
creates another source of return, cf. p. 34.)
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10 WHY INVESTING IN REAL ESTATE PROVIDES YOU THE BEST ROUTE
Refinance to Pocket Cash
Unless history makes a U-turn, buy a property today and within 10 to
15 years, you can sell it for 50 to 100 percent more than the price you paid.
You gain a big pile of cash. But what if you do not want to sell? Can you
still get your hands on some of that equity that you have built up? Sure.
Just arrange a cash-out refi.
Here’s how this possible source of return works. Say after 10 years
your $1 million property is now worth $1.5 million. You’ve paid down your
loan balance to $650,000. Your equity has grown from $200,000 to $850,000
($1.5 million less $650,000). You obtain a new 80 percent loan-to-value ratio
(LTV) mortgage of $1.2 million. You pocket $550,000 tax free!
But don’t spend that cash. Reinvest it. Buy another income property.
Yes, you now owe higher monthly mortgage payments on your first prop-
erty, and your cash flows from that property will decrease. But with the
additional cash flows from your second property, your total cash flows
will go up. How’s that for having your cake and eating it too?
Buy at a Below-Market Price
When the economists (mis)calculate the returns that property investors re-
ceive, they omit the fact that savvy buyers often acquire great properties for
less than their market value. Opportunity (grass-is-greener) sellers, don’t-
wanter sellers, ill-informed sellers, incompetent sellers, unknowledgeable
sellers—and most importantly in today’s markets—financially distressed
sellers all will sell at below-market prices.
And unlike in normal times, the financially stressed and distressed
today not only include individual property owners but also the mortgage
lenders themselves. Financial institutions now own more than a million
foreclosures (called REOs) that they must sell as quickly as they can line
up buyers to take these properties off their books.
How do you find and buy these properties for less than they are
worth? See Chapters 5, 6, and 7.
Sell at an Above-Market-Value Price
How do you sell a property for more than market value? Find a buyer
who is unknowledgeable, incompetent, or pressed by time. Offer seller
financing, a wraparound, or perhaps a lease option. Develop your skills of
promotion and negotiation (see Chapter 13). Match the unique features and
benefits of the property. Sell the property with a below-market-interest-rate
assumable (or subject-to) loan.
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22 SOURCES OF RETURNS FROM INVESTMENT PROPERTY 11
Sometimes buyers pay more than market value because they don’t
know (or do not care) what they’re doing. Sometimes they pay more to
obtain a much-desired feature or terms of purchase/financing. Whatever
their reason, if you wish to exploit this possibility, you’ve created another
source of return.
Create Property Value Through Smarter Management
When you manage your properties and your tenants more intelligently,
you increase your rent collections (without necessarily raising your rents);
you reduce tenant turnover; you increase prospect conversions; you spend
less, yet spend more effectively for maintenance, promotion, and capital
replacements. You enjoy peaceful, pleasant, and productive relations with
tenants.
Fortunately for you, most owners of investor-size (as opposed to
institutional-size) rental properties manage their investments poorly. Why
fortunately? Because their mal-management provides opportunities for
you. Upon acquiring a property, you can execute a more effective and
competitive management strategy to increase the property’s cash flows
and, simultaneously, lift its market value.
How can you achieve such performance? Rely on Chapter 11 to
develop your profit-maximizing management and market strategy.
Create Value with a Savvy Market Strategy
Although investors tend to manage their properties poorly, they show
even less skill as savvy marketers. Go to the property web site,
loopnet.com. Click through to a sample of listings. Look at the listing
promotional information provided. Look at the property photographs.
Does the agent tell a persuasive story about the property? Does the sales
message position that property against the tens of thousands of competing
properties that also hunger for attention? Do the photographs of proper-
ties reveal a well-cared-for property—a property that invites tenants to call
it home?
I will give you the answers. No! No! No! The implication? More
opportunities for you to gain competitive advantage. When you com-
bine the management know-how and marketing strategy lessons of
Chapters 11 and 13, you earn higher cash flows; you provide a better
home for your tenants; and when the time to sell arises, your property will
command a higher price.
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12 WHY INVESTING IN REAL ESTATE PROVIDES YOU THE BEST ROUTE
Create Value: Improve the Location
A famous clich
´
e in real estate says, “You can change anything about a
property except its location.” True or false? Absolutely false. As Chapter 8
shows, not only can you improve a location, but doing so also offers one
of your most powerful sources of return.
Think for a moment. What does the concept of location include? What
makes the location where you live desirable or undesirable? Accessibility,
aesthetics, quiet, good public transportation, cleanliness, the people who
live in the neighborhood, schools, parks, shopping, nightlife . . . the list
could go on and on. What’s the best way to improve any or all of these
attributes? Community action. Examples abound throughout the United
States and throughout the world.
Convert from Unit Rentals to Unit Ownership
Buy wholesale, sell retail. A grocer buys a 48-can box of tomato soup and
then sells each can individually along with a retail mark-up. Property
investors can execute a similar wholesale-to-retail strategy.
Buy a 48-unit apartment building; then, after completing legal ap-
provals and documentation, sell each apartment individually. In princi-
ple, you can apply a similar condo-conversion strategy to office buildings,
neighborhood strip centers, self-storage warehouse units, mobile home
parks, hotels, marinas, boat storage facilities, private aircraft hangars, and
other types of rental real estate where potential users might prefer to own
versus rent. In each case, you typically pay less per unit (or per square
foot) for an entire building than retail buyers are willing to pay for the
smaller quantities of space that they require to meet their needs.
Opportunities for conversion profits never remain constant. As prop-
erty markets change, potential profit margins swing between “make an
easy million” to “call the bankruptcy lawyer.”
3
To capitalize on this source of return, monitor the relative per-unit
prices of properties sold as rentals (income property investments) and
comparable space sold in smaller sizes to end users (see pp. 172–175).
Convert from Lower-Value Use to Higher-Value Use
Assume that in your city, single-family residential (SFR) space rents for,
say, $2 per square foot (psf) (due to a severe shortage)—offices rent for
3
In such distressed market conditions, you might profit from reverse conversions.
Buy a fractured condo and operate it as a rental property.
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22 SOURCES OF RETURNS FROM INVESTMENT PROPERTY 13
$1 psf (due to excess supply). Five years from now, single-family space
rents for $1.50 psf (due to excessive overbuilding), and because of strong
economic and job growth, office space rents for $3.00 psf. What might you
do (if zoning permits)? Convert your SFR to offices.
Conversions of use typically require you to renovate (at least to some
degree) the old, lower-value space use to fit the market needs of the higher-
value use. But when relative prices and/or rent levels grow progressively
wider, conversion of use can generate a lucrative source of returns (see
p. 175).
Subdivide Your Bundle of Property Rights
When you own a freehold estate in property, you actually own an extensive
bundle of divisible property rights. Such rights may include (but are not
limited to):
♦ Air
♦ Mineral
♦ Oil and gas
♦ Coal
♦ Access
♦ Subsurface
♦ Development
♦ Water
♦ Leasehold
♦ Grazing
♦ Timber
♦ Solar/sunlight
♦ Easement
When Donald Trump built his United Nations World Tower, several
nearby property owners pocketed several million dollars. Why? Because
Trump paid these owners to transfer a portion of their air rights to him.
After purchasing their air rights, the City of New York permitted Trump
to build 80 stories instead of 40 stories, as the zoning law then specified.
When you are in Hong Kong, notice that high-rise apartments tower
directly above some of the MTR stations. Developers paid the Hong Kong
government for the right to use that airspace—even though the govern-
ment retained ownership and use rights of the land beneath the apartment
buildings.
Nearly everyone understands that property owners can sell leasehold
rights to earn revenues. (Not all governments, though, permit leaseholds
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14 WHY INVESTING IN REAL ESTATE PROVIDES YOU THE BEST ROUTE
for all properties—and when they do, they may severely limit the terms
and price of the leasehold agreement.) However, in addition to leasehold,
you might sell, lease, or license other rights that derive from a freehold
estate. Transferring one or more of these other rights can generate another
source of return.
Subdivide the Physical Property (Space)
In one sense, condominium conversions represent one form of subdivid-
ing. But usually subdividing refers to selling or leasing land or buildings
in smaller parcels, most commonly, a developer who buys 500 acres and
cuts it up and sells off half-acre lots to homebuilders. For another example,
consider a shut down Kmart store. A still-thriving big box retailer might
pay $10 per square foot to let the entire now-vacant building.
Instead, a property entrepreneur could master lease the property
and subdivide the interior space into a variety of uses such as childcare,
offices, and/or smaller retail merchants. Each small tenant pays a higher
ppsf (price per square foot) rental rate than would the Best Buy or Lowe’s
who might otherwise lease the total building. If the new space users require
lower parking ratios than the old Kmart, the entrepreneur might subdivide
some of the parking lot area for additional retail/restaurant uses.
Thoughtful entrepreneurs steeped in market knowledge and pos-
sibility thinking persistently search for properties to subdivide. In such
cases, the sum of the parts exceeds the value when viewed as a whole.
Create Plottage (or Assemblage) Value
You create plottage or assemblage value when you combine smaller parcels
into a larger parcel of land or space. Say you discover a perfect site to
build a new neighborhood shopping center. Zoning and planners require
a minimum of four acres for such a development. The site equals four acres
but it is owned by eight different persons in one-half acre lots. Individually,
the lots are worth $10,000 apiece—or $80,000 in total.
However, as a four-acre shopping site, the land would sell for
$250,000. You now see how to earn a good profit. Persuade each of the
current owners to sell you his lot at its current market value (or even at
a price that sits somewhat above market value). Perhaps the champion
assembler to create plottage value was the Walt Disney Company. Over a
period of 10 years, Disney secretly accumulated 25 square miles of Central
Florida land at agricultural-valued prices. Once they completed this assem-
blage, the value of the aggregate site probably exceeded cost by a factor of
20 (or more).
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22 SOURCES OF RETURNS FROM INVESTMENT PROPERTY 15
Obtain Development/Redevelopment Rights
Return to the four-acre neighborhood shopping center example. You suc-
ceed. You acquire all eight lots at a total price of $130,000 (several of those
owners did not want to sell—so you sweetened your offer). Can you start
building the center? No. You must first secure a long list of government
permits and approvals. So, your $250,000 current site value stands inde-
pendent of a government go-ahead.
With permits in place, the land could command a price of $500,000.
You could sell now and take your profit. Or you could stay in the game.
Spend $50,000 (or so) for lawyers, soil tests, public hearings, environmental
clearance, traffic studies, and whatever else the city powers throw at you.
This permit process requires (with luck—and no unanticipated delays)
6 to 12 months. If all goes as planned, you earn another $200,000.
In real estate, government approvals add to the value of any property
that is ripe for development, redevelopment, renovation, conversion—or
destruction.
4
Obtain those necessary permits and you earn a good-sized
return.
Tax Shelter Your Property Income and Capital Gains
To build wealth, protect your income and capital gains from the greedy
grasp of government. Fortunately (under current tax law), investing in
real estate provides you more opportunity to avoid paying taxes than any
other asset class.
Depreciation (noncash) deductions shelter all (or nearly all) of your
positive cash flow. A Section 1231 exchange shelters your capital gain as
you pyramid your investment properties. The $250,000/$500,000 capital
gain exclusion provides you tax-free gains from the sale of your personal
residence(s). A cash-out refinance (that your tenants will repay for you)
deposits tax-free cash into your bank account. And if you buy a “first-time”
home, the newly enacted $8,000 tax credit provides part (or maybe all) of
the cash for your down payment.
Some na
¨
ıve souls might object. “I can build my stock market wealth
tax free through my 401(k), 403(b), and IRA plans. That tax break beats
property.”
Well, even if that tax break did beat property—which it doesn’t—you
forget that when you begin to draw on that cash during retirement, the
4
Yes, government even requires permits to tear down buildings. In Sarasota,
Florida, the Ritz Carlton fought a four-year battle to obtain permission to tear
down a historic house located on part of the site where the Ritz planned to build.
In compromise, the Ritz eventually paid to move the house to another site.
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16 WHY INVESTING IN REAL ESTATE PROVIDES YOU THE BEST ROUTE
government will tax every penny as ordinary income. In addition, if you
want to tap into that cash kitty prior to reaching age 59-1/2 (as nearly
50 percent of Americans do), the IRS will grab 35 to 50 percent of those
amounts (taxes plus penalties). If you die before you withdraw, the IRS
still reaches in and pulls out its share.
To minimize loss of income and wealth to the IRS, buy investment
real estate. (For a discussion of property taxes and income tax laws, see
Chapter 14.)
Diversify Away from Financial Assets
Although some investors prefer stocks, those investors would prove them-
selves wise to diversify part of their portfolio into property.
As investment experience shows, during periods of expected and
unexpected inflation, property prices have kept pace with or exceeded the
rate of growth in the CPI. Even better, leverage transforms small price
gains into double-digit rates of increase in your equity wealth.
Property prices show much less volatility than stock and bond prices.
The recent depression, surfeit of foreclosures, and price downturns for
many properties seem mild compared to the precipitous periodic drops
in stock prices. Even in the hard-times property markets, prices have only
fallen back to their 2004-2005 levels. As I write, all major stock indices sit
below their levels of 1998.
Today, most financial planners encourage asset diversification. His-
torical as well as recent experience support that view. The mantra “stocks,
stocks, and more stocks for retirement” does not meet the test of experi-
ence. Add property to your investments—if not for its superior returns,
then to reduce your portfolio risks.
IS PROPERTY ALWAYS BEST?
Some people think that I serve as head cheerleader for investing in real
estate. In one sense, they are right. The record shows that more average
people have built sizeable amounts of wealth through property than any
other type of savings or investment.
However, I do not say, “Property investments will beat stocks or
bonds any time, any place, at any price.” As early as 2005, I told my
investor audiences that I would not buy property in the then-current hot
spots such as Las Vegas, Miami, Singapore, Dublin, or Dubai. Speculative
frenzy drove those markets—not reasoned fundamental evaluation of risks
and rewards.
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IS PROPERTY ALWAYS BEST? 17
So, when people ask me, as they often do, “Which investment pro-
vides the best returns —stocks or real estate?” I answer, “It all depends.”
Certainly, in 1989, I would rather have invested in the S&P 500 index
fund than Tokyo real estate. In 1993, I would have preferred the DJIA to
property in Berlin. In 1997, I would rather have bought Apple Computer
stock than a Hong Kong condominium located on the Peak.
You must rely on investment and market analysis. Investors do not
always make more money with property than they do with stocks. I have
never said otherwise. But that begs the question, “Which investment offers
the best possibilities and probabilities today?”
Given today’s bargain property prices relative to where property
values will likely stand 6 to 10 years from now; given the fact you can
build large increases in property wealth (equity) without big gains in price;
given the relative income yields of property versus stocks (or bonds); given
the tax advantages of property relative to all other investments; given the
multiple sources of returns that property offers; and last—but far from
least—given the entrepreneurial talents that you can apply to property to
increase its price and cash flows; then, yes, in today’s market, I am willing
to lead the cheers for investing in real estate.
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2
FINANCING: BORROW SMART,
BUILD WEALTH
T
o build wealth fast, use borrowed money. Used smart, financial
leverage magnifies your gains. Used dumb, leverage not only in-
creases your chance of loss, it magnifies the loss you incur. Smart
borrowing leads you to financial security. Dumb borrowing leads to sleep-
less nights, drained bank accounts, and forced property sales.
As recent experience shows, excessive debt has drowned the hopes
and dreams of many investors and homebuyers. To help understand why,
look back to the faulty advice that (until recently) enticed millions of na
¨
ıve
and ill-prepared Americans to borrow dumb.
In the early days of the get-rich-quick real estate gurus, property
prices were escalating 10 to 20 percent a year. Just as occurred dur-
ing 2001–2006, back then nearly every would-be investor wanted to get
a piece of the property action. Yet a majority of these hopeful buyers
lacked cash, credit, or both. They possessed the will, but they lacked the
means.
THE BIRTH OF “NOTHING DOWN”
Enter Robert Allen, Carlton Sheets, Tyler Hicks, Al Lowry, Mark
Haroldson, and other promoters of “nothing down.” To sell their books,
tapes, CDs, DVDs, and seminars, these pundits promised the ill prepared
a solution to their dilemma. “No cash, no credit, no problem.” Just learn
the tricks and techniques of creative finance and you too can become a real
18
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SHOULD YOU INVEST WITH LITTLE OR NO CASH OR CREDIT? 19
estate millionaire.
1
Not surprisingly, the property boom of late reinvigo-
rated those guru promises of easy wealth. Scores of books, CDs, seminars
and boot camps have promoted all types of get-rich schemes that tell
wannabe investors that they can win big in real estate through lease op-
tions, short sales, foreclosures, flipping, and a sundry collection of other
so-called no cash, no credit techniques.
In his book Multiple Streams of Income: How to Generate a Lifetime of
Unlimited Wealth (John Wiley & Sons, 2004), Robert Allen recounts his
famous boast to the skeptical Los Angeles Times: “Send me to any city,”
Allen told the newspaper. “Take away my wallet. Give me $100 for living
expenses. And in 72 hours, I’ll buy an excellent piece of property using
none of my own money.” (p. 140)
In response, the L.A. Times hooked Allen up with a reporter, and off
they went. “With this reporter by my side,” Allen writes, “I bought seven
properties worth $722,715. And I still had $20 left over.” The Times ate crow
and headlined a follow-up article “Buying Homes without Cash: Boastful
Investor Accepts Challenge—and Wins.” “Yes, these techniques do work,”
Allen writes.
No question, Robert Allen and others who have preached a similar
gospel are right. You can buy with nothing down, but that begs the real
question. The real question is whether you should buy with little or no cash
or credit.
SHOULD YOU INVEST WITH LITTLE
OR NO CASH OR CREDIT?
If investing in real estate with little or no cash or credit were a sure route
to wealth, this country would be awash in real estate millionaires. Indeed,
more than 10 million people have bought various nothing-down books,
tapes, videos, courses, and seminars. With all this knowledge of creative
finance floating about, you might think that the secrets of building real
estate wealth were available to almost everyone.
So where’s the catch? Why, among so many who have signed up, can
so few boast of success, and why have so many perished?
1
The term creative finance eludes precise definition. In general, it refers to the use
of multiple sources of credit (e.g., sellers, real estate agents, contractors, part-
ners) and out-of-the-norm financing techniques such as mortgage assumptions,
subject-to purchases, land contracts, lease options, second or third mortgages,
credit card cash advances, master leases, and so forth. In some circumstances, in-
vestors can use creative financing to buy real estate even though they lack cash or
good credit. Each of these topics is discussed in this chapter.
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20 FINANCING: BORROW SMART, BUILD WEALTH
What’s Wrong with “No Cash, No Credit”?
To begin with, let me emphasize that many smart, experienced, and suc-
cessful investors and homebuyers do use various forms of creative finance.
I endorse creative finance. I use it myself.
However, we have all seen so many deals crash and burn that I
advise caution. Many promoters of creative finance have oversold its ad-
vantages and underplayed its potential perils. Before you imbibe such an
intoxicating elixir, think through the following issues:
Do You Live below Your Means? In their bestseller The Millionaire
Next Door (Longstreet, 1997), Thomas Stanley and William Danko reveal
that self-made millionaires typically live below their means. More often
than not, they avoid prestige spending. They do not drive new Jaguars
or BMWs, dress for success in Armani suits, spend lavishly with their
platinum American Express cards, or wear $200 (let alone $2,000) wrist-
watches. Serious wealth builders display no foolish affectations of con-
spicuous consumption.
In contrast to the typical wealth builder, many of the dreamers who
were attracted to the schemes of the real estate gurus never learned to
spend (or invest) wisely. They primarily see real estate as a means to
circumvent their money and credit problems—a quick and painless way
to live the envied lifestyles of television’s rich and famous.
In fact, promoters of “no cash, no credit” shamelessly encourage this
lavish image. They typically display themselves in fabulous settings. Mark
Haroldson’s photo on the cover of his book (How to Wake Up the Financial
Genius Inside of You) shows him lounging on the hood of a Rolls Royce.
Irene and Mike Milin (How to Buy and Manage Rental Properties) instead
chose a Mercedes 600 for their photo backdrop. And, of course, nearly
everyone has seen the TV infomercial where Carlton Sheets sat by the pool
enjoying a beautiful Florida bay-front estate.
Take a hard look at yourself. Is your goal to sensibly pursue the inner
security and confidence of a millionaire next door? Do you presently live
well below your means? Do you save a large percentage of your earnings?
Or do you frequently fail to discipline your fiscal frivolities? Do you try
to show the world you’ve “made it”? Do you believe creative finance
techniques can override your need to shape up your financial fitness?
If a borrow-and-spend personal profile describes you, align your
motives and priorities. The “no cash, no credit” gurus have lured too
many people into believing that, as one such promoter puts it, “nothing
down can make you rich.” Wrong! Nothing down can help get you started
in real estate, but only fiscal discipline can pave your path to long-term
wealth and financial security. Before you look to creative finance, critically
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SHOULD YOU INVEST WITH LITTLE OR NO CASH OR CREDIT? 21
review and adjust (revolutionize, if necessary) your habits of spending,
borrowing, and saving.
Price versus Terms. Some creative-finance gurus urge their students
to talk sellers into creative-finance schemes with this gambit: “You set the
price, let me set the terms.” In this way the seller will (ostensibly) receive a
price that exceeds his property’s market value (along with great bragging
rights). In exchange, the creative-finance buyer asks for terms that may
include seller financing, little or nothing down, a below-market interest
rate, lease option, or other seller concessions.
In their eagerness to jump into a “your price/my terms” deal, novice
investors frequently fail to adequately inspect the property for problems.
In addition, they end up owing more than their properties are worth.
When problems develop that a buyer can’t afford to pay for—or otherwise
remedy—he or she also faces the problem of owning a property that can’t
be sold for a price high enough to pay off the mortgage balance. Experience
shows that the financially weak and ill-prepared flock to property during
boom times with no idea that (in the short run) quick advances in price
often signal a coming downturn.
The lesson: Anytime you agree to pay more than a property is worth,
you invite financial trouble. The terms of creative finance can seldom
overcome the tenuous position that an overfinanced, overpriced property
presents. (You’ll see a specific financial example of “you name the price,
I’ll set the terms” later in this chapter.)
Credibility versus Creativity. Many would-be investors use creative
financing techniques not just to buy with little or nothing down but also
to work around credit problems (no credit record, slow pay, write-offs,
bankruptcy, foreclosure, self-employment, etc.). Nevertheless, regardless
of your credit history, before you can arrange any type of sensible financing,
establish your credibility.
Yet credibility and creativity often clash. In contrast to the boom
years, today’s dealmakers have wised up. If you suggest a deal that seems
strange, risky, or simply off-the-wall, other would-be participants in the
transaction (broker, seller, mortgage lender) may doubt that you really
know what you’re doing. Or they may come to believe that you lack
financial resources, experience, or both.
Before you try to negotiate a creative-finance scheme, sound out the
views and possible responses of the other players in the deal. If you go too
far from the reasonable, others may simply walk away and dismiss you
as a fake (big hat, no cattle). For your failure to establish credibility, you’ll
lose good properties.
Perseverance versus Productivity. Nearly all “no cash, no credit”
gurus admit (at least in their fine print) that the majority of sellers, brokers,
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22 FINANCING: BORROW SMART, BUILD WEALTH
and mortgage lenders will reject most of their financing techniques. “How
often does a transaction like this happen?” Robert Allen (Multiple Streams
of Income, p. 142) asks rhetorically after explaining one of his zero-down
techniques. “Very rarely. One in a hundred. It takes luck, chutzpa, and
quick feet.”
Now, ask yourself: Will the search for creative finance lead to success?
For many in the past, that answer has been no. When these previously eager
investors have met repeated rejection and disappointment, they gave up.
They came to see real estate “investing” as a waste of time.
In doing so, they missed the success they could have enjoyed had they
prepared themselves financially and pursued conventional financing and
acquisitions. In other words, if you chase after deals that stand little chance
of profitable completion, steel yourself against slammed doors and fatigue.
To achieve creative possibilities, persevere. Realize, too, that most investors
who build long-term wealth and financial security not only design and
forecast their potential rewards from a deal, they anticipate risks. They
build contingency plans to follow when events turn against them.
Leverage: Pros and Cons
Never assume that good refinance possibilities will exist at the time you
most need them. Never let anyone tempt you into believing any deal rep-
resents a sure thing. Rents can fall. Vacancies can increase. In the short run,
you may not be able to sell your property at a price high enough to pay off
your loan(s). Interest rates can go up, and loan-underwriting standards can
tighten. Today’s foreclosures are multiplying (in part) because of the false
beliefs and assumptions that lay behind “no cash, no credit, no problem.”
Leverage Magnifies Returns. With risks in view, now the good points.
The term leverage means that you employ a proportionately small amount
of cash to acquire or control a property. To illustrate: you buy a $100,000
rental property that produces a net operating income (NOI) of $10,000
ayear.
2
If you finance this unit with $10,000 down and borrow $90,000
(a loan-to-value ratio of 90 percent), you highly leverage your purchase.
You own and control a property. Yet you put up only 10 percent of
the purchase price, whereas if you paid $100,000 cash for the property, you
would not have leveraged your purchase (no OPM).
But leverage can magnify your cash-on-cash returns. The following
four examples calculate rates of gain in equity from price increases based
on alternative down payments of $100,000 (an all-cash purchase), $50,000,
$25,000, and $10,000.
2
Obviously, in high-priced areas of the country, $100,000 won’t buy a studio apart-
ment. But to illustrate, it’s an easy figure to work with.
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SHOULD YOU INVEST WITH LITTLE OR NO CASH OR CREDIT? 23
Example 1: $100,000 all-cash purchase
ROI (return on investment) = Income (NOI)/Cash investment
= $10,000/$100,000
= 10%
In this example, you pocket the full $10,000 of net operating income
(rental income less expenses such as insurance, repairs, maintenance, and
property taxes). Now, if you instead finance part of your purchase price,
you will make mortgage payments on the amount you borrow. If we
assume you find financing at 8 percent for 30 years, you will have to pay
your lender $7.34 a month for each $1,000 you borrow. Now, using various
percentages of leverage, the subsequent examples show how to magnify
your rates of return.
Example 2: $50,000 down payment; $50,000 financed. Yearly mort-
gage payments equal $4,404 (50 × $7.34 × 12). Net income after mortgage
payments (which is called cash throw-off) equals $5,596 ($10,000 NOI less
$4,404).
ROI = $5,596/$50,000 = 11.1%
Example 3: $25,000 down payment; $75,000 financed. Yearly mort-
gage payments equal $6,607 (75 × $7.34 × 12). Net income after mortgage
payments (cash throw-off) equals $3,394 ($10,000 NOI less $6,606).
ROI = $3,394/$25,000 = 13.6%
Example 4: $10,000 down payment; $90,000 financed. Yearly mort-
gage payments equal $7,927 (90 × $7.34 × 12). Net income after mortgage
payments (cash throw-off) equals $2,073 ($10,000 NOI less $7,927).
ROI = $2,073/$10,000 = 20.7%
With the figures in these examples, the highly leveraged (90 percent
loan-to-value ratio) purchase yields a cash-on-cash return that’s double
the rate of a cash purchase. In principle, the more you borrow, the less cash
you invest in a property, and the more you magnify your cash returns. Of
course, the realized rate of return you’ll earn on your properties depends
on the actual rents, expenses, interest rates, and purchase prices that apply
to your properties. Work through those numbers at the time you buy to
see how much you can gain (or lose) from leverage.
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24 FINANCING: BORROW SMART, BUILD WEALTH
Now, for better news. Here’s a greater way that leverage can magnify
your returns and help you build wealth faster.
Over the years (if well-selected), your rental properties will increase
in price. If the price of that $100,000 property we’ve just discussed increases
at an average annual rate of 3 percent, you earn another $3,000 a year. If
its price increases at an annual rate of 5 percent, you’ll gain $5,000 more
a year. And at a 7 percent annual rate of appreciation, your gains will hit
$7,000 a year.
Add together annual rental income and annual price gains, and you’ll
gain these combined returns:
Total ROI = Income + Appreciation/Cash investment
Example 1: $100,000 all-cash purchase and (a) 3 percent, (b) 5 percent,
and (c) 7 percent rates of appreciation:
(a) Total ROI = $10,000 + $3,000/$100,000 = 13%
(b) Total ROI = $10,000 + $5,000/$100,000 = 15%
(c) Total ROI = $10,000 + $7,000/$100,000 = 17%
Example 2: $50,000 down payment and (a) 3 percent, (b) 5 percent,
and (c) 7 percent rates of appreciation:
(a) Total ROI = $5,596 + $3,000/$50,000 = 17.2%
(b) Total ROI = $5,596 + $5,000/$50,000 = 21.2%
(c) Total ROI = $5,596 + $7,000/$50,000 = 25.2%
Example 3: $25,000 down payment and (a) 3 percent, (b) 5 percent,
and (c) 7 percent rates of appreciation:
(a) Total ROI = $3,394 + $3,000/$25,000 = 25.6%
(b) Total ROI = $3,394 + $5,000/$25,000 = 33.6%
(c) Total ROI = $3,394 + $7,000/$25,000 = 41.6%
Example 4: $10,000 down payment and (a) 3 percent, (b) 5 percent,
and (c) 7 percent rates of appreciation.
(a) Total ROI = $2,073 + $3,000/$10,000 = 50.7%
(b) Total ROI = $2,073 + $5,000/$10,000 = 70.7%
(c) Total ROI = $2,073 + $7,000/$10,000 = 90.7%
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SHOULD YOU INVEST WITH LITTLE OR NO CASH OR CREDIT? 25
When you combine returns from annual net rental income and price
increases, highly leveraged properties may produce quite strong annual
rates of return—even without unrealistically high average annual rates of price
increases. That’s why even small investors in rental properties have (over
time) built net worths that run into the millions of dollars. When you own
rental properties, steady rent and price increases grow acorns (relatively
low down payments) into oak trees (property equity worth hundreds of
thousands [or millions] of dollars). As the years pass and you pay down
your mortgage balances, a property portfolio of just 6 or 8 houses or
perhaps 12 to 16 apartment units (sometimes less) can build enough wealth
to guarantee a secure and prosperous future. (Note, too, how these income
property rates of return outshine the widely believed [yet overstated]
10 percent average annual gains that the stock market has supposedly
produced since 1926.)
Manage Your Risks. The advocates of get-rich-quick real estate
schemes often fail to warn their followers that highly leveraged real es-
tate magnifies risks as well as returns. As a result, many na
¨
ıve real estate
investors have lost their shirts. These buyers optimistically expected the
market values of their properties to show price gains of 10 to 20 per-
cent a year. They lost touch with reality. In fact, many “investors” barely
cared what purchase prices they paid, what rent levels they collected,
or how they financed their properties. They just knew that they would
be able to sell their properties in a few years for twice the amount they
had paid.
One such investor, for example, bought a $300,000 fourplex with a
down payment of $30,000. After paying property expenses and his mort-
gage payments, the investor faced an alligator (negative cash flow) that
chewed up $1,000 a month. But the investor figured that $1,000 a month
was peanuts because he believed the sales price of the property would
go up 15 percent a year. Based on that rate of gain, here’s how this in-
vestor calculated the annual returns that he (unrealistically) expected to
receive:
ROI = Income + Appreciation/Cash investment
=−$12,000 (12 ×−$1,000) + $45,000 (.15 × $300,000)/$30,000
= $33,000/$30,000
= 110%
As it turned out, this investor, like so many others, could not con-
tinue to feed his alligator $1,000 a month. He fell behind with his mortgage
payments, and as the market slowed, he was unable to sell the property.
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26 FINANCING: BORROW SMART, BUILD WEALTH
The lender foreclosed, and the investor lost the property, his down pay-
ment of $30,000, the $24,000 of monthly cash outlays he had made before
his default, and his once-high credit score.
Here are four lessons you can take away from this investor’s bad
experience:
1. Never expect the value of real estate, stocks, gold, antique auto-
mobiles, old masters, or any other type of investment to increase by 10, 15,
or 20 percent year after year. When you need high rates of price gain to
make your investment look attractive, you set yourself up for a big loss.
(Avoid dot-com mania.)
2. Beware of negative cash flows. If the income you earn from an asset
does not support the price you pay, you magnify your risk and chance of
loss. You are speculating more than investing. That’s okay if that’s what
you want to do. Just recognize that speculators (whether they realize it or
not) play in a high-risk game.
3. Beware of financial overreach. High leverage (a high loan-to-value
ratio) usually requires large mortgage payments relative to the amount of
net income that a property brings in. Even if at first you don’t suffer
negative cash flows, vacancies, higher-than-expected expenses, or large
rent concessions intended to attract good tenants can push you temporarily
into the swamps where alligators feed.
Over a period of, say, 10 to 20 years, owning real estate will make
you rich. But to get to that long-term future, you will likely pass through
several cyclical downturns. Without cash (or credit) reserves to defend
against alligator attacks, you may get eaten alive before you find the safety
and comfort of high ground.
I first offered this advice in the 1995 (2nd) edition of this book. Un-
fortunately, many recent investors did not heed it. The more times change,
the more they stay the same.
4. Even when the financing looks “good,” avoid overpaying for a property.
Overly optimistic investors buy overpriced properties with little or no
down payment deals. In the earlier fourplex example, the investor agreed
to pay $300,000 for his fourplex not because the property’s net income
justified a price of $300,000. Rather, he paid $300,000 because he was excited
about his easy-credit, low, 10 percent down-payment financing. Compared
with the $600,000 sales price that he expected to reap after just four or five
years of ownership, his $300,000 purchase price looked cheap.
Again, I emphasize: I do not want to discourage you from making
low down payments. But when you do, anticipate possible setbacks. To
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SHOULD YOU INVEST WITH LITTLE OR NO CASH OR CREDIT? 27
successfully manage the risks of high-leverage finance, follow these six
safeguards:
1. Buy bargain-priced properties. You build a financial cushion into your
deals when you pay less than market value or pay less than a property is
worth—not quite the same thing. Discover how in Chapters 4 through 7.
2. Buy properties that you can profitably improve. To build wealth fast
and reduce the risk of leverage, add value to your properties through
creativity, sweat equity, remodeling, and renovation (see Chapter 8).
3. Buy properties with below-market rents that you can raise to market levels
within a relatively short period (six to twelve months). As you increase your
rental income, your mortgage payments will eat up a lower percentage of
your net operating income (NOI).
4. Buy properties with low–interest-rate financing such as mortgage as-
sumptions, adjustable-rate mortgages, interest-rate buydowns, or seller financing.
Low interest rates help you manage high debt. Of course, high rates make
debt less affordable—so beware of low interest rates that may disappear
within just a few years or less.
5. Buy right time, right price, right place properties. “All real estate is
local” is an oft-cited clich
´
e that contains some kernel of truth. Various
neighborhoods and cities offer unique differences with respect to price,
location, and market timing. To reduce risk and increase rewards, proac-
tively study and select from such opportunities (see Chapter 8).
6. When high leverage presents an anxious level of risk, increase your down
payment to lower your loan-to-value ratio and lower your monthly mortgage
payments. If you don’t have the cash, bring in a money partner. Don’t act
penny-wise and pound-foolish. Share gains with someone else rather than
risk drowning in the swamps where the alligators prey.
What Are Your Risk-Return Objectives?
Little- or nothing-down finance creates opportunities for you to magnify
your returns. Smart borrowing and smart investing pyramids your real
estate wealth. But the more you borrow (other things equal), the more you
research and prepare for an adverse turn in the market or your property
operations. When you highly leverage your properties, a slight fall in rents
may push you into negative cash flows. A decline in your property’s value
can pull you underwater. Steer clear of sunshine-every-day optimism.
Work through the numbers for the deals that come your way with various
potential market changes. Decide what profits are worth pursuing and
what risks you prefer to avoid.
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28 FINANCING: BORROW SMART, BUILD WEALTH
If you can’t find properties in your favored area(s) that yield the
numbers you would like to see, look elsewhere. Sift your discovery
from low-promise cities (neighborhoods to areas that offer better income/
appreciation potential.
MAXIMIZE LEVERAGE WITH
OWNER-OCCUPANCY FINANCING
You now know the pros and cons of high leverage (little or nothing down).
Use it; do not abuse it. In this respect, you can pursue low-down good
possibilities with owner-occupied property financing.
The easiest qualifying and often the lowest-cost way to borrow
most (or even all) of the money you need to buy a property remains
owner-occupied mortgage financing. Even at the height of the credit cri-
sis, high-LTV (loan-to-value) owner-occupied loan programs were readily
available on single-family homes, condominiums, townhouses, and two-
to four-unit apartment buildings. LTVs of 90, 95, 97, or even 100 per-
cent financing populate this financial arena. If you do not arrange for
owner-occupied financing (i.e., you choose not to live in the property),
most lenders (banks, mortgage bankers, savings institutions) limit their
mortgage loans on investment properties to a 70 percent to 80 percent
loan-to-value ratio.
3
So, owner-occupied loans provide great advantage
(as to LTV) relative to loans to finance rental properties. (However, some
higher 85 to 90 percent investor loans are available, such as VA REOs—see
Chapter 7.)
As another benefit, owner-occupants pay lower interest rates than in-
vestors. If lenders charge 6.0 to 6.5 percent for good credit, owner-occupied
loans, the interest rate for investor properties will probably range between
6.5 and 7.5 percent. As a beginning real estate investor, weigh the possibil-
ities of owner-occupied mortgage loans.
Owner-Occupied Buying Strategies
If you do not currently own a home, here’s how to begin your wealth
building in rental properties with little or nothing down—if you favor
3
From the late 1990s to 2006, some lenders offered investor loans with total LTVs as
high as 100 percent. When the property boom receded, such liberal lenders either
went broke due to excessive borrower defaults, or tightened their qualifying to
match or exceed more conservative (safer) underwriting standards.
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MAXIMIZE LEVERAGE WITH OWNER-OCCUPANCY FINANCING 29
this approach. Select a high-LTV loan program that appeals to you.
4
Buy
a one- to four-unit property. Live in it for one year, then rent it out, and
repeat the process. Once you obtain owner-occupied financing, that loan
can remain on the property even after you move out. Because the second,
third, and even fourth homes you buy and occupy will still qualify for
high-LTV financing (low or nothing down), within a period of 5 or 6 years,
you can accumulate as many as 8 to 16 rental units in addition to your own
residence—all without large down payments.
You can work this homeowner gambit three or four times, possibly
more. But you may not be able to pursue it indefinitely. At some point,
lenders may shut you off from owner-occupied financing because they will
object to your game plan. Nevertheless, serial owner-occupancy acquisi-
tions make a great way to accumulate (at least) your first several income
properties.
Current Homeowners, Too, Can Use This Method
Even if you own your own home, weigh the advantages of owner-occupied
financing to acquire your next several investment properties. Here’s how:
Locate a property (condo, house, two- to four-unit apartment building)
that you can buy and move into. Find a good tenant for your current
house/condo. Complete the financing on your new property and move
into it. If you like your current home, at the end of one year, rent out
your most recently acquired property and move back into your for-
mer residence. Alternatively, find another “home” to buy and again fi-
nance this property with a new owner-occupied, high-leverage, low-rate
mortgage.
Why One Year?
To qualify for owner-occupied financing, you must assure the lender that
you intend to live in the house for at least one year. Intend, however, does
not mean guarantee. You can (for good reason, or no reason) change your
mind. The lender may find it difficult to prove that you falsely stated
your intent at the time you applied for the loan. Beware: Do not lie about
your intent to occupy a property. Lying violates state and federal laws, and
governments will prosecute.
4
Many of these programs are described with more detail in my book, The 106
Mortgage Secrets That Borrowers Must Learn—But Lenders Don’t Tell, Second Edition
(John Wiley & Sons, 2008).
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30 FINANCING: BORROW SMART, BUILD WEALTH
During the past property boom, borrowers lied and loan reps winked.
Many borrowers and loan reps failed to comply with the “intent-to-
occupy” rule. In fact, a loan rep at Wachovia (a bank that subsequently
went bust) suggested that I finance a new rental house that I was buying
as if it were a second home. I declined.
To succeed in real estate over the short and long term, establish,
maintain, and nurture your credibility with lenders—and everyone else
with whom you want to make deals or build a relationship of trust. To
slip through loopholes, make false promises, sidestep agreements, or en-
gage in other sleights will destroy your reputation for integrity. Unless
you encounter an unexpected turn of events, honor a lender’s one-year
occupancy requirement.
Where Can You Find High-LTV Owner-Occupied Mortgages?
Everywhere! Even in today’s tighter credit market: Look through the yel-
low pages under “mortgages.” Then start calling banks, savings institu-
tions, mortgage bankers, mortgage brokers, and credit unions. Mortgage
lenders advertise in local daily newspapers and on the Internet. Check
with your state, county, or city departments of housing finance. Many
homebuilders and Realtors know of various types of low- or nothing-
down home finance programs. Explore the web sites, hud.gov, va.gov,
homesteps.com (Freddie Mac), and fanniemae.com.
WHAT ARE THE LOAN LIMITS?
The specific maximum amount you can borrow under these high-LTV
programs varies by type of loan and area of the country. However, the
loan limits are high enough to finance properties in good neighborhoods.
For example, Freddie Mac and Fannie Mae programs nationwide will lend
up to the following amounts (usually adjusted upward each year):
No. of
Units
Contiguous States, District
of Columbia, & Puerto Rico Higher-Priced Areas
1 $417,000 $729,750
2 $533,850 $934,200
3 $645,300 $1,129,250
4 $801,950 $1,403,400
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WHAT ARE THE LOAN LIMITS? 31
FHA varies its loan limits by county. Here are several examples:
Low-Cost Areas (FHA/HUD)
Type of Residence Loan Limits
One-unit $271,050
Two-unit 347,000
Three-unit 419,425
Four-unit 521,250
High-Cost Areas (FHA/HUD)
Type of Residence Loan Limits
One-unit $729,750
Two-unit 934,200
Three-unit 1,129,350
Four-unit 1,403,400
For VA loans, eligible veterans may originate—and veterans and
nonveterans alike may assume—up to the following amounts:
5
Lowest-Price Areas Highest-Price Areas
$737,500 $417,000
Unlike Fannie/Freddy and FHA, the VA applies a single loan limit
for all 1–4 unit properties. However, VA has significantly boosted its loan
limit and like FHA, varies each specific limit according to the prevail-
ing local price levels. One- to four-unit properties that are priced higher
than these stated limits seldom bring in rents high enough to cover ex-
penses and mortgage payments. So, when you select rentals that pay for
themselves—even with a small down payment—the limits set by the re-
spective insurers and guarantors should not unduly restrict your choice of
properties.
5
When a veteran makes a down payment, these loan amounts may be higher. Also,
higher limits may apply in selected high-cost areas. Periodically, VA increases its
limits.
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32 FINANCING: BORROW SMART, BUILD WEALTH
HIGH LEVERAGE FOR INVESTOR-OWNER FINANCING
Assume you’ve reached as far as you want to go with high-LTV (low
down payment) owner-occupancy financing possibilities. Or maybe you’re
happy in your present home. No way will you (or your spouse) move
(even temporarily) to another property. Without owned occupied, what
other ways help you avoid placing 20 to 30 percent of the purchase price
in cash from your own savings? In other words, what high-leverage (low
down payment) OPM (other people’s money) techniques can you use to
buy and finance your investment properties?
High Leverage versus Low (or No) Down Payment
Before we go through various low- and no-down-payment techniques,
note this distinction: High leverage does not necessarily require a low
down payment. High leverage means that you’ve acquired a property
using little cash (say, 10 to 20 percent of the purchase price, or sometimes
less) from your own funds.
You find a property priced at $400,000, and your lender agrees to
provide a first mortgage in the amount of $280,000. Because you can’t
(or don’t want to) draw $120,000 from your savings to make this large
down payment, you need another way to raise all (or part) of these funds.
If successful, you will have achieved a highly leveraged transaction. You
will control a $400,000 property with relatively little cash coming out of
your own pocket.
You gain the benefits (and risks) of high leverage in either of two
ways: (1) Originate or assume a high-LTV first mortgage, or (2) originate
or assume a lower-LTV mortgage, then to reduce (or eliminate) your out-
of-pocket cash input, use other sources (loans, equity partners) to cover
some (or all) of the difference between the amount of the first mortgage
and the purchase price of the property.
Creative Finance Revisited
Creative finance encourages you to think through multiple financing al-
ternatives. The term gained popularity when property prices shot up and
millions of hopeful buyers felt shut out of the fast money because they
lacked sufficient cash, credit, or both to enter the game. “The central theme
of my course,” wrote Ed Beckley in No Down Payment Formula, “is to teach
you how to acquire as much property as you can without using any of your
own money.... Starting from scratch requires that you become extremely
resourceful. You need to substitute ideas for cash” (p. 69).
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HIGH LEVERAGE FOR INVESTOR-OWNER FINANCING 33
How might investors use creative thinking and resourcefulness to
substitute for cash?
Look for a Liberal Lender. Under today’s tighter underwriting, most
banks and savings institutions loan only 70 to 80 percent of an (non-owner-
occupied) income property’s value. However, some specialty lenders will
make 90 percent (or higher) LTV loans. As credit markets ease, lender
competition will most likely (once again) edge up LTVs.
In addition, some wealthy private investors provide high-LTV mort-
gages. Find these private investors through newspaper classified ads: Ad-
vertise in the “Capital Wanted” section, or telephone those who list them-
selves in the “Capital Available” section. Also call mortgage brokers who
may have contacts with as many as 20 to 100 sources of property financ-
ing. Through their extensive roster of lenders, mortgage brokers may find
you the high LTV you want. Beware: Read the fine print. Many of these
nontraditional (subprime, hard money) mortgages include costly upfront
fees, high interest, and steep prepayment penalties. Foolish optimism plus
subprime loan equals foreclosure.
Second Mortgages. In the past,some income property lenders per-
mitted what are called 70–20–10 loans, or some other variation such as
75–15–10, or maybe even 80–15–5. The first figure refers to the LTV of a
first mortgage; the second figure refers to the percentage of the purchase
price represented by a second mortgage; and the third figure refers to out-
of-pocket cash contributed by the buyer. A 70–20–10 deal for the purchase
of a $100,000 property would require the following amounts:
First mortgage $70,000
Second mortgage $20,000
Buyer’s cash $10,000
More often than not, the property seller makes the best source for
second mortgage loans. Typically referred to as “seller seconds” or seller
“carrybacks,” these loans require less red tape, paperwork, and closing
costs. You can sometimes persuade a seller to accept an interest rate that’s
lower than what a commercial lender would charge. At a time when first
mortgage rates were at 11 percent, and commercial second mortgage rates
were at 16 percent, my seller carried back a $75,000 interest-only second at
a rate of 8 percent.
6
(Sellers are more likely to offer below-market interest
rates when market rates climb upwards—unlike today’s low market rates.)
6
In this case, the seller second primarily served to reduce my overall cost of bor-
rowing thanks to its low interest rate.
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34 FINANCING: BORROW SMART, BUILD WEALTH
My deal looked like this:
Purchase price $319,500
First mortgage at 11% $180,000
Seller second at 8% $75,000
Cash from buyer $64,500
If the sellers won’t cooperate, look to private investors, mortgage
brokers, banks, and savings institutions. Before you do turn to “loan-
sharking” commercial second mortgage lenders, think of friends or family
members who might like to earn a relatively safe return of 7 to 10 per-
cent (more or less) on their money. Compared to certificates of deposit
and passbook savings that in most times pay interest between 2.0 and
5.0 percent, a 7 to 10 percent rate of interest could look pretty good.
Borrow against Other Assets. If you’re a homeowner with good
credit, you can raise seed money for investment real estate by taking out
a home equity loan (i.e., second mortgage) on your home. Through an
equity line of credit you might raise a fair amount of cash—but remember,
stay prepared for adverse changes in the market or your own finances.
Alternatively, consider a high-LTV refinance of your first mortgage.
What other assets can you borrow against? Retirement accounts,
cars, jewelry, artwork, coin collection, life insurance, or vacation home?
List everything you own. You may surprise yourself at what you discover.
Convert Assets to Cash (Downsizing). Rather than borrow against
your assets, downsize. Friends of mine sold their 6,000-square-foot
Chicago North Shore residence for $1,050,000. With those proceeds they
bought a vacation home, a smaller primary residence, and an in-town
condominium. In the U.K., they call this popular practice “mouse-holing.”
Could you live comfortably in a smaller or less expensive home?
Are you wasting money on unproductive luxury cars, jewelry, watches, or
clothing? Are you one of the many Americans who live the high life—for
now—but fail to build enough wealth to support the twin goals of financial
security and financial independence?
In their study of the affluent, Thomas Stanley and William Danko
(The Millionaire Next Door) interviewed a sample of high-income profes-
sionals whom the authors named UAWs (underaccumulators of wealth).
They chose a sample of PAWs (prodigious accumulators of wealth)—who
worked in less prestigious jobs and earned less income. Because of wise
budgeting and investing, the PAWs’ net worths far surpassed those of the
high-income prodigious spenders. Downsizing now pays big dividends
later.
Wraparound Mortgage. A wraparound mortgage helps buyers obtain
a high LTV while it provides a seller with a good yield. Investors use
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HIGH LEVERAGE FOR INVESTOR-OWNER FINANCING 35
wraparounds to gain some benefit from a below-current-market-rate loan
that exists against a property—and, yet also obtain a relatively high LTV.
To accomplish these twin goals, the investor “wraps” the existing
below-market loan with a new wraparound loan at a higher interest rate.
The seller continues to pay the existing low interest rate loan while the
buyer pays the seller on the new wraparound loan. The seller profits on
the spread in interest rates. The wraparound works best during periods
when interest rates shoot up. Figure 2.1 provides an example.
In Figure 2.1, the seller creates and carries a new loan of $210,000
at 9.0 percent. Payments on the seller’s existing first mortgage total
$1,077 per month. Payments on the new wraparound loan are $1,691 per
month. Therefore the seller earns a $614 per month profit. As a return
on the $60,000 the seller has left in the deal, he or she earns a return of
12.28 percent (12 × 614 ÷ 60,000 = 12.28). The investor gains because the
interest rate charged by the seller falls below the then-prevailing market
interest rate on newly originated loans. (If you wrap a “nonassumable”
mortgage, the seller’s underlying mortgage lender may choose to exercise
its “due-on-sale” clause. If that happens, you and the sellers would have
to pay off the seller’s mortgage and work out some other type of financing.
However, during the past 25 years—and especially during periods of high
foreclosures, lenders rarely throw their performing loans into default by
demanding full payment.)
Use Credit Cards. Although this is one of the more risky techniques
of creative finance, some investors take advantage of every credit card offer
they receive in the mail. Then when they require quick cash to close a deal,
they raise $10,000, $25,000, or even $50,000 from cash advances. Investors
sometimes even pay cash for a property with the entire sum raised from
credit cards.
Naturally, it makes no sense to use cash advances for long-term
financing. On occasion, though, you might find plastic a quick and
Seller Pays
Seller Receives
Sales price $225,000
Cash down 15,000
Wrap balance 210,000
Mo. pymt. @ 9%/30-year 1,691
Seller pymt. 1,077
Seller nets per mo. 614
Seller ROI on $60,000 12.28%
Mtg. bal. $150,000
Mo. mtg. pymt. @ 7.0%
(24 years left) $1,077
Figure 2.1 Wraparound Loan Example
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36 FINANCING: BORROW SMART, BUILD WEALTH
convenient source to cover short-term needs. For example, you might
find a steal of a deal that you can buy (and renovate?), then immediately
flip (resell) the property at a profit. For my taste, credit card cash costs
too much and generates too much risk. But it’s still a possibility– if you
clearly calculate that the rewards decisively trump the risks—and you can
see multiple unlocked exit doors.
Personal Loans. In the days before credit card cash advances (which
are now the most popular type of personal loan), personal loans were called
signature loans. As you build your wealth through growing real estate
equity, you’ll find that many lenders will grant you signature loans—at
much lower fees and interest rates than credit card cash advances—in
amounts of $10,000, $25,000, $50,000, or even $250,000, if your credit record
and net worth can support repayment. Use the money from these signature
loans for down payments or renovation funds.
Although mortgage lenders do not favor borrowers who use per-
sonal loans for down payments, investors routinely find ways to use this
technique. OWC (owner will carry) sellers who finance property sales
probably won’t inquire (and maybe won’t care) about the source of your
down payment. If you’re short on cash, compare the risks and benefits
of using a cash advance or signature loan to raise money for your down
payment.
But again, weigh the risk factors. Ill-conceived borrowing can push
you into those ugly toss-and-turn, sleepless nights, if not financial ruin.
Make sure repayment does not depend on some speculative (uncertain or
unpredictable) contingency.
Land Contracts. A land contract—sometimes referred to as a contract
for deed, contract of sale, or agreement of sale—permits buyers to pay sell-
ers for their property in installments. Under a land contract, a buyer agrees
to buy a property and pay principal and interest to the seller. Unlike mort-
gage financing, title to the property remains in the seller’s name until
conditions of the contract are fulfilled. The buyer takes possession of the
property. If a buyer defaults on the agreement, the seller can typically re-
possess (not foreclose on) the property. Sellers favor repossessions because
they’re quicker, easier, and less costly than foreclosure.
Land contracts may be useful in “wrapping” existing low interest rate
financing (see the previous discussion of wraparounds). Caution: These
contracts include pitfalls for buyers and sellers. State law governs land
contract sales, so consult a competent, local real estate attorney before
accepting this form of financing.
Often, properties sold on land contracts are “nonconforming” prop-
erties such as storefronts with living quarters in the rear or above, farm-
houses with acreage, older properties in need of repair, or larger house that
have been split up into multiple apartment units. My first investment was
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HIGH LEVERAGE FOR INVESTOR-OWNER FINANCING 37
a five-unit property—a large, old house split into four one-bedroom apart-
ments and a one-bedroom, one-bath carriage house that sat on the rear of
the lot. I paid $10,000 down, and the seller (an elderly widow) financed
the balance at 5 percent interest. She said that was the same rate she could
get on a savings account in a bank so she didn’t think it would be right to
charge more than that. (I would like to find sellers like her today.)
In the present market, land contracts serve the same purposes they
always have (nonconforming properties or subpar cash/credit buyers).
Yet, as many traditional mortgage lenders reach out to attract more diverse
homebuyers and neighborhoods, people and properties that might not
have gained lender approval in decades past might now qualify at credit
unions, banks, and other types of mortgage companies. In addition, two
types of seller-assisted financing have become widespread: lease-purchase
and lease-option agreements (see Chapter 9). To some degree, these “rent-
to-own” alternatives have substituted for the use of land contracts.
Nevertheless, land contracts can play a role in your property acqui-
sition strategy. Properly written, land contracts are low cost and relatively
easy to complete; they offer maximum flexibility in price and interest rate;
and they can give sellers quick remedies for borrower default while they
protect buyers against unfair forfeiture and future title problems. If you
find (or create) a good deal using a land contract, don’t pass it up without
thoughtful review (and informed legal advice).
Sweat Equity (Create Value through Renovations). You might buy
some properties with 100 percent financing if you can enhance their value
through improvements and renovations. Say you find a property that
should sell (in tip-top condition) for around $240,000. Yet because of its
sorry state of repair, as well as an eager seller, you can buy the property
at a price of $190,000 with short-term, no-money-down owner financing.
You then contribute labor and $15,000 in materials that you pay for with
credit cards.
After you complete your work and bring the property up to its
$240,000 market value, you arrange a 70 percent LTV mortgage with a
lender. With your loan proceeds of $190,000, you pay off the seller and
your credit card account. Voil
`
a—you have not only achieved 100 percent
financing for your acquisition price and rehab but also created $35,000 of
instant equity (wealth).
Use Your Imagination. In addition to the high leverage techniques
discussed, here are several others:
♦ Bring in partners. If you can’t (or don’t want to) draw on your
own cash or borrowing power, find a good deal and then show
potential money partners (friends, family, contractors, wealthy
investors) how they will benefit if they join you in the transaction.
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38 FINANCING: BORROW SMART, BUILD WEALTH
♦ Agree to swap services or products. Would the seller accept some ser-
vice or expertise that you can provide? Take stock of your skills
(law, medicine, dentistry, writing, advertising, carpentry, account-
ing, landscaping, architecture, etc.). How about products? Say you
own a radio station or newspaper. Trade off advertising time or
space for a down payment. Anything you can produce, deliver, or
sell wholesale (at cost) might work.
♦ Borrow (or reduce) the real estate commission. Most brokers and sales
agents generally hate this technique. Still, sometimes buyers and
sellers do ask the agents involved in a transaction to defer payment
until some later date. A few agents actually prefer to have their
commissions in the deal. In doing so, they avoid paying income
taxes on these fees, and at the same time they build wealth through
interest payments or their receipt of a “piece of the action” (future
profits from a sale).
♦ Simultaneously sell (or lease) part of the property. Does the property
include an extra lot, a mobile home, or timber, oil, gas, air, or
mineral rights? If so, find a buyer who will pay you cash for such
rights. In turn, this money will help you close the deal.
♦ Prepaid rents and tenant security deposits. When you buy an income
property, you are entitled to the existing tenants’ security deposits
and prepaid rents. Say you close on June 2. The seller (of a fourplex)
is holding $4,000 in tenant security deposits and $3,800 in rent
money that applies to the remaining days in June. Together, the
deposits and prepaid rents amount to $7,800. In most transactions,
you can use these monies to reduce your cash-to-close.
♦ Create paper. You’ve asked the seller to accept owner financing with
10 percent down. She balks. She believes the deal puts her at risk.
Alleviate her fears and bolster her security. Offer her a lien against
your car or a second (or third) mortgage on another property
you own. Stipulate that when principal payments and property
appreciation (added together) lift your equity to 20 percent (LTV
of 80 percent), she will remove the security lien she holds against
your other pledged asset(s).
♦ Lease options. To discuss creative finance, one must include lease
options. And because of their widespread usage, Chapter 9 ad-
dresses the pros and cons of this technique.
Are High-Leverage Creative-Finance Deals Really Possible?
Yes, definitely. I have used some type of creative finance (as either buyer
or seller) in more than one-half of the property transactions in which I’ve
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WHAT UNDERWRITING STANDARDS DO LENDERS APPLY? 39
been involved. To make creative finance work, however, you must know
what you are doing. Clearly envision all possible ways the deal might turn
against you. Stay calm. Do not become so excited to make the deal that you
concede too much. Beware: Low down, creative-finance deals frequently
tempt new investors into buying troubled properties or paying excessive
prices. Honor commitments—and, just as important, critically affirm that
the commitments you make are worth honoring.
Fewer Sellers. Because creative finance violates so-called standard
operating procedures, your property choices become fewer. While nearly
every seller will accept all cash, smaller numbers are willing to provide
financing with little or nothing down.
Nevertheless, look for profit-packed high-leverage creative-finance
deals, which are out there. Sellers who first claim they’re not interested
will soften their attitude once you persuasively explain what’s in it for
them and then hand them your signed offer.
Lower-Quality, Overpriced Lemons. Keep a sharp eye out for prop-
erty owners who want to entice you into buying overpriced lemons.
These sellers have read the nothing-down books. They know that adver-
tising come-ons like “owner financing,” “nothing down,” “no qualifying,”
“make offer,” and “EZ terms” will bring dozens of calls from the latest
“graduates” of the Ima Guru School of Creative Finance.
Just standing by to fleece the sheep, these sellers surreptitiously lead
eager buyers into ill-advised purchase contracts. Maintenance and repair
problems, disappearing tenants, phantom leases, illegal units, neighbor-
hood crime, short-term balloon mortgages, troublesome neighbors, and
undisclosed liens represent just a few of the setbacks na
¨
ıve buyers have
run into. (For many other types of potential problems, see my book The 106
Common Mistakes Homebuyers Make (and How to Avoid Them) (John Wiley
& Sons 2008, 4th ed.) In other words, don’t let the siren call of creative
finance crash your boat into the shoals soon after leaving port.
WHAT UNDERWRITING STANDARDS
DO LENDERS APPLY?
To decide whether to grant your request for a mortgage, lenders apply
a variety of mortgage underwriting guidelines.
7
The more you can learn
7
For a more extensive discussion of financing properties, see my book The 106
Mortgage Secrets That All Homebuyers Must Learn—but Lenders Don’t Tell, Second
Edition (John Wiley & Sons, 2008).
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40 FINANCING: BORROW SMART, BUILD WEALTH
about these guidelines, the greater the chance that you’ll locate a lender
(or seller) who will approve the property financing you want.
In times of cheap and easy money, lenders shovel out money to almost
anyone who rolls a wheelbarrow into the bank. In periods of tight money
(which always follow periods of loose underwriting), lenders tighten their
standards.
1. Collateral (LTV, property characteristics, recourse personal
notes)
2. Amount and source of down payment and reserves
3. Capacity (monthly income)
4. Credit history (credibility!)
5. Character and competency
6. Compensating factors
Collateral
Lenders set underwriting standards for properties (not just borrowers).
Although such standards vary, all lenders specify the types of properties as
collateral for their mortgage loans. Some lenders won’t finance properties
larger than four units. Some won’t finance properties in poor condition
or those located in run-down neighborhoods. Many lenders verify that
a property is serviced by all utilities (e.g., some lenders avoid properties
with septic tanks instead of sewer lines). Lenders set standards that apply
to paved streets, conformance with zoning and building regulations, and
proximity to schools, public transportation, shopping, and job centers.
Before you look at properties and write up an offer to buy, verify
whether that property meets the criteria of the lender and loan program
that you intend to use. Otherwise you may waste time and money (loan
application costs, appraisal, and other miscellaneous fees). Often, lenders
will not refund these prepaid expenses.
Loan-to-Value Ratios
As discussed, lenders loan up to a specified percentage of a property’s
market value (or contract price—whichever is less). After your property
meets the lender’s feature profile, the lender will order an appraisal.
To calculate loan-to-value requires an independent estimate of value,
which, as you learned in Chapter 3,may or may not prove accurate or
reasonable.
In good times, appraisers tend to “overappraise.” In tough markets,
they “underappraise.” Thus, as an investor, you face two potential pitfalls:
(1) In loose money, the lender may approve a loan that actually exceeds the
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WHAT UNDERWRITING STANDARDS DO LENDERS APPLY? 41
safe amount you should borrow (without accepting undue risk); and (2) in
tough times, the appraisal may come up short. It will either kill your deal
or force you to increase the amount of your down payment. To avoid any
or all of these underwriting issues, carefully review the lender’s appraisal.
(See Chapter 3.)
Recourse to Other Assets/Income
In addition to the mortgaged property, lenders might also require you
to pledge other assets (property, bank accounts, stocks, etc.) to enhance
their security. Indeed, at times you might even offer cross collateralization
(or pledged collateral) to a bank in exchange for an LTV that’s higher than
you might otherwise receive. In close (and sometimes not so close) calls, a
boost in the collateral you provide will tip loan approval in your direction.
In addition to collateral, banks (and sellers) will ask property in-
vestors to sign a personal note to further guarantee repayment of the
monies owed. If you default, such a recourse loan gives the lender (note-
holder) the right to go after not just the mortgaged property or other
pledged assets, but also, more generally, other assets in which you own
an interest or income you are entitled to receive. Odd as it might sound,
though, once you advance from smaller properties to larger apartment
buildings, offices, and retail centers, lenders typically grant nonrecourse
mortgages. The pledged collateral stands as sole security for repayment.
In case of payment shortfalls, the lender cannot make a claim against your
income or other assets. Other things equal, you should definitely prefer
nonrecourse mortgages. When possible, negotiate for a nonrecourse clause
in your loan agreements.
AmountandSourceofDownPaymentandReserves
Assume that your lender sets a 70 percent LTV for its first mortgage.
Plus your seller will carry back a second mortgage for the balance of the
purchase price. Will the lender approve your loan application? Maybe;
maybe not.
Regardless of LTV, lenders like to see their borrowers put at least
some of their own cash into their properties at the time they buy them.
Moreover, the lender will probably ask you where you’re getting the cash.
The best source is ready money from a savings account (or other liquid
assets). In contrast, most lenders would not want to hear that you’re taking
a $10,000 cash advance against your credit card.
Likewise, most lenders want you to retain cash (or liquid assets) after
you close your loan. Often, they like to see enough reserves to cover two
or three months of mortgage payments. However, the more cash you have
available, the better you look.
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42 FINANCING: BORROW SMART, BUILD WEALTH
Capacity (Monthly Income)
As another underwriting guideline, mortgage lenders evaluate your
monthly income from employment and other sources, as well as the ex-
pected NOI of the property you want to finance. For owner-occupied
properties, a lender will (directly or indirectly) emphasize “qualifying ra-
tios.” A qualifying ratio is the percentage of your income that you can
safely allocate to mortgage payments (principal, interest, property taxes,
and insurance, or PITI). If a lender sets a 28 percent housing-cost qualifying
ratio and you gross $4,000 a month, the lender may limit your mortgage
payments (PITI) to $1,120 a month.
If you are buying your first or second rental house, the lender may
count 75 percent of the rents towards your qualifying ratios—but on this
point lenders differ. Some will count more and some will count less. Also,
for your first few investment property loans, lenders look more to your
personal credit and income to support the loan. As you gain investment
experience, they become more willing to look at your individual property
mortgages on a stand-alone basis. However, the lender will likely still re-
quire a personal guarantee from you, thus placing your net worth/earned
income as additional backup to the collateral property itself.
For apartment buildings and commercial rental properties, lenders
apply a debt coverage ratio (DCR). A debt coverage ratio shows the lender
whether the property brings in enough rental income to cover operating
expenses and debt service (principal and interest). Here’s an example of
DCR for a fourplex whose units each rent for $750 a month:
Gross annual income (4 × $750 × 12) $36,000
less
Vacancy @ 6% p.a. $2,160
Operating expenses and upkeep $7,200
Property taxes and insurance $2,360
equals
Net operating income (NOI) $24,280
If a lender sets a 25 percent margin of net income over debt service,
you calculate your maximum allowable mortgage payment by dividing
the property’s annual NOI by a debt coverage ratio (DCR) of 1.25:
NOI/DCR = Annual mortgage payment
$24,280/1.25 = $19,424
To check, we reverse the calculations:
NOI/Debt Service = Debt coverage ratio
$24,280/$19,424 = 1.25
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WHAT UNDERWRITING STANDARDS DO LENDERS APPLY? 43
Table 2.1 Monthly Payment Required per $1,000 of Original Mortgage Balance
Interest (%) Monthly Payment Interest (%) Monthly Payment
2.5 $3.95 7.5 $6.99
3.0 4.21 8.0 7.34
3.5 4.49 8.5 7.69
4.0 4.77 9.0 8.05
4.5 5.07 9.5 8.41
5.0 5.37 10.0 8.77
5.5 5.67 10.5 9.15
6.0 5.99 11.0 9.52
6.5 6.32 11.5 9.90
7.0 6.65 12.0 10.29
Note: Te r m s = 30 years
From these figures, you can see that with a required 1.25 DCR, the
property will yield enough income to support a monthly mortgage pay-
ment of $1,619 ($19,424 annual mortgage payment ÷ 12). To figure how
much loan a mortgage payment of $1,619 a month will pay off (amortize)
over a 30-year term, refer to Table 2.1.
At mortgage interest rates of, say, 6.0, 7.5, or 9.0 percent, the lender
could loan you up to $270,284, $231,617, or $201,118, respectively.
6.0% Mortgage Interest Rate
$1,619/$5.99 = $270,284 loan amount
7.5% Mortgage Interest Rate
$1,619/$6.99 = $231,617 loan amount
9% Mortgage Interest Rate
$1,619/$8.05 = $201,118 loan amount
Lower interest rates dramatically boost your borrowing power. The
interest rate and debt coverage ratio will partially determine how much
financing a lender will provide (subject to how well you look vis-
´
a-vis the
lender’s other underwriting criteria).
Credit History (Credibility!)
Must you produce high credit scores to buy and finance rental houses,
condos, and apartment buildings? No, but good credit expands your pos-
sibilities. Without a strong credit score, you’ll be limited to seller financing,
“subject to” loan/purchase agreements, or “B,” “C,” or “D” loans that carry
higher discount points, origination fees, and interest rates (if they are even
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44 FINANCING: BORROW SMART, BUILD WEALTH
available). If you show an excellent credit score and credit record, lenders
will welcome your business with competitive rates and terms. You become
a sought-after customer.
Strengthen your credit score. Satisfy your monthly credit obligations
on or before their due dates. Recently, we have heard so much about
“lenders making loans tough to get.” But for investors who show strong
credit scores—say 720 or higher—even troubled lenders have rolled out
the red carpet.
Nevertheless, in our highly competitive mortgage market, some
mortgage lenders will accept borrowers who have experienced foreclo-
sure, repossession, and bankruptcy. To qualify with these lenders, you
typically need (1) to have paid on time, every time for the past 18 to
24 months; (2) to attribute previous adverse credit to divorce, unem-
ployment, accident, illness, or other outside-your-control misfortune; and
(3) to persuade the lender that your present and future financial well-being
is planted on a firm foundation.
If you’ve faced serious credit problems in the past, you need
not wait 5, 7, or 10 years before a lender will qualify you for a new
mortgage—especially if you live in the property you buy. (Remember,
lenders provide their easiest qualifying, lowest costs, and best terms for
owner occupants.)
Character and Competency
Although U.S. lenders cannot legally underwrite by age, race, religion, sex,
marital status, or disability as they evaluate your loan application, they
can and do look at other personal characteristics such as the following:
♦ Education level
♦ Career advancement potential
♦ Job stability
♦ Stability in the community
♦ Saving, spending, and borrowing habits
♦ Dependability
♦ Dress and mannerisms
♦ Experience in property ownership
A mortgage lender might not arbitrarily reject your loan application
because you dropped out of high school, dyed your hair purple, wear
a silver nose ring, change jobs every six months, or have not registered
a telephone in your own name. Nevertheless, subtle (and not so subtle)
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WHAT UNDERWRITING STANDARDS DO LENDERS APPLY? 45
influences still count—especially for investors, and especially when tight
underwriting prevails.
Property ownership requires commitment. Smart lenders trust you
to fulfill your responsibilities. Convince the lender that you are a solid and
dependable worker, investor, and borrower. When appropriate, assure the
lender via a business plan (or other means) that you’ll manage the property
to enhance its value.
The legendary banker J. P. Morgan once told a U.S. congressional
committee, “Money cannot buy credit. A man I do not trust could not get
credit from me on all the bonds of Christendom.” J. P. Morgan knows lend-
ing: character does count. As “liar’s loans” proliferated during 2001–2006,
many lenders ignored (to their later regret) J. P.’s sound advice. Although
during some future boom period lenders will again lose their common
sense, in all loan markets you are wise to play it straight.
Compensating Factors
As you study a lender’s underwriting guidelines, remember, these are
guidelines. Most lenders do not evaluate their mortgage loan applications
by inflexible rules. Lenders weigh and consider. You can help persuade a
lender to approve your loan. Emphasize your positives and play down or
explain away negatives.
If your debt coverage ratio falls below a lender’s desired minimum,
show the lender how you plan to improve the property and increase rents.
If you have accumulated credit problems, compensate with a higher down
payment or pledged collateral. If you’ve frequently changed jobs, point
out the raises and promotions you’ve received. If you lack experience in
property ownership or property management, tell the lenders how you’ve
educated yourself by reading real estate books and how you’ve developed
a winning market strategy (see Chapter 11).
Use employer letters, references, prepared budgets, a business plan,
or any other written evidence that you can come up with to justify your loan
request. Anything in writing to persuade the lender that you are willing
and able to pay back the money you borrow may help. Compensating
factors can make the decision swing in your favor.
Remember, lenders differ—especially when they underwrite in-
vestors. What one rejects, another accepts. To get the loan you want, search
the mortgage market. With thousands of lenders and loan brokers compet-
ing for loans, chances are you can find a lender (or seller) who’s right for
you. If not, those lenders have just sent you a powerful signal: You must
improve your financial fitness and borrower profile.
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46 FINANCING: BORROW SMART, BUILD WEALTH
Automated Underwriting (AUS)
For the past 10 to 15 years, mortgage lenders have relied on automated un-
derwriting. Using such a system, a loan rep gathers pertinent underwriting
facts and enters them into a software program.
If your borrower (and property) profile matches the standards written
into this loan approval program, great. It means a faster, less costly path
to closing, and a shorter stack of paperwork. But if your profile needs
outside-the-box attention, work with a savvy loan rep who can apply the
skill and knowledge necessary to get your loan approved—or at least tell
you the reasons why your application falls short and how you can work
to overcome deficiencies.
To see how you might fare with automated underwriting, go to
myfico.com. From this site, you can learn your credit scores and obtain
pointers on how to improve them.
Automated underwriting (AUS) looks at more than your credit score.
These programs incorporate calculations that evaluate your qualifying ra-
tios, earning power, cash reserves, debts, and assets. When your trimerged
credit scores exceed, say, 720 (or so), the AUS will loosen up on other stan-
dards. Conversely, a score of, say, 640 (or so) will cause the AUS to subject
your financial profile to stricter standards and more documentation of
income, savings, and other pertinent financial data.
Exactly how AUS programs balance and trade off individual un-
derwriting criteria remains a guarded secret. But savvy loan reps have
developed some rule-of-thumb insights. So ask them. Benefit from their
experience.
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3
APPRAISAL: HOW TO DISCOVER
GOOD VALUE
A
pply the know-how of Chapter 2, and you will find ways to finance
your investment properties. But financing provides only a means
to a goal. Your goal is to buy and finance properties that offer
strong potential for profit. And to invest profitably requires you to estimate
(present and future) market value.
Experience shows that many real estate investors (and homebuy-
ers) have glossed over this critical point. Most popular how-to books on
real estate investing give short shrift to valuing properties. Why? Because
many authors and investors have mistakenly assumed that “inflation cures
all mistakes.” Na
¨
ıvely, many investors (speculators) have thought that to
make money in real estate, all you have to do is buy it. Even if you pay too
much, price increases will eventually bail you out. As example, here’s what
multimillionaire investor and author, David Schumacher, once advised:
The amount I paid for this property is inconsequential because
of the degree to which it has appreciated [sic: he means in-
creased in price due to inflation and appreciation] in value....
In my opinion, it is ridiculous to quibble over $5,000 or even
$50,000 in price if you are buying for the long term.... In 1963,
I bought a four-unit apartment building for $35,000. Suppose I
had paid $100,000 for it. It wouldn’t have made any difference
because the property’s worth $1.2 million today. (The Buy and
Hold Real Estate Strategy, John Wiley & Sons, 1992)
1
1
Assuming 20 percent down at 5 percent interest, 30 years, for Schumacher’s
example property, the monthly payment on $80,000 (assuming a $100,000 purchase
47
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48 APPRAISAL: HOW TO DISCOVER GOOD VALUE
Other top-selling real estate authors advise would-be investors to
tell sellers, “You name the price, I’ll name the terms.” If the property
owner agrees to sell on easy terms (usually little or nothing down), the
buyer will agree to the seller’s price. “Who cares about the price you pay
today? What’s important is all that money you’re going to make when you
sell.” During the go-go boom years 2001–2006, I witnessed this mistake
hundreds of time in places as diverse as Dubai, Dublin, and San Diego.
MAKE MONEY WHEN YOU BUY, NOT JUST
WHEN YOU SELL
Long-term price increases (inflation, appreciation) will typically boost a
property’s eventual selling price. But before you can profit from the long
run, you must survive the short run. If you overpay, you may have to wait
five years (or more) for the market to catch up.
Even worse, during that wait, negative cash flows (the alligators)
may eat you alive. You lose the property. Someone else picks up the same
property at a much lower price. Even when investors do struggle through
a swampland of alligators, they still miss the rewards they could have
obtained if they had chosen a surer and safer route.
Want to profit? Buy right! Long-term successful investors make
money when they buy, not just when they sell. You reduce risk and increase
your chance for great returns when you buy properties at or (preferably)
below their market values. But this tactic requires that you know what
the term “market value” really means. (Note: When you buy at a bargain
price, you often pay less than market value for a property. However, I also
encourage you to buy “undervalued” properties. In this sense, underval-
ued refers to all properties and/or locations that are loaded with strong
potential for gains that may result from a variety of sources. You’ll learn
how to find and evaluate “undervalued” properties in later chapters.)
WHAT IS MARKET VALUE?
To the uninformed, “appraised value,” “sales price,” and “market value”
all refer to the same concept. In fact, “Appraised value” could refer to an
insurance policy appraisal, a property tax appraisal, an estate tax appraisal,
or a market value appraisal. Sales price itself merely identifies the nominal
price) would equal $430, whereas a $28,000 loan ($35,000 purchase price) would
have required a payment of just $150 a month.
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WHAT IS MARKET VALUE? 49
price at which a property has sold. That sales price could equal, exceed,
or fall below market value. Market value reliably reflects sales price only
when a property is sold according to these five stipulations:
1. Buyers and sellers are typically motivated. Neither acts under
duress.
2. Buyers and sellers are well informed about the market and nego-
tiate in their own best interest.
The marketing period and sales promotion efforts are sufficient to
bring the property to the attention of willing and able buyers.
3. No atypically favorable or unfavorable terms of financing apply.
(During the most recent property boom, lenders offered dangerously easy
financing, thus pushing sales prices far above their natural market value.)
4. Neither the sellers nor the buyers offer any extraordinary sales
concessions or incentives. (For example, the builders in many countries
offered off-plan buyers three years of rent guarantees—clearly a red flag
that the builders’ prices exceed market value.)
To further illustrate the stipulated conditions underlying the concept
of market value, say that two properties recently sold in a neighborhood
where you’re interested in buying:
Thirty-seven Oak sold at a price of $258,000, and 164 Maple sold at
a price of $255,000. Each of these three-bedroom, two-bath houses was in
good condition, with around 2,100 square feet. You locate a nearby house
of similar size and features at 158 Pine. It’s priced at $234,750. Is that a
bargain (below market value) price? Maybe; maybe not. Before you draw
a conclusion, investigate the terms and conditions of the other two sales.
What if the sellers of 164 Maple had carried back a nothing-down,
5 percent, 30-year mortgage for their buyers (i.e., favorable financing)?
What if the buyers of 37 Oak had just flown into Peoria from San
Francisco and bought the first house they saw because “It was such a
steal. You couldn’t find anything like it in San Francisco for less than
$1.2 million” (i.e., uninformed buyers)?
What if the sellers of 37 Oak had agreed to pay all of their buyer’s
closing costs and leave their authentic Chippendale buffet because it was
too big to move into their new condo in Florida (i.e., extraordinary sales
concessions)?
Sales Price Doesn’t Necessarily Equal Market Value
When you buy real estate, go well beyond merely learning the prices at
which other similar properties have sold. Investigate whether the buyers
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50 APPRAISAL: HOW TO DISCOVER GOOD VALUE
or sellers acted with full market knowledge, gave any unusually favorable
(or onerous) terms of financing, bought (or sold) in a hurry, or made
concessions that pushed up the nominal selling price—or perhaps pulled
it down. If you find that the sales of comparable properties do not meet
the conditions of a “market value” sale, weigh that information before you
write your contract offer on a property.
In other words, before you rely on comp sales prices to value a
property: (1) verify the accuracy of your information; (2) verify the date of
sale; and (3) verify the terms and conditions of the sale. Faulty information
about a comp property’s features or terms of sale can make bad deals look
good (or vice versa). Also, market value assumes no hidden defects or title
issues. A comp (or subject) house with a termite infestation should sell at
a price below market value (see later discussion).
Sound Underwriting Requires Lenders to Loan
Only Against Market Value
Financial institutions loan against market value, not purchase price, un-
less your purchase price falls below market value. When you apply for a
mortgage, you may tell the lender that you’ve agreed to a price of $200,000
and would like to borrow $160,000 (an 80 percent LTV). Yet the lender will
not necessarily agree that this price matches the property’s market value.
First, the lender will ask about special financing terms (e.g., a $20,000
seller second) and sales concessions (e.g., the seller’s plan to buy down
your interest rate for three years and pay all closing costs). If your transac-
tion differs from market norms, the lender won’t loan 80 percent of your
$200,000 purchase price—even if it routinely does make 80 percent LTV
loans. The lender may find that easy terms of financing or sales concessions
are worth $10,000. So, the lender may calculate your 80 percent LTV ratio
against $190,000, not the $200,000 purchase price.
Second, to verify that your purchase price of $200,000 equals or ex-
ceeds market value, the lender will order a market value appraisal. If that
appraisal report comes back with a figure that’s less than $200,000, the
lender will use the lesser amount to calculate an 80 percent LTV loan. Take
notice: You don’t have to passively suffer the results of a low appraisal.
Critique the original. Ask the appraiser to correct errors. Or you can ask
the lender to order a new appraisal with another firm. The lender needs a
file document (appraisal) to justify its lending decision. If you provide an
acceptable (revised or remade) appraisal of a satisfactory amount, you’ll
often get the loan you want.
Danger: Just because a lender’s appraiser comes up with a market
value estimate that matches your purchase price, never assume that the
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HOW TO ESTIMATE MARKET VALUE 51
appraisal accurately sets market value. Accept personal responsibility for
your offering price. Loan reps routinely tell their appraisers the value
estimate they need to make a deal work. In return, appraisers know that if
they fail to “hit the desired numbers,” loan reps will select another, more
accommodating appraiser to prepare their reports.
If you’re a good customer of a bank (or if the bank would like you
to become a good customer), the loan rep may encourage the appraiser to
issue an MAI (made as instructed) appraisal. I know of many instances
where appraisers have acquiesced to not-so-subtle hints from a loan rep
and submitted appraisals that overstated a property’s value. (Indeed, as
early in the property boom as 2003, government investigators found that
loan reps were pressuring appraisers to lift their value estimates.)
You will work with appraisers, and you will solicit their opinions,
but never accept those opinions as the final word. To protect yourself
against inaccurate appraisals (your own, as well as others), understand
how to calculate, apply, and interpret the three technical methods used to
estimate market value.
HOW TO ESTIMATE MARKET VALUE
Investors, lenders, and appraisers rely on three techniques to value
properties.
1. Cost approach. (1) Calculate how much it would cost to build a
subject property at today’s prices, (2) subtract accrued depreciation, and
(3) add the depreciated cost figure to the current value of the lot.
2. Comparable sales approach. (1) Compare a subject property with
other similar (comp) properties that have recently sold, (2) adjust the prices
for each positive or negative feature of the comps relative to the subject
property, (3) via this detailed and systematic comparison, adjust for pos-
itive and negative property differences, and (4) estimate market value of
the subject property from the adjusted sales prices of the comps.
3. Income approach. (1) Estimate the rents you expect a property to
produce, and (2) convert net rents after expenses (net operating income)
into a capital (market) value amount.
You evaluate a property from three perspectives to check the value
estimates of each against the others. Multiple estimates and techniques
enhance the probability that your estimate reflects reality. If your three
value estimates don’t reasonably match up, either your calculations err,
the figures you’re working with are inaccurate, or the market is acting
“crazy” and property prices are about to head up (or down).
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52 APPRAISAL: HOW TO DISCOVER GOOD VALUE
Figure 3.1 shows a sample appraisal form for a single-family house.
Refer to this form as you read the following pages and you’ll see how to
apply these three techniques to appraise properties. Photocopy this form
(or print a copy from the Internet). Use the forms to fill in property and
market information as you value potential property investments.
PROPERTY DESCRIPTION
To accurately estimate the value of a property, first describe the features
of the property and its neighborhood in detail. List all facts that might
influence value favorably or unfavorably. Investors err in their appraisals
because they casually inspect rather than carefully detail and compare.
Focus on each of the neighborhood and property features listed on an
appraisal form. You will value properties more profitably.
Identify the Subject Property
To identify the subject property seems straightforward. Nevertheless, you
might experience some pitfalls. For example, the street address for one
of my previous homes was 73 Roble Road, Berkeley, California 94705.
However, that property does not sit in Berkeley. It is actually located in
Oakland. The house sat back from Roble Road (which is in Berkeley) about
100 feet—just far enough to put it within the city limits of Oakland. As a
result, the city laws governing the property (zoning, building regulations,
permits, rent controls, school district, etc.) were those of Oakland, not
Berkeley.
Similarly, Park Cities (University Park and Highland Park) are high-
income, independent municipalities located within the geographic bound-
aries of Dallas, Texas. Among other amenities, Park Cities are noted for
their high-quality schools. Yet (in the past) if you lived in Park Cities on
the west side of the North Dallas Tollway, your children would attend the
lesser-regarded schools of the Dallas Independent School District.
The lesson: Street and city addresses don’t always tell you what you
need to know about a property. Strange as it may seem, a property may
not be located where you think it is. (See also forthcoming discussion of
site identification.)
Neighborhood
As the appraisal form shows, a neighborhood investigation should note the
types and condition of neighborhood properties, the percentage of houses
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PROPERTY DESCRIPTION 53
Uniform Residential Appraisal Report
File #
Freddie Mac Form 70 March 2005 Page 1 of 6 Fannie Mae Form 1004 March 2005
The purpose of this summary appraisal report is to provide the lender/client with an accurate, and adequately supported, opinion of the market value of the subject property.
Property Address City State Zip Code
Borrower Owner of Public Record County
Legal Description
Assessor’s Parcel # Tax Year R.E. Taxes $
Neighborhood Name Map Reference Census Tract
Occupant Owner Tenant Vacant Special Assessments $ PUD HOA $ per year per month
Property Rights Appraised Fee Simple Leasehold Other (describe)
Assignment Type Purchase Transaction Refinance Transaction Other (describe)
Lender/Client Address
Is the subject property currently offered for sale or has it been offered for sale in the twelve months prior to the effective date of this appraisal? Yes No
Report data source(s) used, offering price(s), and date(s).
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I did did not analyze the contract for sale for the subject purchase transaction. Explain the results of the analysis of the contract for sale or why the analysis was not
performed.
Contract Price $ Date of Contract Is the property seller the owner of public record? Yes No Data Source(s)
Is there any financial assistance (loan charges, sale concessions, gift or downpayment assistance, etc.) to be paid by any part y on behalf of the borrower? Yes No
If Yes, report the total dollar amount and describe the items to be paid.
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Note: Race and the racial composition of the neighborhood are not appraisal factors.
Neighborhood Characteristics One-Unit Housing Trends One-Unit Housing Present Land Use %
Location Urban Suburban Rural Property Values Increasing Stable Declining PRICE AGE One-Unit %
Built-Up Over 75% 25–75% Under 25% Demand/Supply Shortage In Balance Over Supply $ (000) (yrs) 2-4 Unit %
Growth Rapid Stable Slow Marketing Time Under 3 mths 3–6 mths Over 6 mths Low Multi-Family %
Neighborhood Boundaries High Commercial %
Pred. Other %
Neighborhood Description
Market Conditions (including support for the above conclusions)
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Dimensions Area Shape View
Specific Zoning Classification Zoning Description
Zoning Compliance Legal Legal Nonconforming (Grandfathered Use) No Zoning Illegal (describe)
Is the highest and best use of the subject property as improved (or as proposed per plans and specifications) the present use? Yes No If No, describe
Utilities Public Other (describe) Public Other (describe) Off-site Improvements—Type Public Private
Electricity Water Street
Gas Sanitary Sewer Alley
FEMA Special Flood Hazard Area Yes No FEMA Flood Zone FEMA Map # FEMA Map Date
Are the utilities and off-site improvements typical for the market area? Yes No If No, describe
Are there any adverse site conditions or external factors (easements, encroachments, environmental conditions, land uses, etc.) ? Yes No If Yes, describe
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General Description Foundation Exterior Description materials/condition Interior materials/condition
Units One One with Accessory Unit Concrete Slab Crawl Space Foundation Walls Floors
# of Stories Full Basement Partial Basement Exterior Walls Walls
Type Det. Att. S-Det./End Unit Basement Area sq. ft. Roof Surface Trim/Finish
Existing Proposed Under Const. Basement Finish % Gutters & Downspouts Bath Floor
Design (Style) Outside Entry/Exit Sump Pump Window Type Bath Wainscot
Year Built Evidence of Infestation Storm Sash/Insulated Car Storage None
Effective Age (Yrs) Dampness Settlement Screens Driveway # of Cars
Attic None Heating FWA HWBB Radiant Amenities Woodstove(s) # Driveway Surface
Drop Stair Stairs Other Fuel Fireplace(s) # Fence Garage # of Cars
Floor Scuttle Cooling Central Air Conditioning Patio/Deck Porch Carport # of Cars
Finished Heated Individual Other Pool Other Att. Det. Built-in
Appliances Refrigerator Range/Oven Dishwasher Disposal Microwave Washer/Dryer Other (describe)
Finished area above grade contains: Rooms Bedrooms Bath(s) Square Feet of Gross Living Area Above Grade
Additional features (special energy efficient items, etc.)
Describe the condition of the property (including needed repairs, deterioration, renovations, remodeling, etc.).
Are there any physical deficiencies or adverse conditions that affect the livability, soundness, or structural integrity of the property? Yes No If Yes, describe
Does the property generally conform to the neighborhood (functional utility, style, condition, use, construction, etc.)? Yes No If No, describe
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Figure 3.1 Appraisal Report
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54 APPRAISAL: HOW TO DISCOVER GOOD VALUE
Uniform Residential Appraisal Report
File #
Freddie Mac Form 70 March 2005 Page 2 of 6 Fannie Mae Form 1004 March 2005
There are comparable properties currently offered for sale in the subject neighborhood ranging in price from $ to $ .
There are comparable sales in the subject neighborhood within the past twelve months ranging in sale price from $ to $ .
FEATURE SUBJECT COMPARABLE SALE # 1 COMPARABLE SALE # 2 COMPARABLE SALE # 3
Address
Proximity to Subject
Sale Price $ $ $ $
Sale Price/Gross Liv. Area $ sq. ft. $ sq. ft. $ sq. ft. $ sq. ft.
Data Source(s)
Verification Source(s)
VALUE ADJUSTMENTS DESCRIPTION DESCRIPTION +(-) $ Adjustment DESCRIPTION +(-) $ Adjustment DESCRIPTION +(-) $ Adjustment
Sale or Financing
Concessions
Date of Sale/Time
Location
Leasehold/Fee Simple
Site
View
Design (Style)
Quality of Construction
Actual Age
Condition
Above Grade
Total Bdrms. Baths Total Bdrms. Baths Total Bdrms. Baths Total Bdrms. Baths
Room Count
Gross Living Area sq. ft. sq. ft. sq. ft. sq. ft.
Basement & Finished
Rooms Below Grade
Functional Utility
Heating/Cooling
Energy Efficient Items
Garage/Carport
Porch/Patio/Deck
Net Adjustment (Total) + - $ + - $ + - $
Adjusted Sale Price
of Comparables
Net Adj. %
Gross Adj. % $
Net Adj. %
Gross Adj. % $
Net Adj. %
Gross Adj. % $
I did did not research the sale or transfer history of the subject property and comparable sales. If not, explain
My research did did not reveal any prior sales or transfers of the subject property for the three years prior to the effective date of this appraisal.
Data source(s)
My research did did not reveal any prior sales or transfers of the comparable sales for the year prior to the date of sale of the comparable sale.
Data source(s)
Report the results of the research and analysis of the prior sale or transfer history of the subject property and comparable sales (report additional prior sales on page 3).
ITEM SUBJECT COMPARABLE SALE # 1 COMPARABLE SALE # 2 COMPARABLE SALE # 3
Date of Prior Sale/Transfer
Price of Prior Sale/Transfer
Data Source(s)
Effective Date of Data Source(s)
Analysis of prior sale or transfer history of the subject property and comparable sales
Summary of Sales Comparison Approach
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Indicated Value by Sales Comparison Approach $
Indicated Value by: Sales Comparison Approach $ Cost Approach (if developed) $ Income Approach (if developed) $
This appraisal is made “as is”, subject to completion per plans and specifications on the basis of a hypothetical condition that the improvements have been
completed,
subject to the following repairs or alterations on the basis of a hypothetical condition that the repairs or alterations have been completed, or subject to the
following required inspection based on the extraordinary assumption that the condition or deficiency does not require alteration or repair:
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Based on a complete visual inspection of the interior and exterior areas of the subject property, defined scope of work, statement of assumptions and limiting
conditions, and appraiser’s certification, my (our) opinion of the market value, as defined, of the real property that is the subject of this report is
$ , as of , which is the date of inspection and the effective date of this appraisal.
Figure 3.1 (Continued)
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PROPERTY DESCRIPTION 55
Uniform Residential Appraisal Report
File #
Freddie Mac Form 70 March 2005 Page 3 of 6 Fannie Mae Form 1004 March 2005
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COST APPROACH TO VALUE (not required by Fannie Mae)
Provide adequate information for the lender/client to replicate the below cost figures and calculations.
Support for the opinion of site value (summary of comparable land sales or other methods for estimating site value)
ESTIMATED REPRODUCTION OR REPLACEMENT COST NEW OPINION OF SITE VALUE.................................................................= $
Source of cost data Dwelling Sq. Ft. @ $ .....................=$
Quality rating from cost service Effective date of cost data Sq. Ft. @ $ .....................=$
Comments on Cost Approach (gross living area calculations, depreciation, etc.)
Garage/Carport Sq. Ft. @ $ .....................=$
Total Estimate of Cost-New ....................= $
Less Physical Functional External
Depreciation =$( )
Depreciated Cost of Improvements......................................................=$
“As-is” Value of Site Improvements......................................................=$
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Estimated Remaining Economic Life (HUD and VA only) Years Indicated Value By Cost Approach.................................... ..................=$
INCOME APPROACH TO VALUE (not required by Fannie Mae)
Estimated Monthly Market Rent $ X Gross Rent Multiplier = $ Indicated Value by Income Approach
Summary of Income Approach (including support for market rent and GRM)
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PROJECT INFORMATION FOR PUDs (if applicable)
Is the developer/builder in control of the Homeowners’ Association (HOA)? Yes No Unit type(s) Detached Attached
Provide the following information for PUDs ONLY if the developer/builder is in control of the HOA and the subject property is an attached dwelling unit.
Legal name of project
Total number of phases Total number of units Total number of units sold
Total number of units rented Total number of units for sale Data source(s)
Was the project created by the conversion of an existing building(s) into a PUD? Yes No If Yes, date of conversion
Does the project contain any multi-dwelling units? Yes No Data source(s)
Are the units, common elements, and recreation facilities complete? Yes No If No, describe the status of completion.
Are the common elements leased to or by the Homeowners’ Association? Yes No If Yes, describe the rental terms and options.
Describe common elements and recreational facilities
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Figure 3.1 (Continued)
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56 APPRAISAL: HOW TO DISCOVER GOOD VALUE
Uniform Residential Appraisal Report File #
Freddie Mac Form 70 March 2005 Page 4 of 6 Fannie Mae Form 1004 March 2005
This report form is designed to report an appraisal of a one-unit property or a one-unit property with an accessory unit;
including a unit in a planned unit development (PUD). This report form is not designed to report an appraisal of a
manufactured home or a unit in a condominium or cooperative project.
This appraisal report is subject to the following scope of work, intended use, intended user, definition of market value,
statement of assumptions and limiting conditions, and certifications. Modifications, additions, or deletions to the intended
use, intended user, definition of market value, or assumptions and limiting conditions are not permitted. The appraiser may
expand the scope of work to include any additional research or analysis necessary based on the complexity of this appraisal
assignment. Modifications or deletions to the certifications are also not permitted. However, additional certifications that do
not constitute material alterations to this appraisal report, such as those required by law or those related to the appraiser’s
continuing education or membership in an appraisal organization, are permitted.
SCOPE OF WORK: The scope of work for this appraisal is defined by the complexity of this appraisal assignment and the
reporting requirements of this appraisal report form, including the following definition of market value, statement of
assumptions and limiting conditions, and certifications. The appraiser must, at a minimum: (1) perform a complete visual
inspection of the interior and exterior areas of the subject property, (2) inspect the neighborhood, (3) inspect each of the
comparable sales from at least the street, (4) research, verify, and analyze data from reliable public and/or private sources,
and (5) report his or her analysis, opinions, and conclusions in this appraisal report.
INTENDED USE: The intended use of this appraisal report is for the lender/client to evaluate the property that is the
subject of this appraisal for a mortgage finance transaction.
INTENDED USER: The intended user of this appraisal report is the lender/client.
DEFINITION OF MARKET VALUE: The most probable price which a property should bring in a competitive and open
market under all conditions requisite to a fair sale, the buyer and seller, each acting prudently, knowledgeably and assuming
the price is not affected by undue stimulus. Implicit in this definition is the consummation of a sale as of a specified date and
the passing of title from seller to buyer under conditions whereby: (1) buyer and seller are typically motivated; (2) both
parties are well informed or well advised, and each acting in what he or she considers his or her own best interest; (3) a
reasonable time is allowed for exposure in the open market; (4) payment is made in terms of cash in U. S. dollars or in terms
of financial arrangements comparable thereto; and (5) the price represents the normal consideration for the property sold
unaffected by special or creative financing or sales concessions* granted by anyone associated with the sale.
*Adjustments to the comparables must be made for special or creative financing or sales concessions. No adjustments are
necessary for those costs which are normally paid by sellers as a result of tradition or law in a market area; these costs are
readily identifiable since the seller pays these costs in virtually all sales transactions. Special or creative financing
adjustments can be made to the comparable property by comparisons to financing terms offered by a third party institutional
lender that is not already involved in the property or transaction. Any adjustment should not be calculated on a mechanical
dollar for dollar cost of the financing or concession but the dollar amount of any adjustment should approximate the market’s
reaction to the financing or concessions based on the appraiser’s judgment.
STATEMENT OF ASSUMPTIONS AND LIMITING CONDITIONS: The appraiser’s certification in this report is
subject to the following assumptions and limiting conditions:
1. The appraiser will not be responsible for matters of a legal nature that affect either the property being appraised or the title
to it, except for information that he or she became aware of during the research involved in performing this appraisal. The
appraiser assumes that the title is good and marketable and will not render any opinions about the title.
2. The appraiser has provided a sketch in this appraisal report to show the approximate dimensions of the improvements.
The sketch is included only to assist the reader in visualizing the property and understanding the appraiser’s determination
of its size.
3. The appraiser has examined the available flood maps that are provided by the Federal Emergency Management Agency
(or other data sources) and has noted in this appraisal report whether any portion of the subject site is located in an
identified Special Flood Hazard Area. Because the appraiser is not a surveyor, he or she makes no guarantees, express or
implied, regarding this determination.
4. The appraiser will not give testimony or appear in court because he or she made an appraisal of the property in question,
unless specific arrangements to do so have been made beforehand, or as otherwise required by law.
5. The appraiser has noted in this appraisal report any adverse conditions (such as needed repairs, deterioration, the
presence of hazardous wastes, toxic substances, etc.) observed during the inspection of the subject property or that he or
she became aware of during the research involved in performing this appraisal. Unless otherwise stated in this appraisal
report, the appraiser has no knowledge of any hidden or unapparent physical deficiencies or adverse conditions of the
property (such as, but not limited to, needed repairs, deterioration, the presence of hazardous wastes, toxic substances,
adverse environmental conditions, etc.) that would make the property less valuable, and has assumed that there are no such
conditions and makes no guarantees or warranties, express or implied. The appraiser will not be responsible for any such
conditions that do exist or for any engineering or testing that might be required to discover whether such conditions exist.
Because the appraiser is not an expert in the field of environmental hazards, this appraisal report must not be considered as
an environmental assessment of the property.
6. The appraiser has based his or her appraisal report and valuation conclusion for an appraisal that is subject to satisfactory
completion, repairs, or alterations on the assumption that the completion, repairs, or alterations of the subject property will
be performed in a professional manner.
Figure 3.1 (Continued)
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PROPERTY DESCRIPTION 57
Uniform Residential Appraisal Report
File #
Freddie Mac Form 70 March 2005 Page 5 of 6 Fannie Mae Form 1004 March 2005
APPRAISER’S CERTIFICATION: The Appraiser certifies and agrees that:
1. I have, at a minimum, developed and reported this appraisal in accordance with the scope of work requirements stated in
this appraisal report.
2. I performed a complete visual inspection of the interior and exterior areas of the subject property. I reported the condition
of the improvements in factual, specific terms. I identified and reported the physical deficiencies that could affect the
livability, soundness, or structural integrity of the property.
3. I performed this appraisal in accordance with the requirements of the Uniform Standards of Professional Appraisal
Practice that were adopted and promulgated by the Appraisal Standards Board of The Appraisal Foundation and that were in
place at the time this appraisal report was prepared.
4. I developed my opinion of the market value of the real property that is the subject of this report based on the sales
comparison approach to value. I have adequate comparable market data to develop a reliable sales comparison approach
for this appraisal assignment. I further certify that I considered the cost and income approaches to value but did not develop
them, unless otherwise indicated in this report.
5. I researched, verified, analyzed, and reported on any current agreement for sale for the subject property, any offering for
sale of the subject property in the twelve months prior to the effective date of this appraisal, and the prior sales of the subject
property for a minimum of three years prior to the effective date of this appraisal, unless otherwise indicated in this report.
6. I researched, verified, analyzed, and reported on the prior sales of the comparable sales for a minimum of one year prior
to the date of sale of the comparable sale, unless otherwise indicated in this report.
7. I selected and used comparable sales that are locationally, physically, and functionally the most similar to the subject property.
8. I have not used comparable sales that were the result of combining a land sale with the contract purchase price of a home that
has been built or will be built on the land.
9. I have reported adjustments to the comparable sales that reflect the market's reaction to the differences between the subject
property and the comparable sales.
10. I verified, from a disinterested source, all information in this report that was provided by parties who have a financial interest
in the sale or financing of the subject property.
11. I have knowledge and experience in appraising this type of property in this market area.
12. I am aware of, and have access to, the necessary and appropriate public and private data sources, such as multiple listing
services, tax assessment records, public land records and other such data sources for the area in which the property is located .
13. I obtained the information, estimates, and opinions furnished by other parties and expressed in this appraisal report from
reliable sources that I believe to be true and correct.
14. I have taken into consideration the factors that have an impact on value with respect to the subject neighborhood, subject
property, and the proximity of the subject property to adverse influences in the development of my opinion of market value. I
have noted in this appraisal report any adverse conditions (such as, but not limited to, needed repairs, deterioration, the
presence of hazardous wastes, toxic substances, adverse environmental conditions, etc.) observed during the inspection of the
subject property or that I became aware of during the research involved in performing this appraisal. I have considered these
adverse conditions in my analysis of the property value, and have reported on the effect of the conditions on the value and
marketability of the subject property.
15. I have not knowingly withheld any significant information from this appraisal report and, to the best of my knowledge, all
statements and information in this appraisal report are true and correct.
16. I stated in this appraisal report my own personal, unbiased, and professional analysis, opinions, and conclusions, which
are subject only to the assumptions and limiting conditions in this appraisal report.
17. I have no present or prospective interest in the property that is the subject of this report, and I have no present or
prospective personal interest or bias with respect to the participants in the transaction. I did not base, either partially or
completely, my analysis and/or opinion of market value in this appraisal report on the race, color, religion, sex, age, marital
status, handicap, familial status, or national origin of either the prospective owners or occupants of the subject property or of the
present owners or occupants of the properties in the vicinity of the subject property or on any other basis prohibited by law.
18. My employment and/or compensation for performing this appraisal or any future or anticipated appraisals was not
conditioned on any agreement or understanding, written or otherwise, that I would report (or present analysis supporting) a
predetermined specific value, a predetermined minimum value, a range or direction in value, a value that favors the cause of
any party, or the attainment of a specific result or occurrence of a specific subsequent event (such as approval of a pending
mortgage loan application).
19. I personally prepared all conclusions and opinions about the real estate that were set forth in this appraisal report. If I
relied on significant real property appraisal assistance from any individual or individuals in the performance of this appraisal
or the preparation of this appraisal report, I have named such individual(s) and disclosed the specific tasks performed in this
appraisal report. I certify that any individual so named is qualified to perform the tasks. I have not authorized anyone to make
a change to any item in this appraisal report; therefore, any change made to this appraisal is unauthorized and I will take no
responsibility for it.
20. I identified the lender/client in this appraisal report who is the individual, organization, or agent for the organization that
ordered and will receive this appraisal report.
Figure 3.1 (Continued)
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58 APPRAISAL: HOW TO DISCOVER GOOD VALUE
Uniform Residential Appraisal Report
File #
Freddie Mac Form 70 March 2005 Page 6 of 6 Fannie Mae Form 1004 March 2005
21. The lender/client may disclose or distribute this appraisal report to: the borrower; another lender at the request of the
borrower; the mortgagee or its successors and assigns; mortgage insurers; government sponsored enterprises; other
secondary market participants; data collection or reporting services; professional appraisal organizations; any department,
agency, or instrumentality of the United States; and any state, the District of Columbia, or other jurisdictions; without having to
obtain the appraiser’s or supervisory appraiser’s (if applicable) consent. Such consent must be obtained before this appraisal
report may be disclosed or distributed to any other party (including, but not limited to, the public through advertising, public
relations, news, sales, or other media).
22. I am aware that any disclosure or distribution of this appraisal report by me or the lender/client may be subject to certain
laws and regulations. Further, I am also subject to the provisions of the Uniform Standards of Professional Appraisal Practice
that pertain to disclosure or distribution by me.
23. The borrower, another lender at the request of the borrower, the mortgagee or its successors and assigns, mortgage
insurers, government sponsored enterprises, and other secondary market participants may rely on this appraisal report as
part of any mortgage finance transaction that involves any one or more of these parties.
24. If this appraisal report was transmitted as an “electronic record” containing my “electronic signature,” as those terms are
defined in applicable federal and/or state laws (excluding audio and video recordings), or a facsimile transmission of this
appraisal report containing a copy or representation of my signature, the appraisal report shall be as effective, enforceable
and valid as if a paper version of this appraisal report were delivered containing my original hand written signature.
25. Any intentional or negligent misrepresentation(s) contained in this appraisal report may result in civil liability and/or
criminal penalties including, but not limited to, fine or imprisonment or both under the provisions of Title 18, United States
Code, Section 1001, et seq., or similar state laws.
SUPERVISORY APPRAISER’S CERTIFICATION: The Supervisory Appraiser certifies and agrees that:
1. I directly supervised the appraiser for this appraisal assignment, have read the appraisal report, and agree with the
appraiser’s analysis, opinions, statements, conclusions, and the appraiser’s certification.
2. I accept full responsibility for the contents of this appraisal report including, but not limited to, the appraiser’s analysis,
opinions, statements, conclusions, and the appraiser’s certification.
3. The appraiser identified in this appraisal report is either a sub-contractor or an employee of the supervisory appraiser (or the
appraisal firm), is qualified to perform this appraisal, and is acceptable to perform this appraisal under the applicable state law.
4. This appraisal report complies with the Uniform Standards of Professional Appraisal Practice that were adopted and
promulgated by the Appraisal Standards Board of The Appraisal Foundation and that were in place at the time this appraisal
report was prepared.
5. If this appraisal report was transmitted as an “electronic record” containing my “electronic signature,” as those terms are
defined in applicable federal and/or state laws (excluding audio and video recordings), or a facsimile transmission of this
appraisal report containing a copy or representation of my signature, the appraisal report shall be as effective, enforceable
and valid as if a paper version of this appraisal report were delivered containing my original hand written signature.
APPRAISER
Signature______________________________________________
Name________________________________________________
Company Name________________________________________
Company Address_______________________________________
_____________________________________________________
Telephone Number______________________________________
Email Address__________________________________________
Date of Signature and Report______________________________
Effective Date of Appraisal________________________________
State Certification #______________________________________
or State License #_______________________________________
or Other (describe)__________________State #_____________
State_________________________________________________
Expiration Date of Certification or License____________________
ADDRESS OF PROPERTY APPRAISED
_____________________________________________________
_____________________________________________________
APPRAISED VALUE OF SUBJECT PROPERTY $_____________
LENDER/CLIENT
Name________________________________________________
Company Name________________________________________
Company Address_______________________________________
_____________________________________________________
Email Address__________________________________________
SUPERVISORY APPRAISER (ONLY IF REQUIRED)
Signature___________________________________________
Name______________________________________________
Company Name_____________________________________
Company Address____________________________________
__________________________________________________
Telephone Number___________________________________
Email Address_______________________________________
Date of Signature____________________________________
State Certification #___________________________________
or State License #____________________________________
State______________________________________________
Expiration Date of Certification or License_________________
SUBJECT PROPERTY
Did not inspect subject property
Did inspect exterior of subject property from street
Date of Inspection_________________________________
Did inspect interior and exterior of subject property
Date of Inspection_________________________________
COMPARABLE SALES
Did not inspect exterior of comparable sales from street
Did inspect exterior of comparable sales from street
Date of Inspection_________________________________
Figure 3.1 (Continued)
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PROPERTY DESCRIPTION 59
and condominiums that are owner occupied, vacancy rates, property price
(and rental) ranges, the types and quality of government services, and the
relative convenience of the property to shopping, schools, employment
centers, parks and recreational areas—the appeal of the neighborhood to
potential buyers.
Next, imagine the future. Envision the changes that are likely to occur
in the neighborhood during the coming three to five years. Is the neighbor-
hood stable? Is it moving toward higher rates of owner occupancy? Are
property owners fixing up their properties? Do neighborhood residents
and local merchants take pride in their properties and the surrounding
area? Is a neighborhood (or homeowners’) association working to im-
prove the area? If not, could such an association make the neighborhood a
better place to live, shop, work, and play?
When you invest in property, you buy the future even more than
the present. View the neighborhood with both a crystal ball as well as
a magnifying glass. Visualize how the neighborhood will (or could be
made to) look, feel, and live five years into the future.
Site (Lot) Characteristics
Depending on the neighborhood, the size and features of a lot can account
for 20 to 80 percent of a property’s current and future value. Smart investors
pay as much attention to the lot (and its potential) as they do to the
building(s).
In addition to site size and features (see appraisal form), review
the rules and restrictions that govern a site. Determine whether the build-
ings conform to zoning, occupancy, environmental, and safety regulations.
Many two- to four-unit (and larger) properties have been modified (re-
habbed, cut up, added to, repaired, renovated, rewired, reroofed, etc.) in
ways that violate current law. Of course, laws change. Even if the property
did conform, it may now violate today’s legal standards.
Land use law classifies properties as (1) legal and conforming, (2)
legal and nonconforming, and (3) illegal. When a property meets all of
today’s legal standards, it’s called legal and conforming. If it met past
standards that don’t meet current law, but have been “grandfathered,” the
property qualifies as legal but nonconforming.
If the property includes features or uses that violate standards not
grandfathered as permissible, those features or uses remain illegal. Even
work that conforms to the law might place the owner in jeopardy if such
work was performed without a valid permit.
If you buy a property that fails to meet current law, buy with your
eyes open. Lower your offering price to reflect risk. At some future time,
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60 APPRAISAL: HOW TO DISCOVER GOOD VALUE
inspectors may require you to bring the property up to code. Just as im-
portant, health, safety, and environmental violations may:
♦ Subject your tenants to injury
♦ Motivate a rent strike
♦ Expose you to a lawsuit
♦ Expose you to civil or criminal penalties (fines, and in serious
cases, prison)
Before you decide upon the price to pay for a property, verify code
compliance. To bring a nonconforming property up to code (or to tear
out and reinstall unpermitted work) can cost thousands (or even tens of
thousands) of dollars.
Improvements
After you investigate the legal restrictions relative to site size, features, and
improvements (e.g., parking, driveways, fencing, landscaping, utilities,
sewage disposal), detail the size, condition, quality, and appeal of the
house or apartment units located on the site. Building size itself ranks as
one of the most important determinants of value. To determine size (room
count, square footage) requires more than mere counting or pulling out a
tape measure.
As you inspect properties, you’ll see converted basements, garages,
and attics; you’ll see heated/cooled and unheated/uncooled living areas;
you’ll see “bedrooms” without closets and “dining areas” without space
for a family-size table and chairs, let alone a buffet or china cabinet; you’ll
see rooms with 6-foot ceilings or lower, and rooms with 12-foot ceilings
or higher; you’ll see some storage areas that users can access easily and
others that you can reach only by crawling on your hands and knees or
standing on a ladder. You’ll see decks, patios, and porches that display
uniquely strange designs.
In sum, you’ll see that all space is not created equal. Go beyond
comparisons of size, purported space use, or room count. Judge the quality,
livability, traffic patterns, and storage areas within the property.
Even more challenging, not everyone measures square footage in
the same way: A builder recently asked five appraisers to measure one
of his new homes. In sales promotion literature, the builder listed the
home as 3,103 square feet. One appraiser came up with a square-footage
count of 3,047 square feet. The other appraisers came up with measures
that ranged between 2,704 square feet and 3,312 square feet. Differences
such as these occur not just from mistakes but because no “square-footage
police” prescribe or enforce measurement methods.
When you read or hear a property’s room count or size, do not
blindly trust that information. Judge the quality, size, and desirability of
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THE COST APPROACH 61
the space. Here’s another example. I once owned a lakefront house with a
large master bedroom (MBR) that faced the lake through a full wall-sized
window. In valuing that house, an appraiser rated as equivalent another
lakefront home—only its MBR was much smaller and faced street-side.
In his report, the appraiser made no note of that huge difference
(as perceived by most would-be buyers). To compound his errors, the ap-
praiser also rated the “lakefront” lots equivalent—even though one (mine)
was 40,000 square feet with 165 feet of frontage versus the “comp” site at
20,000 square feet with 100 feet of lake frontage. Never accept—without
verification—an appraiser’s comp data or feature adjustments.
THE COST APPROACH
The cost approach recognizes that you can either build (or buy) a new
property or buy an existing one. Replacement cost typically sets the upper
limit to the price you would pay for an existing property. If you can build
a new property for $380,000 (including the cost of a lot), then why pay
$380,000 for a like-kind existing property located just down the street? In
fact, why even pay $380,000 for that older property? It suffers (at least
some) deterioration.
Calculate Cost to Build New
To follow the logic of the cost approach, refer to the appraisal form. First,
calculate the cost to build the property using dollars per square foot. Use
a figure that would apply in your area for the type of property you’re
valuing. To learn these per-square-foot costs, talk with local contractors or
consult the Marshall & Swift construction cost manuals in the reference
section of your local library or on the Internet.
Because replacement costs correlate directly with the size and quality
of buildings, accurate measurement precedes accurate valuation. Notice,
too, that you add the expense of upgrades and extras (crystal chande-
lier, high-grade wall-to-wall carpeting, Italian tile, granite countertops,
high-end appliances or plumbing fixtures, sauna, hot tub, swimming pool,
garage, carport, patios, porches, etc.) to the cost of the basic construction.
Deduct Depreciation
After you calculate today’s building costs for the subject property, deduct
three types of depreciation: (1) physical, (2) functional, and (3) external.
As a building ages, it becomes less valuable than new construction
because of physical depreciation (wear and tear): The property is exposed to
time, weather, use, and abuse; it deteriorates. Frayed carpets, faded paint,
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62 APPRAISAL: HOW TO DISCOVER GOOD VALUE
cracked plaster, rusty plumbing, and leaky roofs bring down a property’s
value when compared with new construction. Exactly how much remains
your call. To fill in a physical depreciation figure for a building in good
condition, estimate, say, 10 percent or 20 percent; if the property appears
run-down, you might justify 50 percent depreciation or greater. Or instead
of applying a percentage depreciation figure, itemize the costs of the repairs
and renovations that would restore the property to like-new condition.
Itemized repairs do not work as well as percentage estimates, because
you can’t economically upgrade an eight-year-old roof, four-year-old car-
peting, or a nine-year-old furnace to like-new condition. Nevertheless, in
one way or another, figure how much you think the subject property has
depreciated relative to a newly built property of the same size, quality, and
features.
Next, estimate the amount of functional depreciation. Unlike wear
and tear, which occurs naturally through use and abuse, functional depre-
ciation creates loss of value due to undesirable features such as outdated
dark wood paneling, a faulty floor plan, low-amperage electrical systems,
out-of-favor color schemes, or weirdly unique architectural design. A prop-
erty may show little physical depreciation but still suffer large functional
obsolescence. The features of the property just do not appeal to potential
buyers or renters.
External (locational) depreciation occurs when a property fails to
reflect the highest and best use for a site. You find a small, well kept house
located in an area now dotted with offices and retail stores. Zoning of the
site has changed. More than likely, the house (as a house, per se) may not
add much to the site’s value. The investor who buys the “house” would
likely tear it down or renovate it and create a retail store or office building.
For such duck-out-of-water properties, external (locational) factors
make the buildings obsolete. External depreciation can approach 100 per-
cent. With or without the building, the site should sell at approximately
the same price. This principle also applies when neighborhoods move up-
scale, and well-kept three-bedroom, two-bath houses of 1,600 square feet
are torn down and replaced with 5,000-square-foot McMansions. Investors
and builders refer to these smaller existing houses as teardowns—even
though their owners may have lovingly maintained them.
Lot Value
To estimate lot value, find similarly zoned (vacant) lots that have recently
sold, or lots that have sold with teardowns on them. When you compare
sites, note all features such as size, frontage, views, topography, legal
restrictions, subdivision rules, and other features that can affect the values
of the respective sites.
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THE COST APPROACH 63
Estimate Market Value (Cost Approach)
As you can see on the appraisal form, after you’ve completed the steps
discussed (calculate a property’s construction cost as if newly built, deduct
depreciation, and add in site value), you have computed market value.
Because you can’t precisely measure construction costs, depreciation, or
site value, the cost approach won’t give you a perfect answer (of course,
neither do the comp sale or income approaches—reason and judgment
rule). But the cost approach will provide a reference point to use with the
comp sales and income approaches. Here’s a simple example of the cost
approach:
Property description: Six-year-old, good-condition, single-family
house of 2,200 square feet. The house includes a two-car, 500-square-foot
garage, a deck, in-ground pool, sprinkler system, and premium carpets,
appliances, and kitchen cabinets. Nearby vacant lots have recently sold for
$60,000.
Dwelling (2,200 × $108 per-square-foot base
construction costs)
$237,600
Upgrades 13,500
Deck, lap pool, sprinklers 21,750
Garage (500 × $33 per square foot) 16,500
Total $289,350
Less
Physical depreciation at 10% (28,935)
Functional depreciation at 5% (14,438)
Depreciated building value $245,978
Site improvements (sidewalks, driveway,
fencing, landscaping)
18,750
Lot value 60,000
Equals
Indicated market value, cost approach $324,728
Typically builders build only when they think they can construct
properties that will sell (or rent) to yield enough revenue to cover their
construction costs and desired profit margin. Therefore, you can usually ex-
pect sales prices to go up when construction costs significantly exceed the
market values of new properties. Why? Because without expected profit,
builders stop building. When growing demand begins to push against a
scarce supply, eventually builder profits return. The real estate construc-
tion cycle starts anew. The opposite also applies. When builder profits
fatten, sooner or later, they overbuild. High expected profits lead to a
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64 APPRAISAL: HOW TO DISCOVER GOOD VALUE
surplus of new construction. Too much housing inventory brings down
market values for new as well as existing properties.
Did I hear someone say Las Vegas, Miami, coastal Spain, or Dubai?
Easy financing encouraged buyers to pay prices that (temporarily) sup-
ported inflated builder profit margins. Builders overbuilt. Buyers over-
leveraged and overpaid. Together they lit the torch for the current market
meltdown.
Investors rejoice. Overbuilding leads to underbuilding. During the
recent downturn, new housing starts nosedived to fewer than 400,000
units—down from 1,600,000 units in 2006. Only large price gains will
bring builders back into the game. Until market values significantly in-
crease, homebuilders will not build many new houses. As new supply re-
mains depressed—and as inventories of foreclosures and REOs are worked
down—the market generates the conditions to support the next cyclical
upswing.
THE COMPARABLE SALES APPROACH
For houses, condominiums, co-ops, townhouses, and apartment buildings,
the comparable sales approach generally provides the most accurate esti-
mate of market value. If you want to know the probable price at which a
specific property will sell, find out the recent selling prices, terms of sale,
and physical features of similar properties.
As explained later, investors rely on the income approach to value
apartment buildings, shopping centers, and offices. However, to apply the
income approach requires good comp sales. The income approach does
not stand independent of the market.
Select Comparable Properties
The accuracy of the comparable sales approach depends on your ability to
find recently sold properties that closely match a subject property. Ideally,
find comp sales in neighborhoods or developments that resemble each
other in property size, age, features, condition, quality of construction,
room count, and floor plan. As a practical matter, you seldom find per-
fect comp matches because each property, each location, displays unique
characteristics.
Nevertheless, you don’t need a perfect match. When you find comp
sales that reasonably match a subject property, you ballpark a value esti-
mate by comparing price per square foot of living area.
Assume that you research three comp sales: (Comp 1) 1,680 square
feet, (Comp 2) 1,840 square feet, and (Comp 3) 1,730 square feet. These
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THE COMPARABLE SALES APPROACH 65
properties sold recently for the respective prices of $225,120, $213,440, and
$211,060. To figure the selling price per square foot of living area for these
homes, divide the sales price of each house by its total square footage.
Comp 1
$225,120/1,680 = $134
Comp 2
$213,440/1,840 = $116
Comp 3
$211,060/1,730 = $122
If the house you’re interested in has 1,796 square feet of living area, it
will probably sell in the range of $120 to $130 per square foot, or $215,520
to $233,480.
Approximate Value Range—Subject Property
$120 × 1,796 = $215,520
$130 × 1,796 = $233,480
Sales price per square foot helps ballpark your value estimate. To gain
deeper insight, compare and contrast similar properties to your subject
property on a feature-by-feature basis.
Adjust for Differences
After you, your real estate agent, or an appraiser finds appropriate com-
parables, adjust the comp sales prices up or down to compensate for the
features that appear inferior or superior to a subject property. Here’s a brief
example of this adjustment process:
Adjustment Process (Selected Features)
Comp 1 Comp 2 Comp 3
Sales price $225,120 $213,440 $211,060
Features
Sales concessions 0 −10,000 0
Financing concessions −15,000 0 0
Date of sale 0 10,000 0
Location 0 0 −20,000
Floor plan 0 5,000 0
Garage 11,000 0 17,000
Pool, patio, deck −9,000 −13,000 0
Indicated value of subject $212,120 $205,440 $208,060
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66 APPRAISAL: HOW TO DISCOVER GOOD VALUE
As you adjust the selling prices of similar houses to reflect their dif-
ferences as per the subject property, you move toward your best estimate of
the market value range for the subject property. Although our preliminary
price-per-square-foot estimated market value for the subject to be worth
between $215,520 and $233,480, after adjustments, a price range between
$212,120 and $205,440 seems reasonable.
Explain the Adjustments
To adjust for differences in size, quality, or features, you equalize a subject
property and each of its comparables: “At what price would the compa-
rable have sold if it exactly matched the subject property?” For example,
consider the $15,000 adjustment to Comp 1 for financing concessions.
In this sale, the sellers carried back a 90 percent LTV mortgage (10
percent down) on the property at an interest rate of 6.5 percent. At the time,
investor financing usually required a 75 percent LTV (25 percent down)
and a 7.75 percent interest rate. Without this favorable owner financing,
Comp 1 would probably have sold for $15,000 less than its actual sales price
of $225,120. Because the definition of market value assumes financing on
terms typically available in the market, the premium created by this OWC
(owner will carry) financing is subtracted from Comp 1’s actual selling
price. Here are the explanations for other adjustments:
Comp 1 garage at (+) $11,000. The subject property stands superior
with its oversize double-car garage, whereas Comp 1 has only a
single-car garage. With a larger garage like the subject’s, Comp 1
would have brought an $11,000 higher sales price.
Comp 1 pool, patio, and deck at (–) $9,000. Comp 1 is superior to the
subject property on this feature because the subject lacks a deck
and tile patio. Without this feature, Comp 1 would have sold for
$9,000 less.
Comp 2 sales concession at (–) $10,000. The $213,440 sales price in this
transaction included the seller’s custom-made drapes, a washer
and dryer, and a backyard storage shed. Because these items aren’t
customary in this market, the sales price is adjusted downward to
equalize this feature with the subject property, whose sale will not
include these items.
Comp 2 floor plan at (+) $5,000. Unlike the subject property, Comp
2 lacked convenient access from the garage to the kitchen. The
garage was built under the house; residents must carry groceries
up an outside stairway to enter the kitchen. With more conven-
tional and convenient access, the selling price of Comp 2 would
probably have increased by $5,000.
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THE INCOME APPROACH 67
Comp 3 location at (–) $20,000. Comp 3 was located on a cul-de-sac,
and its backyard bordered an environmentally protected wooded
area. In contrast, the subject property sits on a typical subdivision
street, and its rear yard abuts that of a neighbor. Because of its
less-favorable location, the subject property could be expected to
sell for $20,000 less than Comp 3.
At this point, you may be asking, “How can I or anyone else come
up with the specific dollar amounts for each of these adjustments?” To that
question, there’s no easy answer. You accrue such knowledge by talking
with sales agents and tracking sales transactions over a period of months
and even years.
Nevertheless, even without experience, you still can weigh the opin-
ions of others against your own judgment. Ask questions. Explore their
reasoning. Verify their facts. As you look at properties, discipline your
mind to list and detail all features that make a difference. Before you at-
tach adjustment numbers to each property’s unique features, first observe
those differences.
THE INCOME APPROACH
Near the bottom of page 3 of the appraisal form, you can see a line labeled
“Indicated Value by Income Approach (If Applicable).” As shown there,
the income approach refers to an appraisal technique called the gross rent
multiplier (GRM).
To calculate market value using the GRM, find the monthly rents
and sales prices of similar houses or apartment buildings. For example,
through market research, you discover the following rental houses: (1) 214
Jackson rents for $1,045 a month and sold for $148,200; (2) 312 Lincoln
rents for $963 a month and sold for $156,000; and (3) 107 Adams rents for
$1,155 a month and sold for $168,400. With this information, you calculate
a range of GRMs for rental houses in this neighborhood:
GRM = Sales price/Monthly rent
Property Sales Price Monthly Rent GRM
214 Jackson $148,200 ÷ $1,045 = 142
312 Lincoln 156,000 ÷ 963 = 162
107 Adams 168,400 ÷ 1,170 = 144
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68 APPRAISAL: HOW TO DISCOVER GOOD VALUE
If the house you value could rent for $1,000 a month, calculate a
value range using the GRMs indicated by these other neighborhood rental
houses:
Subject House (Estimated Value Range)
GRM Monthly Rent Value
142 × $1,000 = $142,000
162 × 1,000 = 162,000
144 × 1,000 = 144,000
Thus, the value ranges between $142,000 and $162,000.
The GRM method does not directly adjust for sales incentives, fi-
nancing concessions, different features, location, property condition, or
property operating expenses. So this technique yields a rough appraisal.
Nevertheless, real estate investors use it as a quick rule of thumb. As with
the comp sales approach, the GRM works best when you find similar
properties in the same neighborhood.
For apartment buildings, the gross rent multiplier is calculated from
annual rent collections rather than monthly. For example:
Multi-Unit Income Properties
Property Sales Price Total Annual Rents GRM
2112 Pope (fourplex) $280,000 ÷ $35,897 = 7.8
1806 Laurel (sixplex) 412,000 ÷ 56,438 = 7.3
1409 Abbot (sixplex) 367,000 ÷ 53,188 = 6.9
The GRMs shown in these examples do not necessarily correspond to
the GRMs that apply in your city. Even within the same city, neighbor-
hoods differ in their GRMs. In the San Diego area, GRMs for single-family
homes in La Jolla can exceed 400; in nearby Claremont, you may find
GRMs in the 250 to 300 range; and in National City, GRMs can drop below
200. Even within the same neighborhood, GRMs for single-family houses
often exceed those of condominiums. In San Francisco, small multi-unit
buildings can sell with annual GRMs of 14 or higher. In Detroit, MI, I have
seen annual GRMs of less than 4.
As with all appraisal methods, search out relevant local data before
you calculate gross rent multipliers. To estimate market value, know the
local (micro) submarkets (type of property, neighborhood, features, and
condition). No set answer rules.
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INCOME CAPITALIZATION 69
INCOME CAPITALIZATION
To value apartment buildings, investors use the direct capitalization tech-
nique. Recall that the direct capitalization method applies the following
value formula:
V = NOI/R
V represents the value estimate. NOI represents the net operating
income of the property. R represents the overall rate of return on capi-
tal that buyers of similar income properties typically require. Here’s an
example.
Net Operating Income
Investors define net operating income as annual gross potential rental
income from a property less vacancy and collection losses, operating ex-
penses, replacement reserves, property taxes, and property and liability
insurance. Study this net income statement for an eight-unit apartment
building where each unit rents for $725 a month:
Income Statement (Annual)
1. Gross annual potential rents ($725 × 8 × 12) $69,600
2. Income from parking and storage areas 6,750
3. Vacancy and collection losses at 7% (5,345)
4. Effective gross income $71,005
Less operating and fixed expenses
5. Trash pickup $1,440
6. Utilities 600
7. Registration fee 275
8. Advertising and promotion 1,200
9. Management fees at 6% 4,260
10. Maintenance and repairs 4,000
11. Yard care 650
12. Miscellaneous 3,000
13. Property taxes 4,270
14. Property and liability insurance 1,690
15. Reserves for replacement 2,500
Total operating and fixed expenses $23,885
16. Net operating income (NOI) $47,120
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70 APPRAISAL: HOW TO DISCOVER GOOD VALUE
The following list explains each of the lines in the net income
statement:
1. Gross annual potential rents. This amount is the largest possible sum
of rents that you could practically bring in at current market rent levels
and 100 percent occupancy.
2. Income from parking and storage areas. This property has a 16-car
parking lot. A shortage of on-street and off-street parking in the neigh-
borhood makes it profitable for the owner to rent the parking spaces
independently of the apartment units. Also, the owner built storage
bins in the basement of the building that are available for rental to
tenants.
3. Vacancy and collection losses. Market vacancy rates in the area typ-
ically range between 5 and 10 percent. Currently, all units in this build-
ing are rented. But even the best-managed apartments experience some
vacancies when apartments turn over. Add in some losses for tenants
who disappear owing rents that exceed the amounts of their security
deposits.
4. Effective gross income. This term refers to the actual amount of cash
that an owner receives net of vacancy and collection, but before operating,
fixed, and financing expenses.
5. Trash pickup. Self-explanatory.
6. Utilities. In this property, tenants pay their own unit utilities. The
property owner pays for lighting in the hallways, basement, and parking
area.
7. Licenses and permit fees. Apartment building owners must some-
times pay for business licenses and other fees. For this property, the owner
pays a rental property registration fee.
8. Advertising and promotion. These units generally rent by word of
mouth, Craigslist.org, or a For Rent sign that’s posted on the property.
However, to be safe, an advertising and promotion expense of $150 per
year per unit is allocated to the operating budget.
9. Management fees. The owner of this apartment building self-
manages the property. Nevertheless, he should pay himself the same
amount he would otherwise have to pay a property management firm.
Keep returns for labor distinct from returns on investment. Do not reward
the seller for the work that you will contribute to the property.
10. Maintenance and repairs. The current owner and her husband
clean, paint, and make small repairs around the property. These labors
deserve payment from the property’s rent collections.
11. Yard care. The owner pays this amount to one of the tenants to
keep the grass cut, rake leaves, and shovel snow off the walks.
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INCOME CAPITALIZATION 71
12. Miscellaneous. This expense covers legal fees, supplies, snow re-
moval from the parking lot, municipal assessments, auto mileage to and
from the property, and other items not accounted for elsewhere in the
income statement.
13. Property taxes. This item includes city, county, and state taxes an-
nually assessed against the property. BEWARE: Tax assessors periodically
revalue properties to reflect increases in market prices. Future tax bills
could jump 30 to 40 percent over the amount of the previous tax years.
Similarly, if your purchase price comes in less than the assessor’s current
assessed value, you may see a reduced tax bill.
14. Property and liability insurance. This insurance reimburses for
property damage caused by fire, hail, windstorms, sinkholes, hurricanes,
and other perils. It also pays to defend against, and compensate for, law-
suits alleging owner negligence (e.g., slip-and-fall cases).
15. Reserves for replacement. Building components wear out. The roof,
plumbing, appliances, and carpeting must be replaced periodically. As per
the income statement, average out these nonroutine costs on a per-year
basis.
16. Net operating income (NOI). After you itemize and total all op-
erating expenses, subtract this sum from the effective gross income. The
resulting figure equals net operating income (NOI).
When you calculate NOI, include all expenses for the coming year.
Never accept a seller’s income statement as accurate. Sellers notoriously
omit and underestimate expenses. (Corporate CEOs aren’t the only ones
who try to dress up their numbers to paint a pretty picture.)
Ask to see the seller’s tax return IRS Schedule E for the subject prop-
erty. The truth will probably sit somewhere between the owner-prepared
income statement for sales purposes (where income is likely to be over-
stated and expenses understated) and a tax return (where you might detect
understated income and overstated expenses). Even if the seller truthfully
reports last year’s income and expenses, estimate how each of those fig-
ures might move up or down in the coming years. You buy the future, not
the past.
Are property tax assessments headed up? Are vacancy rates (or rent
concessions) increasing? Have utility companies scheduled any rate in-
creases? Has the seller deferred maintenance on the property? Has the
owner allocated enough maintenance expenses to cover replacement re-
serves? Has the seller self-managed or self-maintained the property and
therefore failed to include items as cash expenses? When calculating NOI,
never accept numbers on faith. Savvy investors realistically reconstruct
seller-prepared NOIs.
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72 APPRAISAL: HOW TO DISCOVER GOOD VALUE
Estimate Capitalization Rates (R)
After figuring NOI, next decide what capitalization rate (R) to use. When
you buy an income property, you pay now for the rents the property
will produce over the next 20, 30, or 40 years (or longer). The question
becomes how much these future rents are worth in today’s dollars (i.e.,
the property’s market value). If the appropriate capitalization (cap) rate
is 8.5 percent, then the market (capital) value of this eight-unit apartment
building equals $554,365:
$47,121 (NOI)/.085 (R) = $554,365 (V)
But where does that .085 percent “cap rate” come from? You estimate
it from the cap rates that other investors have applied to buy similar
properties. Say a real estate agent gives you NOI and sales price data on
four similar apartment buildings that recently sold:
Market Data
Comparable Property Sales Price NOI R
Hampton Apts. (8 units) $533,469 $43,211 .081%
Woodruff Apts. (6 units) 427,381 35,900 .084
Adams Manor (12 units) 694,505 63,200 .091
Newport Apts. (9 units) 671,241 53,700 .080
Subject (8 units) (estimated) 544,365 47,121 .085
From these data, calculate a market-derived cap rate for each prop-
erty (provided sale meets the criteria of a market value transaction). When
investors in this area buy small income properties similar to the subject
property, they figure cap rates between 8.1 and 9.1 percent. So it appears
that the market of comp sales indicates a cap rate of around 8.5 percent for
the subject property.
Compare Cap Rates
In your market, you may not discover sufficiently similar properties with
such a narrow range of cap rates. You might find that some apartment
buildings have sold with cap rates of 5 to 6 percent (or lower) and others
have sold with cap rates of 8 to 9 percent (or higher). Why such differences?
You pay for a quantity of future rental income, and you pay for the
quality of that income. Today’s price also incorporates expectations about
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INCOME CAPITALIZATION 73
the future price/income gains for that property. The greater its expected rate
of appreciation, the higher the price you pay now. Therefore the higher
the quality of the income stream, and the larger the expected gain in price,
the lower the capitalization rate (or the lower the quality of the property’s
income and price gain potential—in the eyes of the market—the higher its
cap rate).
To illustrate: You compare two fourplexes. One is a relatively new
property located in a well-kept neighborhood near a city’s growth corridor.
Several nearby office towers are under construction. The other fourplex is
located in a deteriorating part of town. Major employers have moved out,
closed, or laid off workers. Crime rates are high and moving higher. Two
recent drug-related murders made front-page news.
If the annual NOIs for these two fourplexes are, respectively, $24,960
and $12,480, how much would investors pay for each property? If investors
applied a 10 percent cap rate to each property’s income stream, they would
value the properties as follows:
$24,960 (NOI)/.10 (R) = $249,600 (V)
$12,480 (NOI)/.10 (R) = $124,800 (V)
But investors would not apply a like cap rate to these very unlike
properties because the quality of their income streams differs. The better-
located property offers more stable rents, less neighborhood risk, and
greater expected gains in price. Investors might actually capitalize the
respective NOIs of these two fourplexes at rates of, say, 6 percent and
15 percent.
$24,960 (NOI)/.06 (R) = $416,000 (V)
$12,480 (NOI)/.15 (R) = $83,200 (V)
Because most investors would rather own a property in a prospering
area as opposed to a troubled area, they will pay significantly more for each
dollar of income produced by such a property.
The Paradox of Risk and Appreciation Potential
Odd as it may seem, the higher-priced “low-risk, high-appreciation” prop-
erties may actually produce more risk and lower gains in price than
their low-rent, highly troubled cousins who are located in the wrong part
of town.
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74 APPRAISAL: HOW TO DISCOVER GOOD VALUE
Compare Relative Prices and Values
Consider this stock market analogy. If you could buy a quality, high-
growth company’s stock at a P/E of 10 or a low-growth company’s stock
at a P/E of 10, by all means invest in the high-growth company. If you
could buy a low-risk, high-appreciation-potential property with a cap rate
of 10 percent or a higher-risk, lower-appreciation property with a cap
rate of 10 percent, buy the low-risk, high-appreciation property. How-
ever, that’s not how markets typically price either real or financial assets.
2
In the real world, investors bid up prices for high-quality, growth-area
properties and reduce their bids for so-called high-risk properties in less
desirable neighborhoods. To figure out which type of property and lo-
cation offers the most profit potential, compare their relative prices and
cash flows.
When investors optimistically bid up the prices of some properties,
neighborhoods, and cities relative to other properties, neighborhoods, and
cities, you can sometimes profitably redirect your investment strategy. In
other words, don’t calculate market cap rates for just one type of property
or neighborhood. Learn as much as you can about a variety of submarkets
and areas of the country. For instance, do you believe that San Francisco
apartments can continue to command a four- to eight-fold price premium
over those of Charlotte, North Carolina?
You overpay for a property when: (1) you apply a cap rate that’s
too low for the property and neighborhood you’re buying into, or (2) you
fail to realize that market cap rates themselves may sit too low relative
to other types of properties or locations. On the other hand, you can earn
extraordinary profits when you discover lesser-publicized (high cap rate)
properties (locations) that yield high rents relative to the price you have to
pay. (We further explore this opportunity in Chapter 15.)
VALUATION METHODS: SUMMING UP
“Market value” does not necessarily equal “appraised value” or “sales
price.” Market value refers to the sale price of a property when a sale
meets the criteria of a market value transaction. To estimate the market
value of a subject property as it compares with other similar properties
that have sold, first investigate the terms and conditions under which
2
If you bought Microsoft and JC Penney stock in 1998 and sold in 2004, JC Penney
stock would have paid you higher returns. As a high-profile growth company, in
1998, Microsoft’s stock price already included a hefty premium for its expected
growth.
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VALUATION METHODS: SUMMING UP 75
the comparative properties sold. A property down the street that sold for
$200,000 after just three days on the market does not necessarily indicate
that a similar property nearby will sell for $200,000. It depends on the
terms of sale and the detailed features of each property.
Even though you can use three approaches to value a property, those
three approaches do not result in the same value estimates. You work
with imperfect data. You need to decide which approach(es) best serves
your purposes. The accuracy of your market value estimate directly re-
lates to how well you identify and evaluate a property’s features. Observe
the differences (positive or negative) that make a difference. Investment
decisions require you to know features, properties, neighborhoods, con-
struction costs, and lot values. Technique never substitutes for knowledge,
close reasoning, and wise judgment.
Past price increases (decreases) do not forecast the future. It’s tougher
to make money when you buy a property that’s about to fall in value—even
if you buy it at a “bargain price.” And you can make great returns—even
when you pay market value (or above)—if you have identified a property
(or location) that’s about to gain increased popularity.
Appraisal Limiting Conditions
One final note on appraisal reports: Property appraisers hedge their
estimates of value with many limiting conditions. Especially relevant
(Figure 3.1) are limitations 1, 2, 6, and 7:
♦ Appraisers do not investigate title. They assume that a property’s
bundle of fee simple rights is good and marketable. For a legal
guarantee of property rights, consult a title insurance company.
♦ Appraisers do not survey the boundaries of a site, nor do they
necessarily note encroachments or other potential site problems.
To precisely identify site dimensions, encroachments, and some
easements, employ a surveyor and walk the property lines.
♦ Appraisers assess the condition of a property that they see
through casual inspection. To thoroughly assess the soundness of a
property and its systems (heating, cooling, electrical, plumbing),
hire a professionally competent building inspection service or
skilled tradesperson.
♦ Appraisers gather much of their market information from sec-
ondhand sources (real estate agents, government records, mort-
gage lenders, and others). Appraisers seldom go inside the comp
properties that they include in their appraisal reports. Because
they incorporate nonverified secondhand data, appraisals often
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76 APPRAISAL: HOW TO DISCOVER GOOD VALUE
err in fact and interpretation. Accept an appraisal report as “for-
what-it’s-worth” information. Never give it more weight than it
deserves. (At a minimum, I verify the appraiser’s comp property
data before I decide how much respect I should give to an ap-
praiser’s estimate of value.)
Valuation versus Investment Analysis
Before you buy, accurately understand the property’s market value. Yet
market value itself does not tell all you need to know to make profitable
investment decisions. Besides figuring out what a property is worth today,
answer these questions:
♦ Will the property generate adequate cash flows?
♦ Can you expect the property to increase in price?
♦ Can you add value to the property?
To address these investment issues, we turn to the following chapters.
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4
MAXIMIZE CASH FLOWS AND
GROW YOUR EQUITY
T
o value income properties, investors capitalize net operating in-
come (NOI) by dividing it by the capitalization rate (R). But because
you will finance your investment properties, you won’t pocket the
full amount of NOI that your property produces. Nor does the capitaliza-
tion rate itself reveal your actual yearly cash return on your actual amount
of invested cash (i.e., your down payment). So, now you will learn how to
calculate the returns you can achieve through leverage.
WILL THE PROPERTY YIELD GOOD CASH FLOWS?
From Chapter 2 recall that you calculate before-tax cash flow (BTCF) as
follows:
NOI less debt service (annual mortgage payments) equals BTCF
Now let’s return to the eight-unit apartment building example
from Chapter 3. We calculated NOI for that property at $47,121. Apply-
ing an 8.5 percent cap rate, we figured the property’s market value as
$544,365:
$544,365 (V) = $47,121 (NOI)/.085 (R)
If you finance this property with a mortgage loan-to-value (LTV) ratio
of 80 percent (20 percent down) at 7.5 percent interest, amortized over a
77
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78 MAXIMIZE CASH FLOWS AND GROW YOUR EQUITY
term of 25 years, figure your mortgage balance and annual payments as
follows:
$544,365 (value)
.80 LTV
$435,492 loan amount
With mortgage terms of, say, 7.5 percent, fully amortized over
25 years, the monthly mortgage factor equals $7.39 per $1,000 borrowed.
Because you originally borrowed $435,492, your monthly payments equal
$3,218 for a yearly total amount of $38,618:
$435,492 ÷ 1,000 = 435.492
435.492 × $7.39 (mo. pymt. per 1,000 borrowed) = $3,218
12 × $3,218 = $38,618 (yearly amount paid)
Given the above amount of mortgage payments (debt service), this
eight-unit apartment building brings in a first-year BTCF of $8,503:
$47,121 (NOI)
less $38,618 (yearly debt service)
$8,503 (BTCF)
To calculate your annual cash-on-cash return on investment (i.e., your
annual rate of return on the actual amount of out-of-pocket cash that you
have invested), divide the down payment (original cash investment) into
your annual before-tax cash flow (BTCF):
Cash ROI = $8,503 (BTCF)/$108,873 (down payment) = 7.81%
Does this first-year cash-on-cash rate of return look attractive? That
would depend on the property’s potential. Can you add value to the
property through creative improvements? Is the property strategically
positioned for appreciation? If you see strong potential for the property,
you might accept a relatively low return from cash flows. But maybe
you’re not happy with an annual BTCF of $8,503 and a cash-on-cash ROI
of 7.81 percent. Does this mean you should cross this property off your
list? Not necessarily. Before you reject a property that fails to produce
satisfactory cash flows, look for ways to increase those returns:
♦ Could you arrange alternative financing with lower annual
payments?
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WILL THE PROPERTY YIELD GOOD CASH FLOWS? 79
♦ Should you decrease (increase) your down payment?
♦ Can you buy at a bargain price?
Arrange Alternative Terms of Financing
As explained in Chapter 2, smart investors think through their financing
alternatives. You can restructure the cost and/or terms of financing to
improve cash flows. In a first pass through the numbers for this eight-unit
apartment building, we assumed a 7.5 percent interest rate amortized over
25 years with a 20 percent down payment. To improve the cash flows, try
the following:
♦ Seek a lower interest rate.
♦ Lengthen the term of the mortgage.
♦ Use some type of balloon second mortgage.
♦ Combine several of these alternatives.
To obtain a lower interest rate, switch to an adjustable-rate mort-
gage, ask for below-market seller financing, buy down the interest rate,
or perhaps assume a seller’s lower-interest-rate mortgage. Here’s how an
interest rate of, say, 6.7 percent would boost cash flows:
Monthly payment per $1,000 at 6.7% for 25 years = $6.88
435.492 × $6.88 = $2,996 monthly payment
12 × $2,996 = $35,954 annual payments (debt service)
$47,121 (NOI)
less $35,954 (yearly debt service)
$11,167 (BTCF)
ROI = $11,167 (BTCF)/$108,873 (down payment) = 10.26%
If this BTCF and ROI still fall short of your investment goal, extend
the amortization period from 25 to 40 years (with, say, a balloon at year 10
or 15, if necessary).
Monthly payment per $1,000 at 6.7% for 40 years = $6
435 × $6 = $2,610 per month
12 × $2,610 = $31,320
$47,121 (NOI)
less $31,320 (debt service)
$15,801 (BTCF)
ROI = $15,801 (BTCF)/$94,242 (down payment) = 16.77%
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80 MAXIMIZE CASH FLOWS AND GROW YOUR EQUITY
Now return to the first calculation, when you borrowed mortgage
money from a bank at 7.5 percent interest with a 25-year term. Say the
sellers won’t carry back the entire amount of the financing but will give
you a $100,000 balloon second mortgage due in five years, with interest
only payable at 6 percent. You borrow $335,492 from the bank on its terms,
and $100,000 from the sellers on their terms. Here’s what your cash flow
would look like under this financing arrangement.
335.492 × $7.39 × 12 = $29,775 (to the bank)
.06 × $100,000 = $6,000 (to the seller)
Total annual debt service = $35,775 ($29,775 + $6,000)
$47,121 (NOI)
less $35,776 (debt service)
$11,345 (BTCF)
ROI = $11,345 (BTCF)/$108,873 (down payment) = 10.42%
Although the cash flow here falls below the seller-financed transac-
tion, it still beats the baseline bank financing. My intent here is not to show
which type of financing seems best. Rather, it is to encourage you to calcu-
late possible returns via alternative financing scenarios, and then discover
which (if any) financing might make a deal work—for you and the sellers.
In just the few possibilities shown here, the first-year BTCF ranged from
a low of $8,502 to a high of $15,765. Change the terms of financing and
you might materially improve (or diminish) the financial performance of
a property.
Decrease (or Increase) Your Down Payment
You also change cash flow and correspondingly, cash-on-cash return,
when you decrease (or increase) your down payment. Instead of placing
20 percent down ($108,873) on this eight-unit property, you close the deal
with a 10 percent down payment of $54,436.50. The seller finances the bal-
ance of $489,928 at 7.5 percent interest for 25 years (with perhaps a shorter
term balloon payoff):
489.9285 × $7.39 × 12 = $43,446 (debt service)
$47,121 (NOI)
less $43,446 (debt service)
$ 3,675 (BTCF)
ROI = $3,675 (BTCF)/$54,436 (down payment) = 6.75%
In this case, a lower down payment gives you a thin margin of cash
flow and drops your cash-on-cash ROI to 6.75 percent. By comparison,
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WILL THE PROPERTY YIELD GOOD CASH FLOWS? 81
here’s what happens to cash flow and ROI if you buy with 10 percent
down, seller financing at 6.5 percent interest, amortized over 40 years:
459.928 × $5.85 × 12 = $32,287 (debt service)
$47,121 (NOI)
less $32,287 (debt service)
$14,834 (BTCF)
ROI = $14,834 (BTCF)/$54,436.50 (down payment) = 27.25%
This outcome looks attractive. Combine the benefits of the lower
interest rate with the leveraged gain from higher LTV and you beat
the returns realized with the baseline bank financing (20 percent down,
7.5 percent, 25 years).
In areas of the country with generally high property prices, you
may find that well-kept properties (single-family houses, duplexes, four-
plexes, small apartment buildings), when financed with high LTV loans,
produce negative cash flows. Say that our eight-unit building is lo-
cated in a prime neighborhood that’s in high demand by both owner-
occupants and investors. Instead of a cap of 8.5 percent, the market values
properties in this neighborhood with a 7.0 percent cap rate. Given this
lower cap rate, this building commands a higher value ($673,157 versus
$544,365):
$673,157 (V) = $47,121 (NOI)/.07 (R)
If you finance with an 80 percent loan, you’ll put down $134,631 and
secure a mortgage of $538,526. With a 7.5 percent interest rate and a 25-year
term, your annual mortgage payment would total $47,756:
538.526 × $7.39 × 12 = $47,756 (debt service)
$47,121 (NOI)
less $47,756 (debt service)
$ –635 (BTCF)
In situations of negative cash flow (an alligator), search for low-
cost financing. If that doesn’t work, cover the negative (feed the alligator)
from other income or increase the amount of your down payment. With
30 percent down ($201,947.1) on a price of $673,157, you would borrow
$471,210 and then pay back $43,242 a year:
471.210 × $7.39 × 12 = $41,786 (debt service)
$47,121 (NOI)
less $41,786 (debt service)
$ 5,335 (BTCF)
ROI = $5,335 (BTCF)/$201,947.10 (down payment) = 2.645%
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82 MAXIMIZE CASH FLOWS AND GROW YOUR EQUITY
At least the larger (30 percent) down payment converts your nega-
tive cash flow into a positive, but your cash on cash looks anemic. Buy
such a property if you can profitably improve it, or when neighborhood
property values are about to escalate. Alternatively, to combat low cap
rates or negative cash flows, ferret out bargain-priced properties or move
your search for properties to lower-priced (higher cap rate) geographic
areas.
Buy at a Bargain Price
To increase your cash flow (or avoid a negative cash flow), locate proper-
ties that you can buy at less than market value. Although this technique
requires hustle, knowledge, and creativity, you can do it. Motivated sell-
ers, lender-owned properties (REOs, i.e., bank-owned real estate), foreclo-
sures, tax sales, uninformed sellers, trade-in properties, and other sources
of bargains routinely account for between 10 and 20 percent of property
sales. More recently, such distress sales—in some cities—have exceeded
50 percent of total sales.
Sources of bargains are discussed in later chapters, but at least here
you can see how a below-market price can lead to higher cash flows.
Return to the eight-unit example that was valued with an 8.5 per-
cent cap rate at $544,365. With the hypothetical baseline bank financing of
20 percent down and 7.5 percent, 25-year terms, the property produced
a first-year cash flow of $8,502. But what if you could buy that prop-
erty (or a similar one) at a bargain price (say 10 percent under market)?
You would pay $489,928.50, put $97,935.70 down, and borrow $391,942.80
(80 percent). Your annual debt service would fall to $34,757, and your cash
flow (BTCF) would increase to $11,539:
391.943 × $7.39 × 12 = 34,757 (debt service)
$47,121 (NOI)
less $34,757 (debt service)
$12,364 (BTCF)
Your first-year ROI would increase to 12.62 percent:
ROI = $12,364 (BTCF)/$97,985.70 (down payment) = 12.62
In markets where properties typically fail to give you the cash flows
you want, don’t give up your search. Instead, discover a property you
can buy at a bargain price. In today’s markets, distressed sellers have
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WILL THE PROPERTY YIELD GOOD CASH FLOWS? 83
multiplied. Careless property management, dumb financing, and a down
economic cycle have conspired to force the sale of hundreds of thousands
of properties at bargain prices.
Should You Ever Pay More than Market Value
for a Property?
Recall the negotiating ploy where you tell sellers that you will pay their
price if the owner will sell on your terms. You stroke the sellers’ egos and
give them a price they can brag about. But (ostensibly) you’ll earn good
cash flows and a high ROI because you receive a high LTV and low-cost
financing.
Staying with the eight-unit example, say the sellers accept your offer
and set a price of $600,000 ($544,365 market value). You say, “Fine, here are
my terms: $25,000 down, 5.75 percent interest, and 40-year payoff period
with a balloon note due in 12 years.” This arrangement means that the
sellers would carry back a mortgage (or contract for deed) in the amount
of $575,000. Here’s how the numbers work out:
575.000 × $5.33 × 12 = $36,777
$47,121 (NOI)
less $36,777 (debt service)
$10,344 (BTCF)
ROI = $10,344 (BTCF)/$25,000 (down payment) = 41.38%
Wow! These numbers look terrific. Compared with a market value
price and bank financing, you’ve achieved three important objectives:
(1) You reduced the cash you need to buy the property; (2) you increased
your cash flow; and (3) you lifted your ROI into superstar territory. You
can readily see why some authors encourage you to trade off a higher price
for a low down payment, low-cost OWC financing.
Nevertheless, you created a serious problem. You owe more than the
property is worth. Absent a strong increase in market price, you could not
sell the property for an amount high enough to pay off the outstanding
mortgage balance (a dilemma faced by millions of buyers in the country’s
recent downturn). Just as troubling, if market interest rates drop, you
could not refinance your outstanding mortgage balance. Your one-time
favorable financing now locks you into a higher than market rate for what
could turn out to be an extended period (especially in a less-than-robust
market).
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84 MAXIMIZE CASH FLOWS AND GROW YOUR EQUITY
To protect against these risks, negotiate these two financing clauses:
1. The right to assume. If a buyer can take over your 5.75 percent
financing, you increase your ability to sell the property without coming
up with cash out of your own pocket.
2. The right to prepay the loan balance at a discount. To help you over-
come the owe-more-than-you-own mortgage problem, insert a prepay-
ment discount clause into your financing agreement. If you pay off the
seller within the first five years (for example), the seller will discount the
payoff balance by, say, 5 or 10 percent. Sellers who are eager to cash out
their loan on a property may agree to this discount. (Even when an OWC
mortgage does not include a prepayment discount clause, sellers may later
accept such an offer. But if you offer a discount, play it coy. First raise the
possibility of early payoff to prompt a reaction from the seller. Generally,
the more eager the seller, the greater the discount you negotiate.)
“You set the price, I’ll set the terms,” can work to decrease your down
payment, increase your annual cash flow, and leverage up your ROI. Yet if
such prices and terms leave you with negative equity, you’ve crossed into
risky territory. Calculate whether the benefits of the deal outweigh these
risks. Most importantly, never assume that market appreciation rates of
6 or 8 percent a year will bail you out of the excessive mortgage problem.
Maybe you will get lucky, but don’t bet the ranch on it.
The Debt Coverage Ratio
You’ve seen how financing (mortgage amount, interest rate, amortization
period) can increase or decrease your annual cash flows and ROI. In addi-
tion, recall that the lender may apply a debt coverage ratio (DCR) as one of
its underwriting criteria. The lender wants to see whether the property’s
NOI is large enough to amortize the loan and provide a margin of safety.
For example:
DCR = $47,121 (NOI)/$38,618 (debt service) = 1.22
Among lenders who incorporate debt coverage ratios into their un-
derwriting decisions, for moderate to high-quality apartment buildings, a
DCR range of 1.1 to 1.3 usually proves acceptable. If a property’s NOI fails
to provide enough cushion for the lender, rework the terms of the financing.
Investors frequently work their deals not only to meet their own cash flow
requirements but also to meet a lender’s required DCR.
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WILL THE PROPERTY YIELD PROFITABLE INCREASES IN PRICE? 85
Numbers Change, Principles Remain
Previous discussions focused on the cash flows of an eight-unit apartment
building with a variety of interest rates, loan balances, amortization peri-
ods, cap rates, and purchase prices. The numbers used in these examples
illustrate techniques and principles—not the specific numbers you should
apply in your market or for your investment goals.
In Tulsa, not long ago, you could buy a good eight-unit rental prop-
erty for less than $300,000. In San Francisco, you can pay $2 million for
a similar building. In Tulsa I’ve seen cap rates over 10 percent. In San
Francisco, I’ve seen them at less than 4 percent. Property markets differ.
Even within the same city, properties, neighborhood quality, gross rent
multipliers, and terms of financing vary.
When you buy condos, single-family houses, or small apartment
buildings, search throughout your local area. Talk with well-informed
realty agents, mortgage loan officers, real estate appraisers, property man-
agers, and real estate investors.
As you learn the numbers that apply to proposed deals, work through
your value estimates and ROI figures as illustrated in this chapter (and
Chapter 3). To a certain degree, investing profitably means structuring
deals to yield positive cash flows and high ROIs while avoiding foolish
financial risk. When you buy at a below-market price, you increase your
odds of success. But “price” represents one variable. Without positive cash
flows and sufficient cash-on-cash returns, even a “bargain-priced” deal
can turn sour.
WILL THE PROPERTY YIELD PROFITABLE
INCREASES IN PRICE?
In addition to yearly cash flows, property investors expect their properties
to sell at prices substantially greater than they paid. Over longer peri-
ods, even price increases of 3 or 4 percent per year can add hundreds of
thousands of dollars to your net wealth.
Buy just one rental unit at a price of $100,000 and finance it with a
$90,000 mortgage at 6.5 percent interest and a 30-year term at an annual
appreciation rate of 4 percent. After 15 years, that $100,000 unit would be
worth $180,000. Subtract your outstanding mortgage balance of $64,803,
and your $10,000 down payment has grown 11-fold to $115,197. After
30 years, your mortgage balance would drop to zero, and the value of
the property (at a long-term 4 percent yearly average rate of appreciation)
would total $324,340. In a down cycle, price increases may express hope
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86 MAXIMIZE CASH FLOWS AND GROW YOUR EQUITY
more than reality. But over a period of 15 to 30 years, an average price gain
of 4 percent per year matches past experiences. In fact, experience shows
that investors who acquire bargain-priced properties during down cycles
typically gain long-run price increases that average greater than 4 percent
ayear.
Buy just three or four $100,000 rental units within the next several
years, and at retirement (if you’re under age 50), your net wealth from
those units will total somewhere between $400,000 and $1 million. With
only modest increases in rents, your income from those properties could
reach $6,000 to $10,000 a month. And that’s from only three or four units!
After 18 years, today’s monthly rent of $1,000 would grow to $2,000 a
month—assuming a 4 percent average increase each year.
[To Californians and residents of other high-priced areas, these pur-
chase figures look quite low, so double or triple them. The same principle
applies. To improve your cash flows, look for properties in lower-cost
geographic areas. Also, join with others and buy multi-unit buildings.
Commercial properties provide another option (see Chapter 15). “Fixers,”
too, offer a good alternative. (See especially Chapter 8 herein and my book
Make Money with Flippers, Fixer-Uppers, and Renovations, John Wiley & Sons,
2008, 2nd ed.)]
Low-Involvement versus High-Involvement Investing
Hold properties for income and appreciation for a period of 15 to 30 years
(or more) and you’ve put in place a low-involvement investment strat-
egy. Anyone who is serious about building wealth can come up with the
limited time and money necessary to make this modest strategy pay off.
However, if you want to build wealth over a shorter period, then pur-
sue high-involvement strategies to boost value. High involvement won’t
necessarily require more cash, but it will require more time, effort, and
knowledge.
To beat the market average price increases, spot communities, neigh-
borhoods, and properties that are positioned for increased popularity and
faster appreciation.
Most everyone now realizes that short-term price increases are never
guaranteed. Job layoffs, speculative overbuilding, high interest rates, tight
credit, and other factors can temporarily push property prices into a tail-
spin. Yet especially in perilous times (when fear and confusion drives oth-
ers to the sidelines), opportunities to score large price increases multiply.
Look for areas that signal strong potential. Here’s how to find these star
performers.
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WILL THE PROPERTY YIELD PROFITABLE INCREASES IN PRICE? 87
Compare Relative Prices of Neighborhoods (Cities)
An oft-cited clich
´
e in real estate tells investors to “buy in the best neigh-
borhoods you can afford; the best neighborhoods always appreciate the
fastest.” On closer inspection, this advice makes no sense. No neighbor-
hood or community can persistently outperform all others. The law of
compound interest proves the statement false. (Similarly, recall that the
stock price of Microsoft—a great company—was higher in 1999 than it
was in the fall of 2008.)
Say that you can choose between a neighborhood where apartment
buildings are priced at $100,000 per unit (College Park) and a neighborhood
where apartment buildings are priced at $50,000 per unit (Modest Manor).
Within the recent past, properties in College Park jumped in value by
8 percent a year. Units in Modest Manor have moved up by only 3 percent
a year. Can College Park outpace Modest Manor forever? Not likely. A
look at projected values shows why.
Future Appreciated Values: College Park versus Modest Manor
Years
$100,000 Units
at 8% p.a.
$50,000 Units
at 3% p.a.
3 $125,970 $54,635
6 158,690 59,700
9 199,900 65,200
12 251,820 71,250
15 317,222 77,900
20 466,100 90,300
Today, rental units in College Park cost twice as much as those located
in Modest Manor. But after 20 years of (assumed) faster appreciation,
these superior higher-priced units would cost more than five times as much
as their “inferiors.” Unless some rare market forces were at work, such an
unbalanced situation would not occur.
Long before such exaggerated price differences could result, increas-
ing numbers of potential investors (and tenants) would become priced out
of College Park. In response, they would switch their buying (or renting)
to Modest Manor. Price gains in College Park would slow. Price gains in
Modest Manor would accelerate.
The intelligent investor never assumes that future rates of apprecia-
tion will mirror the recent past. (Nor do they assume recent price declines
can be trend-lined into the future.) Intelligent investors compare the prices
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88 MAXIMIZE CASH FLOWS AND GROW YOUR EQUITY
and features of a variety of properties, neighborhoods, and cities. They
compare local economies. They note changes up or down in the number
of for sale and for rent properties. Then they search for properties and
locations that show the best possibilities for price gains.
Undervalued Neighborhoods and Cities
At any time and in any area, no fixed relationship applies to neigh-
borhood or community appreciation potential. Sometimes lower-priced
areas represent a great buy. At other times, higher-priced areas look
best. Sometimes new developments beat established neighborhoods;
sometimes established beats new. Nor can anyone advise definitively
about close-in versus far-out, well-kept versus run-down, or low-crime
versus high-crime. Neither racial nor ethnic composition, nor household
income level, nor occupational status necessarily relates to the potential
price gains of a neighborhood.
The neighborhood or city that offers the best outlook for price gains
is the neighborhood (city) where growth prospects, property prices, and
rent levels look good relative to the growth prospects, prices, and benefits
offered by other areas. Consider one of my favorite examples of how
modest can appreciate faster than classy.
Beverly Hills versus Watts (South Central Los Angeles)
Between 1985 and 1989, property prices in prestigious Beverly Hills had
shot up by 50 percent or more. During the same period, property prices
in the troubled neighborhood of Watts had barely budged. But by 1995,
$5 million (1989) properties in Beverly Hills were selling at reduced prices
of $3 million to $4 million, whereas $85,000 (1989) properties in Watts
were selling at the increased price of $125,000. Between 1989 and 1995,
property investors who owned units in troubled South Central Los Angeles
outperformed investors who owned properties in the movie star haven of
Beverly Hills.
In response to this fact, here’s what I wrote in 1995 in the second
edition of this book: “Will appreciation rates in South Central continue to
outpace Beverly Hills? I don’t think so. Relative to other premier neigh-
borhoods in world-class cities, homes in Beverly Hills now stand as terrific
bargains. With the California economy at last climbing out of recession,
house prices and rentals in Beverly Hills may now be positioned to hit
new record highs.”
Looking back now, you can see that my forecast proved correct.
Between 1995 and 2005, upscale property prices in California did hit
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WILL THE PROPERTY YIELD PROFITABLE INCREASES IN PRICE? 89
record highs. Although South Central prices also continued to climb, you
would have made far more money had you invested in Beverly Hills.
Between 2008 and 2009 in Dubai, the multimillion-dollar villas located on
world-famous Palm Jumeira suffered price declines of nearly 50 percent
off their peak. During this same period the modest town homes of Dubai’s
International City held their value. Dubai was running a huge excess of
top-end villas and apartments, whereas affordable units such as those of
International City remained in short supply relative to the demographics
of the population.
As these examples show, investors can profit (or avoid loss) when
they study neighborhood home prices relative to features, benefits, and
buyer/renter demographics. Savvy buyers never prejudge. They gather
facts about supply and demand. They reason. They forecast the future.
They neither extrapolate the past into the future nor do they apply clich
´
es
and slogans to anticipate price movements.
Apart from relative prices, what facts should you compare?
♦ Demographics
♦ Accessibility
♦ Job centers
♦ Taxes, services, and fiscal solvency
♦ Construction and renovation
♦ Land-use laws
♦ Civic pride
♦ Sales and rental trends
Demographics
Demographics refer to the income levels, occupations, education, ages,
household size, household composition, and other population charac-
teristics. You can obtain such data from the U.S. Bureau of Census and
commercial market research firms (see www.census.gov). The magazine
American Demographics alerts its readers to emerging demographic trends.
Truly news you can use.
More important than current neighborhood demographics, learn who
is moving into the area. A historically lower-income area that’s attracting
middle- or even upper-middle-income younger residents points towards
appreciation potential. Likewise, an area where many residents are moving
from welfare to jobs signals turnaround.
To learn about the people in an area, get out of your car. Talk with
residents who are working in their yards or walking their dogs. Talk
with Realtors, mortgage loan officers, retail shop owners, schoolteachers,
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90 MAXIMIZE CASH FLOWS AND GROW YOUR EQUITY
postmen, taxi drivers, policemen, government planners, and others whose
firsthand, everyday experience places them in the know about an area.
Ask anyone and everyone how the area is changing and whether they
see these changes as positive or negative. Ask the people you talk to
what they like least and what they like most about the neighborhood.
Evaluate what you hear, see, and research. Then form your own conclu-
sions. Do you think the people moving into the neighborhood are likely to
push up home prices and rental rates? Or does “filtering down” point to
deterioration?
Accessibility (Convenience)
Areas don’t change their position on the face of the earth. Nevertheless,
they can become more or less convenient relative to other areas and rel-
ative to their own past. Several years back, I chose to buy property in
the southeast part of town rather than the more popular northwest corri-
dor. Why? Lower prices, similar quality, and easier accessibility. Because
of rapid growth and development, the freeway leading to the northwest
corridor had become congested. What had been a 15- to 20-minute drive
to town from those neighborhoods was now taking 45 to 60 minutes. And
traffic was getting worse.
As a result, increasing numbers of renters and homebuyers decided
that they did not want the hassle of fighting traffic every day. They switched
their preferences to the east and southeast developments. Within three
years, my properties jumped in value by 40 percent. Momentum feeds
upon itself for a while.
Improved (Increased) Transportation Routes
Find out whether an area might become more convenient because of chang-
ing (or lower cost) transportation routes. Are any new or expanded free-
ways or toll roads planned or under construction? What about bridges,
ferries, subways, commuter trains, or bus service? Will travel to and
from a neighborhood or community become easier, cheaper, or faster?
After the Euro tunnel connected England to France, British demand for
vacation homes doubled the (historical) appreciation rate of attractive
French properties. Discount airline fares increased the demand for Florida
properties—especially among New Yorkers and Chicagoans.
Can you recall 15 or 20 years ago when some of those “outlying”
developments were built in your area? Are they still outlying? More
than likely they’re now just minutes from shopping centers, office com-
plexes, and restaurants. Because growth moves outward, identify how
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convenience will change. Developments, cities, or even countries that to-
day seem far away may tomorrow sit just minutes from everything.
Jobs
Most people prefer to live close to their jobs. As you search for appreci-
ation potential, discover neighborhoods that are situated near employers
or employment centers that are adding jobs to their payrolls. Look for new
or expanding office districts, factories, shopping centers, and distribution
facilities. As these job sites fill up with employees, they will push up the
prices and rents of nearby housing. When Sarasota Regional Medical Cen-
ter underwent a major expansion, home prices in nearby neighborhoods
jumped 40 percent within just a few years.
Taxes, Services, and Fiscal Solvency
As you ferret out neighborhoods, communities, and even countries in
which to invest, check their property taxes, government services, political
stability, and fiscal fitness. Does the area offer a high level of services
and social programs? Are the public finances of the area well managed?
Does the tax/benefit ratio for the community compare favorably with
other areas? Consider all taxes and services. Do community governments
provide residents relatively good value?
Co-ops, condos, and housing developments governed by homeown-
ers’ associations present another layer of inquiry. A homeowners’ associ-
ation functions as a government within a government. It issues rules and
regulations, it provides services and recreational amenities, and it charges
legally enforceable fees and assessments.
If you plan to buy into property development that is governed by a
property owners’ association, check out the association’s “laws,” services,
fees, financial reserves, and fiscal solvency in the same way that you would
check out a local government. Some property owners’ associations have
failed to put aside enough money to fund repairs and improvements.
Owners will suffer costly assessments. (See my book, Make Money with
Condominiums and Townhouses, John Wiley & Sons, 2003).
New Construction, Renovation, and Remodeling
Are neighborhood owners (especially those who have recently bought
into the area) upgrading their properties? Are they painting exteriors,
remodeling interiors, building additions, or installing amenities such as
central heat and air, decks, patios, hot tubs, or skylights? Do you see
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92 MAXIMIZE CASH FLOWS AND GROW YOUR EQUITY
properties brought back to life after years of neglect? Do you see front yard
dumpsters loaded with remodeling debris? Check with contractors, home
improvement stores, and government building inspectors. Note trends
in building permits for the area. Learn whether spending for property
improvements is increasing.
Look for new construction of housing, office buildings, manufac-
turing plants, retail stores, or parks and recreational facilities. New con-
struction not only creates jobs, but if properly integrated into an area, it
increases the area’s desirability. Note, too, the prices or rental rates of any
housing that’s newly built or under construction. Is the new housing more
expensive than the existing homes and apartments? If so, these higher
prices indicate that a neighborhood is moving upscale.
Watch carefully, though. Too much new housing can temporarily pull
prices and rental rates down. Although everyone thinks Oil Belt property
values fell in the 1980s because of the collapse in oil prices, that’s only
a small part of the story. In fact, overbuilding (especially apartments and
condominiums) proved far more damaging. In Houston, during the early-
to mid-1980s, developers brought more than 100,000 new multifamily units
to market. Apartment vacancy rates ran close to 20 percent. Rent levels for
new luxury two-bedroom apartments fell to less than $300 a month. Low
rents for apartments pulled down the prices of condominiums and houses.
In response to such an excess of competition, lenders tightened
financing for new subdivisions, condominiums, and apartments. During
the 1990s, fewer new rental units were built than in any other 10-year
period since the 1960s. The stage was set for the 2000–2006 property boom.
After 2002, construction took off into the stratosphere. Builders set
new records for construction of housing units—especially in such hot spots
as Miami, Phoenix, and Las Vegas. Even worse, much of this excess was
sold to speculators and shaky credit buyers. Just as we have experienced
multiple times in the past, a downturn was sure to follow such excesses.
(And as in the past, recovery and growth will again send property prices
up to new peaks within a decade or so.) Before you invest, check whether
new housing in competing areas is renting (selling) without difficulty
and that vacancy rates aren’t flying up toward 10 percent or higher. (Your
local planning and building permits agency keeps detailed records of past,
present, and planned construction.) Smart investors position themselves
to profit from a down cycle. When foreclosures and REOs pile up and new
housing starts collapse, they grab the bargains.
Land-Use Laws
Land-use laws include zoning, building codes, health and safety rules,
occupancy codes, rent controls, environmental protection, historical
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WILL THE PROPERTY YIELD PROFITABLE INCREASES IN PRICE? 93
preservation, architectural review boards, and many other laws, rules,
and regulations. These laws may restrict growth and increase costs of
development.
To forecast price gains for an area, learn community attitudes toward
growth. Do current (or pending) land-use laws limit construction and drive
up building costs? Is government restricting new supply? Is the amount
of buildable land in short supply over the mid- to long run? While debates
rage between pro-growth and no-growth forces, experience shows that in
desirable areas where no- or slow-growth attitudes prevail, over time, rent
levels and housing prices are pushed up. Compare the rate of increase
in housing starts to the rate of growth in new households. A shortage of
zoned, buildable land positions an area for above-average price gains—as
long as the jobs, incomes, and desirability of the area increases.
Pride of Place
You’re not buying the past, you’re investing in the future. You and other
property owners in an area can join together to improve the future of an
area. Civic pride, community spirit, and community action can upgrade
a neighborhood with a poor reputation into one that becomes “the place
to be.” Contrary to received opinion, you can change and improve the
location of a property.
To evaluate price gain potential, assess the pride of place for neighbor-
hood residents. Are they working individually and collectively to make
their community a better place to call home? Are they cooperating with the
people responsible for government services such as schools, libraries, po-
lice, street maintenance, parks and recreation, and public health? Are res-
idents and public officials solving problems such as crime, graffiti, school
quality, traffic congestion, or littered public areas?
Locate a neighborhood with genuine possibilities for improvement,
and you locate a neighborhood with strong potential for price gains. When
you, other property owners, and tenants work together, civic pride and
community action can transform an ugly duckling to a peacock. (For
dozens of examples, see Fixing Broken Windows, by George Kelling and
Catherine Coles [Free Press, 1996].)
Sales and Rental Trends
Among the leading indicators of rising (or falling) property prices are
sales trends and rental trends. As you move forward to a profitable career
in real estate investing, create a system for tracking and recording trend
data such as the number of “for sale” listings, new housing starts, sales
prices, time on market, rent levels, and vacancy rates. Watch these trends.
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94 MAXIMIZE CASH FLOWS AND GROW YOUR EQUITY
You can detect market changes as they occur and sometimes score large
short-term gains.
Sales Trends. As prices begin to increase in a neighborhood, time-on-
market data will show increasingly faster sales. In slow markets, properties
can sit unsold for months (180, 270, or 360 days, or longer). More positively,
as average time on market falls from, say, 270 days to 180 days to 120 days,
prices are about to go up. A decreasing inventory of “for sale” properties
also points the way to rapid advances in property prices.
When the numbers of For Sale and For Rent signs dwindle, sellers
soon raise their prices and rental rates. At the ebb of San Diego’s major re-
cession of the early 1990s, the local MLS included 18,000 homes for sale. By
2004, that number had fallen to 6,000. No wonder prices increased as “for
sale” properties declined in number while jobs, population, households,
income, and wealth continued to grow.
Rental Market Trends. Four major rental market trends include:
(1) vacancy rates, (2) time on market, (3) annual rent increases (or rental
concessions), and (4) rates of owner occupancy. Review the past 12 to
24 months. Are area vacancy rates falling or increasing? How long do
vacant apartments or rental houses sit empty before they’re rented? Visit
a sampling of vacant units. Then follow up to learn their lease-up pe-
riods. What types of units rent the quickest? How do vacancy rates
differ among various neighborhoods and communities? Do some types
of buildings or units enjoy waiting lists? What are their features and
locations?
Are rents steady or increasing? Or are property owners giving con-
cessions like one or two months’ free rent for a 12-month lease? Are homes
in the area primarily owner occupied or tenant occupied? In which direc-
tion is the area trending? Look for areas where tenants are being squeezed
out by homebuyers. Increasing numbers of homeowners usually signal
higher property prices and higher rental rates for the relatively few rental
units that remain.
Of course, every general principle gives rise to exceptions. For ex-
ample, during the latest boom, houses in family-dominated neighbor-
hoods close to the University of Florida jumped 50 to 100 percent in value
within less than 5 years—even though renters were increasingly displacing
homeowners.
Why? Investors had discovered that they could lease these houses
out to groups of students and collect rents of $1,500 to $2,500 per month.
Accordingly, they bid up prices. Out-of-town parents of students also
entered the market. They would buy a house for a son or daughter—who
would then bring in several other students as roommates and charge each
one $400 to $600 per bedroom.
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SUMMING UP 95
The lesson: Learn trends early. Track the data. Talk with those who
live and work in the area. Act on inside information.
SUMMING UP
To discover properties that will gain from higher-than-average appreci-
ation, thoroughly track market data. Monitor changes in selling prices,
accessibility, pride of place, and community action. Property prices and
rent levels gallop ahead or fall behind because buyers and tenants
persistently shop neighborhoods and communities to discover the best
values—not necessarily the best features or lowest prices per se. When you
locate relatively undervalued, undiscovered, and underappreciated areas,
price increases will surely follow.
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5
HOW TO FIND
BARGAIN-PRICED PROPERTIES
W
hen stockbrokers and financial planners compare the profit
potential of property to stocks, they err in many ways. They
ignore leverage; they omit cash flows from rents; they fail to
understand the gains achieved through entrepreneurial research and tal-
ent. And they miss the fact that (unlike with stocks) you can buy property
at a price less than its current market value.
If Wal-Mart stock sells for $20 per share, you will pay $20 per share.
No one will sell for less. The same principle applies for every stock from
Apple to Xerox.
In contrast, if you want to pay $200,000 to $225,000 for a property
that’s valued at $250,000, you can find sellers who will oblige. In fact,
one popular axiom of real estate goes like this, “In real estate, you not
only make money when you sell, you can make money when you buy.”
Although you do not really “make money” when you pay less than market
value, you do fast track your profit potential.
WHY PROPERTIES SELL FOR LESS (OR MORE)
THAN MARKET VALUE
Recall from Chapter 3 that a market value sale specifies these five criteria:
1. Buyers and sellers are typically motivated. Neither acts under
duress.
2. Buyers and sellers are well informed and knowledgeable about
the property and the market.
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WHY PROPERTIES SELL FOR LESS (OR MORE) THAN MARKET VALUE 97
3. The marketing period and sales promotion efforts are sufficient to
reasonably inform potential buyers of the property’s availability
(i.e., no forced or rushed sales).
4. No unusual terms of purchase (e.g., low-down seller financing,
all cash, below-market interest rate) apply.
5. No unusual concessions are made by either the seller or the buyer
(e.g., sellers are not permitted to stay in the house rent free for
three to six months until their under-construction new house is
completed, buyers’ offer contingent upon the sale of their current
residence).
Owners who sell in a hurry may have to accept a price lower than
market value. Likewise, a FSBO (someone who sells “for sale by owner”)
who doesn’t know how to market and promote a property will not likely
receive top dollar. Or say the sellers live out of town. They don’t realize
that recent sales prices have jumped up, or maybe they don’t realize that
their property (or the neighborhood) is ripe for profitable improvement.
Owners in Distress
As news stories so vividly report, every day people hit hard times. They
lose their jobs, file for divorce, suffer accidents or illness, experience set-
backs in their business, fall behind on their car loans, credit cards, and
mortgage payments, and get hit by a freight train of other problems. Any
or all these calamities can create financial distress. For many of these prop-
erty owners, their only way out of a jam is to raise cash by selling their
property fast at a bargain price.
Some investors find it distasteful to prey on the down-and-out. Yet
owners who find themselves in financial distress long to get rid of their
sleepless, toss-and-turn nights. If that means selling their property for “less
than it’s worth,” then that’s what they’re willing to do. These people do
not just sell a property; they buy relief.
Under such circumstances, when the sellers believe they have gained
more from a sale than they’ve lost, both parties win. If you want to help
people cope with adversity—as opposed to fleecing them—seek out dis-
tressed owners who will give you the bargain price (or favorable terms)
you want.
The “Grass-Is-Greener” Sellers
One day Karla Lopez is sitting in her office, and in walks the executive
vice president of her firm. “Karla,” she says, “Aaron Stein in the Denver
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98 HOW TO FIND BARGAIN-PRICED PROPERTIES
branch just quit. If you want his district manager’s job, you can have it. We
will pay you $40,000 more a year plus bonus. But you have to be relocated
and on the job within thirty days.”
“Do I want it?” Karla says. “Of course I want it. A promotion like this
is why I’ve been working seventy-hour weeks for these past four years.”
Think about it. In this situation, does Karla think, “Well, the first thing
I must do is put my house up for sale and go for top dollar?” Hardly. More
than likely, Karla wants to strike a deal with the first buyer who gives her
any type of offer she can live with. Karla has her sights set on the greener
grass of Denver. Optimistic about her career and facing a time deadline,
Karla wants to get her home sold as quickly as possible.
Grass-is-greener sellers stand opposite to the financially distressed.
Whereas distressed owners sell on bargain terms or price to relieve them-
selves of pain, grass-is-greener sellers will accept an offer of less than
market value so they can quickly grab better opportunities that lie else-
where.
On one occasion when I was a grass-is-greener seller, I not only gave
my buyers a slight break on price, but more importantly from their per-
spective, I let them assume my below-market interest rate first mortgage
and carried back an unsecured note for the amount of the difference be-
tween the price they paid and the outstanding balance on the mortgage
they assumed (i.e., they bought with nothing down and below-market
terms). On various occasions, I’ve bought from sellers who were eager to
pursue better opportunities elsewhere. Each time, I negotiated a good (if
not great) price and favorable financing.
If looking for distressed owners doesn’t appeal to you, turn your
search in the opposite direction. Sellers who want to move to greener
pastures (especially under a deadline of time) are frequently the easiest
people to work with and the most accommodating in price and terms.
Stage-of-Life Sellers
When shopping for below-market price deals, find bargains among stage-
of-life sellers. These sellers include owners whose lifestyle now conflicts
with their property. They may no longer enjoy a big house or yard, collect-
ing rent, or dealing with tenant complaints. They eagerly anticipate their
move to that condo on the 14th green at the Bayshore Country Club. Or
perhaps they would rather not go through the trouble of updating and re-
pairing their current property. Whatever their reasons, stage-of-life sellers
are motivated to get on with their lives.
In addition—and this fact makes these sellers good prospects for
a bargain price or terms—stage-of-life sellers have typically accumulated
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WHY PROPERTIES SELL FOR LESS (OR MORE) THAN MARKET VALUE 99
large amounts of equity in their properties. And because they’re older, they
may have substantial sums in savings or other investments. Stage-of-life
sellers are open to offers. They don’t need to squeeze every last penny out
of their sale—or pocket all cash from the deal. Because stage-of-life sellers
often do not face a pressing need for cash, they make excellent candidates
for OWC (owner will carry) financing. Not only will OWC terms help
them sell their property more quickly, but an installment sale reduces or
defers the capital gain taxes that a cash sale might otherwise trigger (if
the property does not qualify for the principal residence tax exclusion
benefit; see Chapter 14). As another advantage, OWC financing—even
when offered at below-market interest rates—will often net the sellers
a higher cash income return than they could earn in a savings account,
certificate of deposit, bonds, money market fund, or stocks.
Case in point: As a college student who wanted to invest in real estate,
I sought stage-of-life owners of rental properties. These people were tired
of managing their properties. Yet, they valued a monthly income and
(most) didn’t want to settle for the meager interest paid by banks or the
low-income yield and big risks of stocks. They also didn’t want to sell their
investment properties and get hit with a tax bill for capital gains.
Their solution: Sell on easy OWC terms to an ambitious young col-
lege student who was willing to accept the work of rental properties in
exchange for an opportunity to start building wealth through investment
real estate. This opportunity remains today. Because properly selected,
well-managed rentals will pay for themselves, if you are willing to work,
you can substitute ambition and perseverance for a large down payment
and high earnings.
Seller Ignorance
Some sellers underprice their properties because they don’t know the
recent prices at which similar properties have been selling. Or they do not
know of a unique advantage that favorably distinguishes their property
from others. I confess that as a seller, I have made the mistake of selling
too low because I was ignorant of the market.
Some years ago, I lived in Palo Alto, California. The rental house I
decided to sell was located across the country. A year earlier, this house
had appraised for $110,000, which at the time of the appraisal was about
right. So I decided to ask $125,000. I figured that price fair and still left
some room to negotiate.
The first weekend the house went on the market, three offers came
in at my asking price of $125,000. Immediately, I knew I had underpriced.
What I had not known but soon learned was that during the year I’d been
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100 HOW TO FIND BARGAIN-PRICED PROPERTIES
away, property prices in that neighborhood had jumped 30 percent. After
learning of my ignorance, I could have rejected all the offers and raised
my price. Or I could have put the buyers into a bidding war. But I didn’t.
I decided to sell to the person with the cleanest offer (no contingen-
cies). I was making a good profit; why get greedy? In addition, at that time
I was teaching at Stanford University, writing a book, and consulting for
Wells Fargo Bank. In other words, I did not want to give this property sale
much attention. So, in part, my grass-is-greener-in-California attitude also
contributed to my desire to go for the quick dollar rather than top dollar.
Sellers sometimes mistakenly and sometimes intentionally under-
price their properties. Stay on the lookout for this possibility. When you
spot a good deal, jump on it. Underpriced properties often get snapped
up quickly.
Although good deals go fast, not all bargain-priced properties repre-
sent good deals. You receive a good deal only if you can sell the property
for substantially more than you have put into it. Watch out for long-term
declining markets where a seemingly low price today morphs into an even
lower price tomorrow. Also, accurately calculate fix-up expenses, hidden
defects, and environmental problems (e.g., lead paint, underground oil
storage tanks, asbestos, contaminated well water). Ration your cash. Keep
your improvements in line with the rent levels your prospective tenants
are willing and able to pay.
Temper your eagerness to buy a bargain-priced property with a thor-
ough physical, financial, market, and legal analysis. Go slowly for low-
or nothing-down seller financing. Delay the temptation to jump without
looking. First put on your Sherlock Holmes hat. Act quickly—with cau-
tion. The less you know about a property and the more you assume, the
greater your risk. Balance eagerness to buy with an explicit and realistic
view of potential pitfalls. Prepare to buy before you buy.
PREPARE SCREENING CRITERIA
Select properties to bid on in an area. Even if you could, you would not buy
every property (bargain-priced or not) that strikes your attention. Before
you move to the “buy” stage, narrow your choices:
What neighborhoods look promising?
Do you want a single-family house, condominium, co-op, town
house, or multi-unit rental property? If multi-units, how large
a property will you accept?
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BARGAIN SELLERS 101
Would you prefer to occupy and invest simultaneously? If owner
occupancy is important, how does this fact limit your choice of
neighborhoods and properties?
How much repair, renovation, or remodeling work are you willing
and able to take on?
What types of improvements will you try? Structural? Cosmetic?
Environmental? Fire damaged? Earthquake damaged? Other?
Which is most important: a bargain price or bargain terms? Would
you buy a property with negative cash flows? If no, what is your
minimum cash-on-cash return on investment?
Would you accept a property occupied by problem tenants?
How much risk will you tolerate? When buying fixer-uppers, your
repairs and renovation costs may exceed your estimates. If you
buy into a turnaround neighborhood, the turnaround may take
longer than you expect.
How much cash or borrowing power can you draw on to carry you
through a period of impaired rent collections (vacancies, bad ten-
ants)?
What’s the minimum time period you would accept on a balloon
mortgage or other short-term financing?
How long do you plan to own the property? When all costs are
considered, will the property command a selling price or rent
level high enough to meet your profit objectives?
What are your profit objectives? What sources of return seem possible
with this property?
Focus on properties that match your requirements. Eliminate the
wild-goose chases that steal the time of many beginning real estate in-
vestors. Clarify goals and circumstances. Resist the temptation to grab
a deal just because it is a deal. Go after those properties that suit your
abilities, finances, and inclinations.
BARGAIN SELLERS
Now that you have developed your screening criteria, how do you start
finding potential sellers?
Networking/Get the word out
Newspapers and other publications
Cold call owners
Agent services
Internet listings
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102 HOW TO FIND BARGAIN-PRICED PROPERTIES
Networking/Get the Word Out
Some time back, I was leaving the United States for several years and
decided to sell my house with a minimum of hassle. Coincidentally, the
Ph.D. student club at the university where I was teaching was looking for
a faculty member to host the upcoming faculty-student party. “Aha,” I
thought—what better way to expose my house to more than 100 people?
So I volunteered. In the week following the party, I received two good
offers and accepted the best.
The buyers received a good price and excellent financing. I avoided
the hassle of putting the property on the market and did not pay a sales
agent. Win-win for buyers and seller.
Draw on the power of networks. Yet, few buyers and sellers con-
sciously try to discover each other through informal contacts among
friends, family, relatives, coworkers, church groups, clubs, business asso-
ciates, customers, parent-teacher groups, and other types of acquaintances.
Make your search common knowledge. Tell everyone you know. Describe
what you’re looking for.
Why search alone when you can enlist dozens of others to help you?
Nearly all property owners prefer a quick direct sale—even at a lower than
market price. Like me, they prefer to bypass the hassles and costs of listing
and selling through a realty firm.
In addition, network searches often awaken sleeping sellers—owners
who are open to offer, but for various reasons are not yet marketing
their property(ies). Indeed, right now I am a sleeping seller on a property
located in North Carolina.
Newspapers and Other Publications
Some investors browse the real estate classified display and ads with a
highlighter, then call owners or Realtors, obtain cursory information, and
when a property sounds promising, set up an appointment to view it. This
method might work, but it can fail for two reasons: (1) If a property isn’t
advertised, you won’t learn about it; and (2) you may pass by ineffectively
written ads—even though the property itself might actually deserve your
attention.
The solution: Run your own advertisement in the real estate “wanted
to buy” column. Describe the type of property and terms that you seek.
You will invite serious sellers to contact you. When I began investing, I
used this technique to locate about 30 percent of the properties I bought.
As another way to use the newspaper, read the “houses for rent,”
“condos for rent,” and “apartments for rent” ads. This research helps you
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BARGAIN SELLERS 103
gauge rent levels. You will also see properties advertised as “lease-option”
or “for rent or sale.” These kinds of ads generally indicate a flexible and
motivated seller.
When you search for bargain sellers, look beyond the real estate
classified ads. Identify potential sellers from the public notices: births,
divorces, retirements, deaths, bankruptcy, foreclosure, or marriage. Each
of these events can trigger the need to sell real estate. If you contact these
potential sellers before they list with a sales agent, you stand a fair chance
of buying at a bargain price. (In addition, subscribe to your area’s “default”
or “foreclosure” newsletters published in print or via the Internet. Chapter
6 tells you how to profit from foreclosures.)
Cold Call Owners
To cold call productively, adopt the Realtor technique and cultivate a neigh-
borhood farm. Many top-selling realty agents select a neighborhood (or
other geographic area) and cultivate relationships to find sellers who will
list their properties for sale with that agent. Agents telephone property
owners from names listed in a crisscross directory, walk the neighbor-
hood, talk with residents, circulate flyers by mail or door-knob hangers,
and participate in neighborhood or community-sponsored events. By cul-
tivating a neighborhood farm, an agent becomes known in the area. He
positions himself as the first person property owners think of when they
decide to sell their house.
You can beat the agent at his own game. Cultivate your own neigh-
borhood (or community) farm. Among residents and businesses, circulate
a flyer that reads:
Before you list your property for sale, please call me. I plan to
buy a property in this neighborhood directly from the owners.
Let’s see if we can sit down together and work out an agreement
that will benefit both of us.
When property owners learn how they can save time, effort, and
money selling direct, they may offer you a favorable price or terms.
Also, if you get to them before they talk with an agent, they may even
quote you a below-market price because they lack reliable market comp
data. (Of course, uninformed sellers may also quote you an above-market
price—especially if comparable prices are below their previous peaks.)
Vacant Houses and Out-of-the-Area Owners. Your farm area will
include some properties (vacant or tenant occupied) that are owned by
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104 HOW TO FIND BARGAIN-PRICED PROPERTIES
people who do not live in the neighborhood. These owners may not see
your flyers, nor will you find them listed in a crisscross directory. To reach
these potential sellers, ask neighbors and talk with the tenants who live in
the property.
If this research doesn’t reveal the owners’ names and addresses,
contact the tax assessor’s office. There you can learn where and to whom
the property tax statements are mailed. It’s not unusual to find that out-
of-the-area property owners are actually “sleeping sellers” (as I am with
my North Carolina property). They will sell but haven’t as yet awoken to
the idea. You can become their alarm clock.
Broker Listings. For any number of reasons, properties listed with
real estate agents do not sell during their original listing period. When this
failure occurs, the listing agent will try to persuade the owners to relist
with his or her firm. And quite likely, agents from other brokerage firms
also will approach the sellers. Here’s what you can do to cut them off at
the pass and perhaps arrange a bargain purchase.
When you notice a listed property that looks as if it might fit your
requirements, do not call the agent. Do not call or stop by to talk to the
owners. Instead, write the owners a letter stating the price and terms that
you would consider paying. Then ask the owners to contact you after their
listing has expired. (If a seller goes behind his agent’s back and arranges a
sale while the property is listed, the owner is still legally obligated to pay
the sales commission.)
Consider this possibility: You find a property listed at its market
value of $200,000. The listing contract sets a 6 percent sales commis-
sion. The sellers have told themselves that they will accept nothing less
than $192,500, meaning that after paying the expenses of sale they would
net around $180,000. You offer $175,000. Would the sellers accept it? Or
would they relist, postpone their move, and hold out for another $5,000 to
$10,000?
They just might accept your offer. It depends on their finances, their
reason for moving, and any pressures they may face. But you can see that
even though your offer is low relative to the market value of the house,
it still provides the sellers almost as much as they could expect to net if
their agent found them a buyer. (Naturally, your letter would not formally
commit you to purchase the property. It would merely state the price and
terms that you have in mind.) Also, when you make such offers, emphasize
the relative amounts the seller will net—not price per se.
Although agents can provide you services, if you want to buy at a
bargain price or buy on bargain terms (especially with low- or no-down-
payment seller financing), where is the agent’s fee going to come from? To
negotiate a bargain price, at times, forego an agent’s services and do your
own legwork.
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BARGAIN SELLERS 105
Agent Services
As to agent services, investor and renovator Suzanne Brangham wants to
rely on them. In her book, Housewise (HarperCollins, 1987, p. 163), Suzanne
exclaims:
You need realty agents as much as they need you. After you
have narrowed your choice to one or two neighborhoods or
towns, enlist the aid of an expert. Your real estate agent will
guide you so that you can sit back, take out your notebook,
ask questions, and learn.... Good agents know what prices
properties are selling for, which areas are strong, and which
neighborhoods are getting hot....
If you let your agent know that you plan to buy and sell
several properties over the next few years, he (or she) will do
everything short of breaking and entering to show you the
properties that are available.... I’d been lusting after a beautiful
two-unit building, but it had never been up for sale. My agent
called me the minute it was listed and I bought it in less than an
hour. In fact, I soon became notorious for signing offer forms on
the roof of my agent’s car. When there’s a race to get in your bid
on a particularly juicy piece of property, a faithful agent who
knows exactly what you want can make all the difference.
Although my experience with agents does not reach the gushing
praise that Suzanne extols, a skilled agent can assist you with at least eight
helpful tasks:
Suggest sources and techniques of financing and help you run
through the numbers.
Research comp sales and rent levels so that you can better understand
values.
Act as an intermediary in negotiations.
Recommend other professionals whose services you may need
(lawyer, mortgage broker, contractor, designer, architect, property
inspector).
Handle innumerable details and problems that always seem to pop
up on the way from contract to closing.
Clue you in about what type of interest and market activity has
developed around various properties.
Give you an insider’s glimpse into an area to let you know who’s
doing what and where.
Disclose negatives about a property or neighborhood that might oth-
erwise have escaped your attention.
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106 HOW TO FIND BARGAIN-PRICED PROPERTIES
Agents will sort through your neighborhood and property trade-offs,
suggest possibilities for value-creating improvements, and try to persuade
sellers to accept your price and terms. The best agents, as Brangham points
out, “[are] those who listen when you explain what you are looking for.
They will take you directly to the buried treasure you want to find.”
Civil Rights Caveat. Real estate agents (like everyone else) must con-
stantly guard what they say out of fear of lawsuits alleging discrimination.
If you ask, “What’s the quality of the schools in this neighborhood?” the
agent may hedge an answer if, say, at one time school busing or racial
strife spurred exodus to suburbia, and correspondingly, student achieve-
ment test scores fail to meet acceptable levels.
Likewise, if the ethnic, religious, or racial composition of a neighbor-
hood affects property values (either up or down), a sales agent would not
mention this fact. The U.S. Department of Justice (DOJ) and the U.S. De-
partment of Housing and Urban Development (HUD) have decreed that
neither ethnic, religious, nor racial demographics affect property values.
Real estate agents (or property appraisers) who disagree with
HUD or the DOJ can find themselves liable for civil and/or criminal
penalties—including monetary damages, fines, and even prison. When
your inquiries clash with fair housing mandates, do not expect straight
talk from your realty agent.
Property Condition Caveat. In addition to fair housing issues, most
agents tread lightly in response to questions about the condition of a
property. “How’s the roof?” you ask. The agent answers, “As far as I
know, it’s eight years old and hasn’t had any leaks.” You buy the property,
and three months later the roof begins to leak. On the basis of the agent’s
statement, you sue the brokerage firm for misrepresentation and fraud.
Even though the agent told the truth as far as he or she knew it, many
judges or juries would find the agent liable.
Buyers have sued agents so many times for giving “to the best of
my knowledge” answers concerning property condition that smart agents
avoid such questions. They prefer to refer you to appropriate property spe-
cialists and inspectors. In one major precedent-setting case in California,
a realty agent was held liable for not informing his buyers that a property
was located in a mud slide area—even though the agent did not know that
the area was risky. In response to this case, the California Association of
Realtors convinced the California legislature to enact a seller disclosure law.
Most other states have followed California’s lead.
To buy at a (true) bargain price, rely on accurate information about
neighborhoods and properties. A top real estate agent will provide you
with some of these data, but not all that you need. Recognize the practical
and legal limits that restrain even the most knowledgeable agents.
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SELLER DISCLOSURES 107
Buyer Loyalty. For every real buyer they work with, most agents
encounter a dozen pretenders—wannabe investors who steal an agent’s
time and knowledge but feel no obligation to buy from that agent. Or if
they do buy, the first thing they do to make a deal work is to try to cut the
agent’s commission. Such an approach does not build a relationship. To
gain the benefits Suzanne Brangham celebrates, demonstrate buyer loyalty.
Show loyalty to your agents, and in turn, they will favor you as a
client who gives them repeat business (as well as referrals). In return, they
provide top service and include you among the first to learn of those “juicy
deals” as soon as they hit the market—and sometimes even before a listing
goes into the MLS (Multiple Listing Service).
Internet Listings
Property investors not only cruise neighborhoods, they cruise the Internet
to look for properties. Thousands of web sites now list properties for sale.
Property buyers (or browsers) can directly access the Realtors’ Multiple
Listing Service (MLS) at www.realtor.com.
A huge entrepreneurial industry of content providers publish spe-
cialized listings of everything from foreclosures to commercial properties
to FSBOs. Online, you can locate investors looking for money—or money
looking for properties. Nearly all real estate information that in the past
has been available from Realtors—government records, newspaper ads,
newsletters, and other sources—is now (or will soon be) accessible. Elec-
tronic shopping for real estate (and mortgages) has rendered the MLS book
as obsolete as a slide rule. In addition to the web sites referenced in this
book, search engines can guide you to a cornucopia of useful data and
topical discussions.
SELLER DISCLOSURES
What you see is not all that you get. That below-market price won’t seem
like such a great deal once you learn the roof leaks, the foundation is crack-
ing, and termites are munching on floor joists for their dinner. Moreover,
if the next-door neighbors make Animal House look tame, quality tenants
will not rent your property—or if they do move in, they will not stay.
Prepare against such unwanted surprises. Thoroughly inspect the
property, talk to existing tenants, walk the neighborhood, and avail
yourself of knowledgeable and trustworthy real estate agents. Get the
property checked out by a property inspector, a structural engineer, a pest
control expert, or other specialists who accurately assess the condition of
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108 HOW TO FIND BARGAIN-PRICED PROPERTIES
the property. And last but not least, ask the sellers to complete a seller
disclosure statement.
The Disclosure Revolution
More than 40 states now require (or encourage) sellers to complete a seller
disclosure statement that lists and explains all known problems or defects
that may plague a property. But even if your state doesn’t yet mandate
seller disclosure, obtain a disclosure form (most realty firms keep blank
copies on hand) and ask the sellers to fill it out. (Or google “seller disclosure
statements.” Your hits will include blank forms from multiple states.)
As you review a seller-completed disclosure statement, watch for
these five issues:
1. Sellers cannot disclose facts or conditions of which they are un-
aware. Disclosures do not substitute for inspections.
2. Disclosures reveal the known past. They make no guarantees.
Sellers do not warrant the present or future condition of the
property. They report only what they know.
3. Disclosure questions permit subjective answers. Are playing chil-
dren a neighborhood “noise” problem? Is a planned street widen-
ing an “adverse” condition?
4. Disclosure statements may not require sellers to disclose prop-
erty defects that you can readily see. Keep your eyes attentive.
5. Beware of seller (or agent) statements that begin, “I believe,”
“I think,” “as far as we know,” and other similar hedges. Do
not accept these answers as the final word. Follow up hedged
statements or assertions with definitive inquiry or inspection.
Seller disclosures help you accurately understand and value proper-
ties. But even so, give them only as much weight as they deserve. Indepen-
dently check out the property to verify that you know what the property
is worth more than the price you are agreeing to pay.
Income Properties
Some seller disclosure laws apply only to one- to four-family owner-
occupied properties. If you buy an apartment building or shopping center,
the law may not require the seller to fill out a disclosure statement. If, in this
situation, the seller refuses, offset this additional risk by scaling down the
price you offer—and enhance the rigor of your pre-purchase inspections.
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SUMMARY 109
Verify rental income and operating expenses. Ask the sellers to sign
a statement whereby they swear that the income and expense figures
that they have reported to you are true and factual. Some owners place
friends, relatives, and employees into their buildings at inflated rent levels.
These tenants do not pay the rents shown in the lease (or if they do, they
get kickbacks in cash or other benefits), but their signed leases sure look
attractive to unsuspecting buyers.
SUMMARY
To find owners who will sell at a below-market price is like panning for
gold. Even when you know a stream is loaded with potential, you will
probably sift through a ton of muck and rock before you discover the
nuggets that yield the profits. When searching for below-market deals,
expect to work. As you gain experience and reputation, deals will start
coming to you. But as stock speculator Gordon Gekko (Michael Douglas)
tells Bud Fox (Charlie Sheen) in the movie Wall Street, “Kid, I look at 100
deals a day. I may choose one.” Prepare yourself.
Among the properties that sellers (or agents) promote as bargains,
many turn out otherwise. Through skillful negotiation and financial struc-
turing, you can sometimes transform an apparently mediocre deal into
a winner. Except in cases of luck, putting gold nuggets into your pocket
will require intelligence, knowledge, and possibility thinking. But like the
industrious and fortuitous miner who pans for gold, those bargain-priced
properties you do find will generously reward you for your diligence.
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6
PROFIT WITH FORECLOSURES
F
or the past several years, the news media have given the topic of
foreclosures more pages of coverage than at any time since the early
1930s. In the beginning of this current financial downturn, jour-
nalists positioned their foreclosure stories in terms of human hardship.
“Greedy bankers ruin lives.”
More recently, stories highlight the extraordinary (one could almost
say “chance of a lifetime”) opportunities that many of today’s property
markets offer (especially foreclosures/REOs).
But as with all property investing, foreclosures present pitfalls as well
as potential. Do not fall for the “easy money” media stories or the inflated
“pennies on the dollar” claims of the foreclosure gurus.
To profit big with foreclosures—and at the same time steer clear of
big risks—requires you to gain knowledge of the foreclosure process, mar-
ket research, valuation, reliable “cost to cure” estimates, and the power of
persuasion. Develop your talents within each of these skills and today’s
market will present you with more good possibilities than any market I
have experienced throughout my career. The low risk/high reward fore-
closure opportunities are best captured by investors who prepare.
THE FORECLOSURE PROCESS
Borrowers default because they fail to make their mortgage payments. But
defaults also occur when owners fail to pay their property taxes; fail to pay
some related obligation (homeowners’ association fees, a superior mort-
gage claim, special assessments); transfer a mortgaged property without
lender approval; or undertake renovations, remodeling, or demolition that
diminish the value of the property.
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THE FORECLOSURE PROCESS 111
Lender Tries to Resolve Problem
In contrast to the late 1980s and early 1990s, most lenders today give delin-
quent borrowers generous opportunity to restructure, reinstate, or refi-
nance their mortgages. That’s why even though the number of mortgages
in default is now approaching six million, the number of properties actually
sold at foreclosure auctions comes in below two million. With more loan
workouts, a smaller percentage of troubled borrowers lose their properties
via a foreclosure sale. Nevertheless, mortgage lenders (or guarantors) will
get the keys to more than one million properties this year. And the number
of borrowers who have fallen behind in their payments (and thus are in
need of a workout) now exceeds 4 million. Given these huge numbers, the
foreclosure business (preforeclosure workouts including short sales, gov-
ernment foreclosures, and postforeclosure REOs) provides a cornucopia
of profit potential.
Filing Legal Notice
When a lender finally gives up on a preforeclosure workout, its lawyers
file either a legal “notice of default” or a “lawsuit to foreclose” (depending
on the state). This legal filing and its subsequent posting of notice on the
Internet or in newspapers formally announce to (1) the property owners,
(2) any other parties who may have legal claims against the owners or their
property, and (3) the public in general, that legal action is moving forward
to force a “courthouse” sale of the property.
At least one month passes between the date of legal filing and the
foreclosure sale. More typically, this waiting period ranges between 60 and
180 days. If the property owners file a legal defense to the lender’s fore-
closure action (e.g., lender violated due process, fraud, consumer rights,
truth in lending), the foreclosure sale may have to wait for a lender victory
in settlement or trial. These kinds of litigation battles can drag on for a
year, two years, or even longer. The sheer volume of defaults today is also
extending the period between the date of the original default and the ac-
tual day of the foreclosure sale. Lenders and mortgage servicing companies
lack the personnel necessary to steer a defaulting borrower into foreclosure
(or workout) in a timely manner. In addition, to halt the foreclosure sale for
at least a month or two longer, defaulting property owners sometimes file
for bankruptcy. Bankruptcy filing by the property owners immediately and
automatically stays a foreclosure action. To proceed further in its efforts to
force a sale, the lender petitions the bankruptcy court. Only after the court
grants permission will the foreclosure process start running again. (In fact,
in some situations, a bankruptcy court can annul a foreclosure sale that
has already occurred.)
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112 PROFIT WITH FORECLOSURES
The Foreclosure Sale
Eventually, when defaulting property owners run out of legal defenses or
delaying tactics, the foreclosure sale date arrives. At this point, the property
is auctioned to the highest cash bidder. Sometimes a real estate investor
(foreclosure specialist), speculator, or even a homebuyer submits the win-
ning bid. More likely, the lender who has forced the foreclosure sale bids,
say, one dollar more than the amount of its unpaid claims (mortgage bal-
ance, late fees, accrued interest, attorney fees, foreclosure costs) and walks
away with a sheriff’s deed to the property. Next, the lender eventually sells
the property directly through a real estate brokerage firm, or in troubled
times like these through some type of auction sale where dozens—or even
hundreds—of REO properties meet the rap of the auctioneer’s gavel.
REOs
Remember these words: LENDERS DO NOT WANT TO OWN FORE-
CLOSED REAL ESTATE. For a lender (or institutions such as the Fed-
eral Housing Administration [FHA], Department of Veterans Affairs [VA],
Fannie Mae, Freddie Mac), holding onto an REO that has been acquired
through foreclosure rarely seems like a good idea. No matter how much
potential the property offers, owners of REOs want to sell quickly. Lenders
expect to lose money on their sales of REOs—but they would lose even
more by holding onto these properties. Lenders find themselves quite ill-
suited to operate as property management companies.
Therefore, to profit with foreclosures, pursue one or more of these
three approaches:
1. Negotiate with the distressed property owners and, if necessary,
the foreclosing lender (i.e., to obtain a short sale or refinance).
2. Bid at the foreclosure auction.
3. Buy an REO from the lender or the “insuring” agency (FHA, VA,
Fannie Mae, Freddie Mac) that owns the property. (This topic is
covered in Chapter 7.)
BUY PREFORECLOSURES FROM DISTRESSED OWNERS
Each year in every community, hundreds (sometimes thousands) of prop-
erty owners hit the financial skids. Divorce, job loss, accident, illness,
business failure, payment shock (ARMs), and other setbacks render peo-
ple unable to make their mortgage payments. Rather than effectively deal
with their problems as soon as default is imminent, most owners hang on
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BUY PREFORECLOSURES FROM DISTRESSED OWNERS 113
too long, hoping for a miracle to bail them out. Since miracles are rare,
most of these people end up staring foreclosure in the face.
At that point, you may be able to help them salvage their credit
record and part of their home equity and at the same time secure a bargain
for yourself. Faced with pressures of time and money, distressed property
owners accept a quick, credit-rescuing sale at a price less than market value.
Approach Owners with Empathy
No one can give you a magic system to buy property from people who
face foreclosure. These owners must contend with financial troubles, per-
sonal anguish, and indecisiveness brought on by emotional depression.
They have probably been attacked by foreclosure sharks, speculators, bank
lawyers, and recent attendees of get-rich-quick foreclosure seminars. These
owners live with the public shame of failure. For all these reasons and more,
they are not easy people to deal with.
To succeed, develop a sensitive, empathetic, problem-solving ap-
proach. Think cooperation. Think win-win. You gain a bargain price. The
sellers will shed their burdens and limit their potential losses. To find and
persuade sellers, you compete against foreclosure specialists. A “Here’s
my offer—take it or leave it” approach antagonizes the owners. It does not
favorably distinguish you from a dozen other potential buyers (sharks).
Design your negotiations and offer to preserve what little may be left of
the owner’s dignity and self-esteem. Share personal information about set-
backs you have lived through. Emphasize win-win outcomes. Dire straits
or not, no one wants his or her home (property) stolen away.
The Difficulties of Dealing Profitably with Owners in Default
Some “get rich in foreclosures” seminars, CDs, and books exaggerate the
possibilities of profiting from property owners who face foreclosure. The
enticing scenarios imagined by these promoters place you in the picture
with high-equity sellers who hold a nonqualifying assumable mortgage.
You offer the sellers a few thousand dollars in cash and agree to make up
their past-due mortgage payments. The sellers deed you their property and
move out. You then put a tenant in the property, collect rents, and pay the
property expenses and scheduled mortgage payments. Or, alternatively,
you fix up the property, put it on the market, and sell for a fat profit.
Regardless of which strategy you choose, buying foreclosures can make
you wealthy fast—at least that’s the pitch of the foreclosure gurus.
Admittedly, such easy pickings are great when you can find them.
As you might expect, though, deals rarely move forward with step-by-
step simplicity. When you talk with property owners in foreclosure, you
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114 PROFIT WITH FORECLOSURES
uncover a minefield of problems that you must crisscross with skill and
creativity. Here are some of the issues you will need to deal with.
Mortgage Debt Exceeds Market Value. Property owners who contend
with foreclosure often owe more than their properties are worth. To make
a deal work, you must talk the lender into a “short sale”; that is, the
lender voluntarily reduces the balance due on its loan so that you receive
a “fair” profit for agreeing to make up past-due payments and take over
the loan.
Today, increasing numbers of lenders do accept short sale investors,
but you must thoroughly prepare your short sale package. Then you wait,
suffer runarounds, and sometimes lose the deal to a higher bidder.
Nonquals Are Tough to Find. Few mortgages today automatically
permit assumptions. Finding a homeowner in foreclosure who actually
has a nonqualifying assumable is like finding the proverbial needle in a
haystack.
Qualifying Assumptions Are Limited. Today’s FHA and VA mort-
gages do permit assumptions, but only by credit-qualifying owner-
occupants. If your credit or income is shaky, or if you plan to “flip” the
property without taking occupancy or hold the property as a rental, neither
FHA nor VA will let you assume an existing mortgage.
Multiple Creditors, Multiple Title Problems. Property owners who
suffer foreclosure often get hit by claims of other creditors. Check to see
ifoneormoreofthesecreditorshasfiledalis pendens, a tax lien (Internal
Revenue Service or other taxing authority), or has secured a judgment
against the homeowners. To clear title, you may have to clean up and
settle with several creditors—not just one mortgage lender.
Workout with Credit Counselors. Most lenders today (especially
FHA, VA, Fannie Mae) encourage financially troubled property owners
to seek credit counseling and loan workout with nonprofit agencies such
as CCCA (Credit Counseling Centers of America). Neither the homeown-
ers nor the lenders may need a profit-minded workout specialist. The new
“foreclosure rescue” program that Congress enacted will also compete to
a degree with profit-motive investors.
Save Equity through Bankruptcy. In many states, homeowners can
file bankruptcy and save all or part of their home equity. Fifteen or
20 years ago, only the most bold or financially ruined Americans pur-
sued bankruptcy. Now, bankruptcy serves as just another tool of financial
planning. Approximately 1.5 million couples and individuals elect to file
for bankruptcy each year.
When someone can get rid of all those credit card balances and unpaid
medical bills—and at the same time save their most valuable asset (their
home equity)—why let a foreclosure investor come through the door?
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PREQUALIFY HOMEOWNERS AND PROPERTIES 115
Note: In 2005, Congress passed a revised bankruptcy law that intends
to make debtors pay back more of the money they owe as well as to tighten
the bankruptcy homestead exemption. Because bankruptcy combines both
state and federal law, talk with an attorney in your area. My guess is that
this tightening of bankruptcy law will increase your opportunities for
profitable preforeclosure workouts.
Bankruptcy Doesn’t Ruin Credit. The threat of “ruined” credit
doesn’t instill the same fear in Americans today that it did two decades
ago. In fact, it’s not easy to actually ruin your credit. After a bankruptcy
discharge, people with steady jobs can shortly thereafter obtain credit
cards (albeit secured), car loans, and home loans (e.g., lease option, seller
financing). After bankruptcy, with two years of clean credit, FHA, VA, and
sometimes even Fannie Mae/Freddie Mac lenders will approve reestab-
lished borrowers. The somewhat easy credit-rebuilding techniques reduce
the probability that you can persuade homeowners to transfer a large
chunk of their home equity to you so that they can “save their credit.” (In
decades past, a bankruptcy or foreclosure would turn a debtor into a credit
leper—no longer does this shunning occur.)
Estimate Repair and Renovation Costs. Before you finalize a prefore-
closure purchase with a property owner, thoroughly inspect the property
and accurately estimate the costs of necessary repairs, renovations, and
perhaps environmental cleanup. In their enthusiasm to do a foreclosure
deal, unsuspecting buyers gloss over the inspection and make only an eye-
ball guesstimate of expected costs. Much to their dismay, they soon learn
that slick foreclosure sellers can put one over on unsophisticated buyers,
just as slick foreclosure sharks may at times take advantage of distressed
property owners.
PREQUALIFY HOMEOWNERS AND PROPERTIES
By warning you of some potentially difficult preforeclosure issues, I do not
intend to discourage you. Rather, I want to educate you. Investors who
close their minds to facts rarely earn long-term (or even short-term) prof-
its. You can gain outstanding rewards through foreclosures—but only if
you prequalify the homeowners and the property. Before moving forward
toward a workout, evaluate your possibilities and probabilities. Answer
these eight questions:
1. What amount of equity have the owners built up in their
property?
2. If necessary, will the lender cooperate in a short sale?
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3. Will the lender permit you to assume the mortgage? As an
investor? As an owner-occupant? At what interest rate? If no
assumption, will the lender waive the mortgage prepayment
penalty (if any)?
4. Can you satisfy yourself, through a title check or title insurance,
that the sellers can convey a marketable title, that is, a title free
of consequential clouds (actual and potential)?
5. Will the homeowners work to avoid bankruptcy or foreclo-
sure to alleviate their financial distress? (When sellers refuse
to cooperate—as they sometimes do—your chance to succeed
drops close to zero.)
6. Would the property owners lose more economically in a
bankruptcy than they would stand to gain? (As noted, bankrupts
may emerge from bankruptcy with their unsecured debts extin-
guished and their most valuable assets [IRA, 401(k), home equity,
life insurance cash value, furniture, clothing, car] preserved.)
7. Can you firmly establish how much you must spend to repair,
redecorate, and renovate the property?
8. Is the potential profit margin large enough to justify your invest-
ment of time, money, effort, and opportunity cost (i.e., the profits
of other deals you pass up to invest in this one)? Complete the
following revenue and cost schedule to evaluate risk and profit
potential:
Sales price after improvement $
Less
Acquisition price (cash, notes, assumed mortgages) $
Mortgage assumption fee $
Legal fees $
Back property taxes and assessments $
Back payments and late fees $
Closing costs $
Cost of improvements $
Holding costs until sold or rented $
Miscellaneous $
Time and effort (imputed value) $
Opportunity costs (imputed value) $
Equals
Profit potential $
Do your answers to these eight questions reveal any serious un-
knowns, uncertainties that magnify risk? Does the amount of profit look
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FINDING HOMEOWNERS IN DEFAULT (PREFILING) 117
high enough to offset cost and market uncertainties? Yes? Then you’ve
created a good deal you should go for.
FINDING HOMEOWNERS IN DEFAULT (PREFILING)
Ideally, learn the names of homeowners who have defaulted on their mort-
gages before their lender files formal legal notice. Although such discovery
can prove difficult, these techniques often work:
Networking
Choose an area that offers potential. Then develop strong networking re-
lationships with some of the people who know the neighborhood, such
as mail carriers, delivery truck drivers, school personnel (teachers, princi-
pals), social service workers, busybody residents, real estate agents, local
merchants, church leaders, and credit counseling personnel. Through this
network of contacts, find out who’s thinking about selling their home,
who’s been recently laid off, who spends above their means, who can’t
pay their bills.
Mortgage Collections Personnel
Some foreclosure specialists develop personal relationships with the lend-
ing personnel who collect delinquent accounts. Of course, lenders prohibit
their employees from revealing private information about customers. But
we all know that what is prohibited and what is practiced can run opposite
to each other—especially when “it’s just between friends.”
An obstacle even greater than privacy now detours this approach.
That obstacle is distance. In the good old days, local lending personnel
handled a majority of mortgage lending and collections. Today, a mortgage
loan in Peoria, Illinois, may be owned by a bank headquartered in San
Francisco and serviced by a company located in Boston. When out-of-
town personnel deal with the early stages of homeowner default, your
chances of nurturing a confidential relationship becomes more difficult.
Drive Neighborhoods
When you really get to know your territory, keep your eye out for
properties that appear unkempt, or perhaps suffer a sudden, mysterious,
or extended vacancy. Such indicators may signal a property owner who
faces financial distress. Ask a neighbor or two to confirm your suspicions.
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118 PROFIT WITH FORECLOSURES
Informal inquiry may turn up a prime prospect with whom you can
negotiate—before a flock of foreclosure vultures land to compete for the
pickings.
FIND HOMEOWNERS (POSTFILING)
Once a lender files suit, you can learn the names and addresses of distressed
property owners in at least four ways:
1. Visit the clerk of civil court’s office and ask to see the list(s) of
foreclosure filings.
2. Subscribe to a specialized legal newspaper or e-mail newsletter
that reports court filings.
3. Read the “legal notices” section of your local daily (or weekly)
newspaper.
4. Go online. Although currently many counties throughout the
United States lag behind in the Internet revolution, within a few
years even the most backward (or obstinate) will post foreclosure
filings on the Web.
As soon as the foreclosure shows up in the public records, competi-
tion for quality deals gets heated. To succeed, present yourself and your
offer to the distressed property owners in a way that distinguishes you
(not merely differentiates you) from the crowd.
Cultivate a Relationship with Property Owners
During periods of stress, property owners often hide the truth about their
personal matters. Understandably, the loss of home or property stirs the
emotions. As a result, you cannot rely on owner statements. Verify all
details about the property and its liens.
Here are several suggested approaches to open negotiations with an
owner in foreclosure:
“If you’ll allow me to complete a financial analysis of the prop-
erty, I can be back within twenty-four hours with a firm offer
that might solve your current dilemma.”
“I would like to pay you cash for your equity, which
you otherwise will likely lose in a foreclosure sale. By working
together, we can rescue your credit and you can begin to reestab-
lish your life.”
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FIND HOMEOWNERS (POSTFILING) 119
“May I review the loan documents on your home? Can
you locate a copy of the mortgage, the title policy, and the
monthly loan statements?”
Act faster and offer better results than anyone else. Do not
insult or criticize the owners or their property—even though
their house may show cosmetic blemishes and deferred main-
tenance. (In fact, the worse it looks, the better for you.)
As you inspect the property, realistically estimate costs
and evaluate its potential market value. You are now prepared
to begin discussions of price and terms.
Position your critique as polite inquiry. “Do you think I
might have to replace the roof?” “I wonder how I can remove
those stains from the carpet?” “Do you think most buyers today
prefer the dark kitchen cabinets like these—or the lighter ones
like I see in many new model homes?” In this way, you lead
the owners to the deficiencies of their property without sharp-
edged complaints.
Two More Issues
Up to this point, we have assumed that you were able to: (1) meet directly
with the property owners; (2) explore the exact nature of their situation;
(3) evaluate the financials of the property; and (4) work through potential
win-win-win (owners-lender-you) possibilities. But you may not be able
to meet directly with the owners if they are represented by a realty firm,
or if they have abandoned the property and relocated away from the
community.
Sales Commissions Eat up Owner’s Equity. I have found it difficult
to work with property owners in foreclosure when they have listed their
home for sale with a realty firm. Most run-of-the-mill real estate agents
know next to nothing about bank workouts, though I see this lack of
knowledge changing. Given the market today, more agents are honing
their skills in foreclosure opportunities. Still, rather than help, many do
hinder the creative, cooperative process that workouts require.
In addition, real estate agents want to be paid in cash at closing. When
a sales agent expects to pull six percent of the sales price—an amount
that eats up a large chunk of owner’s equity (providing the owner has
accumulated any equity), it squeezes your negotiating range. The amount
of that commission comes straight from monies that could otherwise go to
you, the lenders, or the property owners.
On occasion, I have dealt with savvy agents who understand that
if they insist on a full commission they will kill the deal. In one such
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120 PROFIT WITH FORECLOSURES
transaction, the agent agreed to accept just $1,000 in lieu of $4,500. (As
this agent realized, he wasn’t giving up a fee of $4,500 for a fee of $1,000.
Instead he was earning a fee of $1,000 in lieu of earning nothing at all.)
Realty Agents Can Price Too High. Sometimes realty agents hurt the
property owners’ chance to sell their home when they overprice the listing.
Say the distressed owners owe $280,000 on a property with a market value
of $300,000. To get the listing, an agent may lead the owners into falsely
believing that they can sell the property at a price of $325,000. “Great!” the
owners think, “We will net $20,000 to $25,000.”
Sixty to 90 days pass, and the overpriced property doesn’t sell. The
owners panic. The foreclosure lawyers are closing in for the kill. But now
the listing is stale. To really grab buyer attention requires a severe price
cut to maybe $275,000. By this time, the unpaid mortgage balance along
with missed payments and late fees could total $300,000. There’s no way
a sale will clear out the mortgage debt and the sales commission. More
often than not, the foreclosure sale date rushes closer like a speeding
freight train.
Quick FSBO Beats Realty Listing. When you talk with low-equity
distressed sellers, persuade them not to list with a realty firm in hopes
of getting some pie-in-the-sky sales price. Property owners almost always
stand a better chance of minimizing loss by going for a quick, discounted
FSBO (for-sale-by-owner) sale. In some cases, they should even pay some-
one (cash, note, barter) to take over their loan—or to buy the property and
arrange new financing.
Property owners in foreclosure must forget the idea of maximizing
gain. Rather, they must eliminate the possibility of severe loss. You must
lead distressed property owners to see that time is not their friend. Time is
their enemy. The frequently heard homeowner refrain, “We’re going to try
this for a while and see what happens,” does not make sense. What does
happen? They lose the property to foreclosure.
Sometimes you fish; sometimes you cut bait. Foreclosure means it’s
time to cut bait. It’s not prudent for property owners to keep throwing the
line into new waters. To work successfully with these distressed property
owners, repeatedly encourage them to act now. Delay brings regret. Action
brings relief.
Vacant Houses
When you discover a vacant house in foreclosure, you discover both a
problem and an opportunity. It’s a problem because you may have to
do some detective work to locate the owners. Unless the owners have
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SATISFY LENDERS AND LIEN HOLDERS 121
purposely tried to disappear, though, you can probably locate them in one
of the following five ways:
1. Contact nearby neighbors to learn the owners’ whereabouts, or
the names of friends or family who would know.
2. Call the owners’ telephone number and see if you get a “number
changed” message.
3. Ask the post office to provide the owners’ forwarding address.
4. Find out where the owners were employed and ask coworkers.
5. Contact parents, friends, teachers, or students at the school the
owners’ children attended.
After you locate the owners comes opportunity. Because they have
abandoned the property, they probably aren’t entertaining any fanciful
hopes for a sale at an inflated price. At this point, they may view any offer
you make them as “found money.”
In some cases, you will learn that the owners have split up and gone
their separate ways. This type of situation raises another problem: Espe-
cially in hostile separations, working out an agreement with one owner in
the belief that you can convince the other(s) to go along often proves futile.
To avoid this difficulty, bring all owners into the negotiations early. Never
rely on, “Oh, she will go along with whatever deal you and I work out.”
SATISFY LENDERS AND LIEN HOLDERS
Before you talk numbers in your preforeclosure negotiations, identify who
holds legal claims against the property and in what amounts. Ask the
property owners for this information. However, do not commit yourself
to a deal. Verify the owners’ figures through a preliminary title report
issued by a lawyer or title insurer. Also verify claims through direct contact
with claimants. Your investigation may turn up claimants in the following
categories:
Mortgage holders (first, second, third ...)
Taxing authorities (federal, state, local)
County or city special assessments
Homeowners’ association fees and assessments
Unpaid sewage or water bills
Special assessment or bonding districts
Judgment creditors
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122 PROFIT WITH FORECLOSURES
Mechanics liens for labor or materials provided to the property
Spouse (or ex-spouse) rights, including dower and curtsey
Unfound heirs
One way or another, you will have to decide how you want to satisfy
the claimants you find. You can use some combination of the following
four techniques:
1. Pay off immediately any or all claimants for the full amount of
their claims.
2. Pay off over time any or all claimants for the full amount of their
claims.
3. Pay off immediately any or all claimants at a mutually agreed
discount.
4. Pay off over time any or all claims at a mutually agreed discount.
Consider a preforeclosure in Phoenix that would likely sell for
$110,000. The owner agrees to deed the property to you if you pay off
all outstanding liens, which total $105,000:
First mortgage $78,000
Second mortgage $18,000
Roofing contractor $3,000
Credit card judgment $6,000
Total $105,000
Facing these numbers, the deal won’t get off the ground. The potential
profit margin of $5,000 is much too low. But what if you could persuade
the first mortgage lender to extinguish its old $78,000 balance and write
you a new loan on the property in the amount of $88,000 (80 percent loan-
to-value ratio) and waive all closing costs? You then work out discount
deals with the other creditors. After negotiations, your total payoff looks
like this:
First mortgage $78,000
Second mortgage $10,000
Roofing contractor $2,000
Credit card judgment $1,500
Total $91,500
By combining $88,000 in proceeds from the new loan and $3,500 in
out-of-pocket cash, you have just bought a $110,000 property for $91,500.
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SATISFY LENDERS AND LIEN HOLDERS 123
All Parties Are Better Off
If this property had completed its trip through foreclosure, only the first-
mortgage lender stood a chance of emerging whole. But more than likely,
after adding up continuing lost interest payments, late fees, attorney
fees, foreclosure expenses, and REO risks and carrying charges, the first-
mortgage lender, too, may have ended up worse off. As for the other
parties, here’s how they would gain from this workout proposal:
The property owners. Theoretically they lost $5,000 in eq-
uity, but as a practical matter, that was $5,000 they were never
going to see. Far more important, the workout not only kept a
foreclosure entry off their credit record but also rescued them
from a possible deficiency judgment.
The second-mortgage holder. Again, theoretically the prop-
erty held enough value to liquidate the full $18,000. As a prac-
tical matter, this second mortgagee was better off to take a
quick and sure $10,000 and cut its potential losses. Owing to
the low prices bid at foreclosure sales, in all likelihood, this
lender would have ended up empty-handed.
Roofing contractor. Not a chance of collecting any money
from a foreclosure sale. (Accepting $2,000 beats nothing.)
Credit card judgment. Not a chance of collecting any money
from a foreclosure sale. (Again, $1,500 beats nothing. Besides, at
this point this debt is probably held by an asset-recovery com-
pany who paid less than 5 cents on the dollar to buy the claim.)
In any specific deal, the numbers could come out better or worse
for the respective parties—including you. It all depends on the parties’
relative negotiating power and skills, their need for cash, their need to
avoid risk, and their capacity for understanding. To succeed in the face
of this ambiguity, entrepreneurial workout specialists size up people and
situations. You have to figure out fast whether a deal looks doable.
Who is willing to settle for how much? Who stands to lose the most?
Who needs cash now? Who is willing to wait? What concessions will the
first-mortgage lender make, if any? Do the parties understand the likely
adverse outcome of a foreclosure sale?
Win by Losing Less
In a foreclosure sale, more often than not, everyone loses except the
lawyers. But think what happens when all principals agree to work
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124 PROFIT WITH FORECLOSURES
with—rather than against—each other. You can create an outcome where
everyone walks away better off. Maybe they receive less than they hoped
for, certainly less than they were theoretically entitled to, but far more than
they could expect from a bidder at a foreclosure auction.
PROFIT FROM THE FORECLOSURE AUCTION
Although foreclosure sales typically lose money for lenders, lien holders,
and property owners, savvy bidders can turn these sales into big prof-
its. But you must prepare. Bidding blind can buy you problems you do
not see.
Why Foreclosures Sell for Less than Market Value
Foreclosure (court ordered) properties sell at prices much lower than their
market values. Why? Because court sanctioned auctions do not satisfy the
criteria of a market value transaction:
Sale Characteristics
Market Value Sale Foreclosure Auction
No seller or buyer duress Forced sale
Buyer and seller well informed Scarce information
60- to 120-day marketing period 5 minutes or less selling time
Financing on typical terms Spot cash (or within 24 hours)
Marketable title No title guarantees
Warranty deed Sheriff’s (or trustee) deed
Seller disclosures No seller disclosures
Close inspection of physical condition No physical inspection
Yard sign Rarely a yard sign
“Homes for sale” ads Legal notice posting
Sales agent services No sales agent services
Foreclosure auctions seem purposely designed to sell at the lowest
possible sales price. They take place under conditions that run contrary to
all principles of effective marketing.
Adverse Sales Conditions. The auction sellers (sheriff’s office, clerk
of court, trustee) provide potential buyers no information about a property
other than its legal description. They insist on cash. They offer no “con-
tingency” contracts to allow buyers time to arrange financing. The seller
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PROFIT FROM THE FORECLOSURE AUCTION 125
rarely holds an open house or sets up appointments to show the property.
Buyers must take the property “as is” with no guarantees or assurances
about title quality, physical condition, or environmental hazards. No sales
agents offer advice, counseling, MLS listing, or persuasive reasons to buy.
No Guarantee of Vacancy. The foreclosure authorities don’t even
agree to convey the property free of occupants (owners, tenants, squatters).
You may buy a property at a foreclosure auction and spend several months
(or longer) to evict the people staying there. Clever occupants use delay
tactics. Here are several:
File bankruptcy.
Claim that the foreclosure sale violated due process.
Organize a “people’s protest” of some sort.
Continuously make idle promises, “We’ll be out by the end of next
week.”
Seek intervention from some type of child welfare office or other
social service agency.
Claim a female in the household is pregnant.
Seek protection under a lease agreement (even though foreclosure
sales nullify leases if made after the mortgage on the property was
recorded in the public records).
Threaten you or the property with physical harm unless you permit
the occupants to stay on for “just a little while.”
It’s rarely a question, though (in the United States), of if you can get
the people out—as a rule you can—it’s more a question of when, and at
what cost and effort—and in what condition will you receive the property?
For most would-be buyers, the risk, expense, and aggravation of
foreclosure sales deter them from even showing up to bid. When you
consider the lame marketing efforts, the adverse conditions/risks of sale,
and the potential occupancy problem, is it any wonder that foreclosed
properties deserve to sell at a fraction of their market value?
Make the Adverse Sales Efforts Work for You
You might look at the foreclosure sales process and say, “Too many poten-
tial problems. No way do I want to take those risks. Besides, how could
I ever come up with so much cash on short notice?” That’s the attitude
of most real estate investors. It explains why at most sales the foreclosing
lender “wins” the bid at a price equal to (or slightly above) its outstanding
balance.
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126 PROFIT WITH FORECLOSURES
Overcome the Risks of Bidding. Risk looms large to block your path
to foreclosure profits. To bid smart, know as much about the property as
due diligence demands.
How can you obtain this information? First, meet with the defaulting
property owners to talk over preforeclosure workout possibilities. Even
when those discussions end without agreement, you still learn about the
property (market value, fix-up needs, improvement opportunities), the
neighborhood, and the owner’s intentions. This step places you ahead of
the game. Second, research the title records. Look for recorded liens and
encumbrances, You can research property records in the clerk of court’s
office or, increasingly, on the clerk of court’s web site. If you find no obvious
title problems, ask for preliminary opinion of title from a lawyer or title
insurer.
Time and Money. To meet with owners and check the title will cost
you time, legwork, and perhaps several hundred dollars. Yet, if you buy
only one property out of every ten you investigate, you still gain a good
payback for your efforts. Just confirm your numbers. Question whether
the sales price of the fixed-up property will exceed the total amount of
your bid price and fix-up costs by a healthy profit margin.
Inferior Liens Wiped Out. When you buy a property in foreclosure,
all liens inferior to the one foreclosed will usually get wiped out. Assume
that the first mortgagee is forcing the foreclosure. You win the auction by
outbidding this lender by $1,000. The first mortgagee takes what it’s owed.
The next claim in line takes whatever money is left.
Judgment creditors, mechanic’s liens, second mortgagees, tenant
leases, and any other claims disappear. Only existing tax liens, special
assessments, and perhaps past-due homeowners’ association fees may
survive. (Lien priority and survival laws differ throughout the United
States and throughout the countries of the world.)
For any specific property, discuss the “priority” and “wipeout” issues
with legal counsel. But realize that many (if not all) of those preforeclosure
liens that clouded the title will vanish. This fact torques up the prefore-
closure negotiating leverage that you hold with lienholders. Creditors
who don’t settle before foreclosure will likely end up with nothing after
foreclosure—unless, of course, they also plan to show up at the foreclosure
auction and bid.
How to Arrange Financing
After you put together enough information to adequately manage the risks
of buying at foreclosure, you face the problem of financing. How are you
going to get the cash to close the sale? If you lack wealth or credit, you’re
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THE FORECLOSURE SALE: SUMMING UP 127
probably out of luck. Unless you bring in a money partner, it’s difficult to
buy at the foreclosure sale.
If you can temporarily raise cash—for example, take out a home
equity loan, get a cash advance on a credit card, sell (or borrow against)
stocks, or maybe take out a signature loan—you can bid at a foreclosure
auction. Then, after the foreclosure paperwork clears, you can place an
interim or longer-term mortgage loan against the property (as long as
your lawyer or title insurer can clear liens or clouds) and pay off your
short-term creditors.
Investors who buy foreclosed properties sometimes establish a line
of personal credit at a bank. Then they draw on the money whenever they
need it. Or they maintain cash balances in amounts sufficient to cover their
usual buying patterns.
THE FORECLOSURE SALE: SUMMING UP
Few real estate investors bid regularly at foreclosure sales. Most prefer to
avoid the time, expense, risks, and financing difficulties that foreclosure
buying entails. You, too, may agree with this view.
But if you will learn the foreclosure game (as it’s played in your
locale), do your homework, and manage your risks, you can build profits
quickly. You can buy properties at foreclosure auctions for less (sometimes
much less) than their market value. Your challenge is to learn which of
these properties meet the test of a true bargain—and which ones carry
outsized risks, expensive problems, or excessive (upside-down) financing.
Naturally, too, foreclosure opportunities expand and diminish as
real estate markets weaken or strengthen. In strong real estate markets,
foreclosure bargains become more difficult to locate. In contrast, cyclical
downturns like we find today provide boom times for foreclosure buyers.
Don’t fret about pessimistic news reporting. Prepare yourself mentally and
financially to enter and win the foreclosure game.
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7
PROFIT FROM REOs AND OTHER
BARGAIN SALES
A
s anyone who reads newspapers or watches television knows,
banks now hold more than one million foreclosed properties
(REOs). In addition, VA, FHA, Fannie Mae, Freddie Mac, private
mortgage insurers, and even OWC sellers have taken back perhaps an-
other million houses, condominiums, small apartment buildings, retail
stores, mobile home parks, and vacant lands.
Although RTC sales/auctions during the early 1990s created huge
REO opportunities in some areas (mostly Texas, Oklahoma, Southern
California, and Arizona), today’s REO bargains extend more broadly
throughout the United States, Canada, and other countries of the world
(especially Spain and the U.K.).
Indeed, sales of REOs at distressed prices account for much of the
more general drop in property prices. As REOs pile up, even sellers free
of financial distress must cut their prices to compete. Likewise for new
homebuilders. In many newly built subdivisions, homebuilders’ houses
now compete directly with the same houses that the builders sold a year
or two ago—only at the much lower distressed seller prices.
BAD NEWS FOR SELLERS/BUILDERS, GOOD
NEWS FOR YOU
As discussed in the Prologue, bad news for sellers means good news for
homebuyers and investors in two ways: (1) You can buy properties today
at prices that not only sit 15 to 50 percent below peak prices, but also at
prices less than replacement cost. And (2) during the next several years, the
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HOW TO FIND REOs 129
high numbers of REOs that now crowd the market will gradually fall back
to much lower levels. Their depressing effect on market prices will slow
and eventually disappear. Accordingly, until REOs dwindle and property
prices climb substantially above replacement costs (the costs of construc-
tion), new housing starts will remain well below long-term demand (as
supported by growth in population, immigration, household formations,
incomes, and jobs).
As emphasized throughout this book, you now enjoy the perfect
right time, right price opportunity to buy low and sell for a nice-sized
gain within 5 to 10 years (or fewer). Even better, REOs provide these
benefits without unusual risks. Unlike a foreclosure auction where you
face uncertainty about property condition and title defects, REOs provide
a safer alternative. As standard operating procedure, lenders clean up title
problems, evict unauthorized occupants, and bring all past-due property
tax payments and assessments up to date. REO lenders may also permit
buyers to write contingency offers subject to appraisal, financing, and
professional inspection. You can buy REOs without fear of nasty surprises.
1
HOW TO FIND REOs
In desperate times like these, REO lenders often sell REOs through highly
advertised auctions. Property agents even organize foreclosure bus trips
to tour distressed neighborhoods and properties. (In stable and strong
markets, lenders play it low key. No lender likes to publicize the fact that it’s
“throwing down-on-their-luck families out of their homes.”) In addition
to big auctions, you can find REOs in two other ways: (1) Follow up after
court-ordered foreclosure sales, and (2) locate Realtors who specialize in
REO listings.
Follow Up with Lenders after Foreclosure Sales
Attend the sheriff’s foreclosure sale. When a lender wins the bid for a
property that interests you, buttonhole the bidder and start talking busi-
ness. Also, visit the REO (loss mitigation) departments of lenders. Show
1
Several exceptions might include (1) states where the foreclosed owners may
have a right of redemption; (2) cases where the foreclosed owners still retain some
legal right to challenge the validity of the foreclosure sale; or (3) instances where
a bankruptcy trustee or the Internal Revenue Service (tax lien) is entitled to bring
the property within their powers. Rarely would any of these potential claims be
worth losing sleep over. But before closing an REO purchase, talk over these issues
with a real estate attorney.
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130 PROFIT FROM REOs AND OTHER BARGAIN SALES
a lender how your offer saves (makes?) the bank money. If you run into
a bureaucratic stone wall, persevere. Today, many lenders do not know
what they are doing. Your perseverance may not only reward you with a
good property, but more importantly, you’ll build personal relationships
that open the bank’s doors for future transactions.
Sometimes, too, lenders acquire REOs without foreclosure. Lenders
occasionally open their morning mail to find the keys to a house, a deed,
and a note from the distressed owners, “We’re out of here. It’s your
problem now.”
To learn about REOs that lenders now hold in their portfolio of prop-
erties, cold call mortgage lenders. Ask for a list of their REOs. Or, rather
than ask for a complete list of REOs, narrow your focus. Tell lenders what
you’re specifically looking for in terms of location, size, price range, floor
plan, condition, or other features. In that way, a lender can answer your
request without disclosing the full number of REOs within its inventory.
Locate Specialty Realtors
Many mortgage lenders do not sell directly to REO investors for two
reasons: (1) As mentioned, they do not want to invite unfavorable publicity;
and (2) they do want to promote good relations with Realtors.
2
Because
most mortgage lenders expect Realtors to bring them new loan business,
the lenders can’t then turn around and become FSBO (for sale by owner)
dealers. “You scratch my back and I’ll scratch yours” sets the rules in this
business. Network relations stimulate mutual referrals.
Cultivate relationships with Realtors who specialize in this market.
(In fact, HUD, VA, Fannie Mae, and Freddie Mac almost always sell their
REOs through Realtors.) In most cities, you can easily find REO specialists
by looking through newspaper classified real estate ads and the foreclosure
web sites. Increasingly, too, some Realtors are creating foreclosure listing
brochures and even office window displays.
Hire a Foreclosure Pro. Once you have identified several advertised
foreclosure specialists, call them or stop by for a visit. Learn their back-
grounds. Do they only dabble in the field of REOs and foreclosures? Or
do they make this field their full-time business? When I telephoned REO
specialist John Huguenard in Orlando, Florida, he talked with me for
an hour and a half about property availability, detailed financing and
2
Also, most lenders don’t want to waste time with all of those investor wannabes
who have just read a “nothing-down” book or “graduated” from a foreclosure
guru’s seminar.
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HUD HOMES AND OTHER HUD PROPERTIES 131
purchase procedures, hot areas of town, rehab potential, estimating repair
costs, portfolio lenders, strategies for buying and managing properties as
well as selecting tenants, and a dozen other related topics.
At one point during our conversation, he asked, “I’ll bet you haven’t
talked to any other agents who know as much as I do about REOs and
foreclosures, have you? I’ve been doing this for twenty-three years. Last
year, I sold 90 houses and rehabbed 16 others for my own account.”
John is the kind of REO pro you want to work with. When you build
a relationship with an agent who’s really in the know, you won’t have
to do your own legwork and door knocking. Your REO agent will screen
properties as soon as—if not before—they come onto the market. He will
then notify you immediately.
Specialty agents stay on top of the finance plans that portfolio, gov-
ernment, and conventional lenders offer to homebuyers and investors.
John Huguenard knew of portfolio lenders doing 100 percent LTV investor
loans for investor acquisition and rehab. Tighter underwriting makes such
loans more difficult—if not impossible—to find now. But a good REO spe-
cialist will know the best loan products available no matter what phase of
the credit/property cycle we are going through.
HUD HOMES AND OTHER HUD PROPERTIES
Each year the FHA (Federal Housing Administration), a division of HUD,
insures hundreds of thousands of new mortgage loans. (Nationwide, the
total number of outstanding FHA mortgages runs into the millions.) FHA
loans are originated by banks, savings institutions, mortgage bankers,
mortgage brokers, and credit unions.
If borrowers fail to repay their FHA loans, the owner of the mortgage
may force the property into a foreclosure sale. Rather than keep the prop-
erty in its own REO portfolio, that lender turns in a claim to HUD (FHA’s
parent). HUD then pays the lender the amount due under its mortgage
insurance coverage and acquires the foreclosed property. Next, HUD puts
the property (along with all the others it has acquired in similar fashion)
up for sale to the general public. To see HUD’s inventory, go to hud.gov
and follow the HUD homes link.
Although HUD is best known for selling single-family houses, it
also sells:
♦ Vacant lots
♦ Duplex or two units on one lot
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132 PROFIT FROM REOs AND OTHER BARGAIN SALES
♦ Triplex (three units)
♦ Fourplex (a four-unit building)
♦ Condominiums
♦ Apartment complexes
Homeowners versus Investors
In the contest for HUD homes,
3
HUD favors owner-occupants over in-
vestors in two ways: (1) Owner-occupants get the first right to bid; and
(2) HUD offers FHA low- or nothing-down insured mortgages only to
owner-occupants of 1–4 family properties. HUD does not presently fi-
nance HUD homes for those who do not intend to live in the property. (Do
not lie to HUD and falsely claim that you plan to occupy a property. Do so
and you commit a felony, which HUD will prosecute.)
Given HUD’s owner-occupant bias, you might think that homebuy-
ers snap up all of the great buys and investors are stuck with the dregs.
On the one hand, that may be true. If as an investor you look for “red
ribbon deals” at a bargain price, your HUD pickings might prove few and
far between. That type of HUD home typically sells fast at a good price.
When HUD homes pile up in an area, your chances go up substantially.
On the other hand, if a “fixer” fits your fancy, you can find great HUD
buys because first-time homebuyers (HUD’s primary market) scare easily.
As one HUD investor told me, “I always look for properties with the
highest fear factor. Most homebuyers are afraid of homes that need work.
They don’t want the risk of cost overruns. They think they lack the knowl-
edge and time to handle the fix-up. And they’re right. But I do know how
to deal with these things—and that knowledge gives me the advantage to
earn good profits through HUD home rehabs for either rental or resale.”
“As-Is” Condition
HUD does not warrant the condition of any of the properties that it sells.
Even when HUD/FHA offers insured financing, HUD inspects the prop-
erty for its own benefit only, not for the benefit of the buyer.
HUD Recommends Professional Inspections. Because HUD sells its
properties “as is,” HUD encourages prospective bidders to obtain profes-
sional independent inspections before they submit a bid. HUD does not
accept offers with an inspection contingency. What you see (or don’t see)
is what you get.
3
This section discusses procedures for HUD homes. We address other types of
properties later.
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HUD HOMES AND OTHER HUD PROPERTIES 133
However, HUD’s refusal to accept inspection contingencies does
make buying somewhat risky. Because professional inspections cost
$150 to $300, hopeful buyers are expected to incur this fee up front without
knowing whether they will actually win the bid.
This fact explains why most first-time buyers avoid HUD “fixers.”
Inspection fees can easily get wasted. HUD’s policy of “as is—no contin-
gencies” favors experienced investors who can accurately estimate fix-up
costs and can afford to accept the risks.
Disclosures and Repair Escrows. Although HUD refuses to permit
offers with an accept inspection contingency, prior to closing a sale, HUD
does allow the winning bidder to run a lead paint assessment on the
property if it was built pre-1978. HUD may disclose property defects that
it knows about. In some instances, HUD will agree to insure a mortgage
for a property only if a buyer agrees to make specified repairs.
None of these actions by HUD cancels HUD’s “as is—no warranties”
policy. Partial disclosure doesn’t mean full disclosure. At HUD, caveat
emptor (let the buyer beware) rules.
Potential Conflict of Interest
Although most foreclosure specialists will work to find you a good deal,
potential conflict of interest does arise in the sale of HUD properties. First,
if you do not submit a winning bid, your sales agent does not earn a
commission. An unethical agent could pressure you to raise your bid even
if the value of the property doesn’t justify a higher price. Second, sales
agents may submit bids from competing buyers who bid on the same
property. If you bid $80,000, an agent could tell another more favored
buyer to bid $80,100. You lose. Third, HUD typically pays brokers who
submit a winning bid a 5 percent sales commission plus, on occasion, a
$500 (or more) selling bonus for designated properties. Again, this reward
may encourage your agent to push you to bid high on a property because
she will receive an extra reward.
Although you should not unjustly insinuate that your agent is likely
to engage in underhanded sales tactics, it shows good sense to ask your
agent how she handles these potential conflicts.
Buyer Incentives
When hard times hit, HUD foreclosures accumulate to unmanageable and
costly numbers. To reduce this big inventory of REOs and create quicker
sales, HUD may offer buyers easy financing, cash bonuses, and steep
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134 PROFIT FROM REOs AND OTHER BARGAIN SALES
discounts. If unsold HUD properties pile up in your area, you might land
a particularly good deal.
The Bid Package
As might be expected of a government agency, HUD does not make buying
simple. Unlike a private purchase, where you simply write out your offer
on any valid contract form, HUD requires a specific contract submission
package. Bidders must use only HUD-approved forms and documenta-
tion. To bid, complete the required forms, addenda, and enclosures fully
and accurately. In addition, your contract package must arrive in HUD’s
regional office according to HUD’s posted schedule.
HUD may (and does) refuse to accept bid packages that do not con-
form to its instructions. Given HUD’s well-known inflexibility, work only
with conscientious foreclosure pros who know in detail the ins and outs
of HUD’s requirements.
DEPARTMENT OF VETERANS AFFAIRS (REOs)
To sell its foreclosed properties, VA follows rules similar to those of HUD.
For example, here are 12 major ways the programs resemble each other:
1. The VA sells through a sealed bid process. Likewise, as either a
potential homeowner or an investor, you may submit multiple
bids during the same bid period.
2. You cannot directly negotiate with, or submit a bid to, the VA.
You must submit your bid through a VA-approved broker (your
foreclosure pro).
3. The VA sells its homes on an as-is basis. Even though it may
partially disclose a home’s defects, it offers no warranties. Caveat
emptor.
4. The VA does guarantee title, and it permits buyers to obtain a
title policy.
5. The VA accepts bids that yield it the highest net proceeds (not
the highest price). If you agree to pay closing expenses or sales
commissions, you can win the bid over others who offer higher
prices, but pass these costs (a lower net) on to the VA.
6. Just as HUD/FHA charges FHA buyers an insurance fee, the
VA charges buyers who choose its financing a guarantee fee of
around 2 percent of the amount financed.
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DEPARTMENT OF VETERANS AFFAIRS (REOs) 135
7. The VA accepts bids only on VA forms. If you err in completing
the forms, your bid gets tossed out.
8. The VA publicizes its properties through a combination of news-
paper ads, broker lists, and Internet postings. You can access VA
REOs via the links at hud.gov.
9. Local VA offices report to regional directors, who may issue
policies and procedures that differ from those in other regions
throughout the country.
10. The VA may choose to keep your earnest money deposit if you
fail to close a winning bid for any reason other than inability to
obtain financing.
11. As with HUD sales contracts, VA purchase offers do not include a
contingency for post-bid property inspections. You may, though,
inspect a property before you bid.
12. When necessary, the VA evicts holdover tenants or homeowners
before placing a VA property on the market. At closing, you
receive the keys to a vacant property.
Big Advantages for Investors
Although the VA follows rules similar to HUD, investors gain more from
theVAintwoways:
1. The VA gives equal status to investors. The VA looks for the high-
est net offered by any credible buyer—homeowner or investor.
2. Unlike HUD, the VA offers financing to investors. At present
in my area, for example, investors can close financing on a VA
home with total cash out-of-pocket of less than 6 percent of a
property’s purchase price. In addition, the VA typically applies
“relaxed” qualifying standards. VA buyers (who need not qualify
as veterans) must show acceptable, not perfect, credit records.
(For specifics in your area, talk with your foreclosure pro.)
With relatively attractive investor/homebuyer financing, VA homes
in good (and even not-so-good) repair sometimes sell at or near market
value prices. However, at today’s depressed market values, even market
value can look good to investors for these three reasons:
1. Leverage permits you to accelerate your wealth-building returns.
2. Even at market value prices, many VA properties pull in rents
high enough to provide a positive cash flow from day one of
ownership.
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136 PROFIT FROM REOs AND OTHER BARGAIN SALES
3. The VA allows future buyers to assume your VA financing. For
investors who want to “fix and flip,” an assumable loan makes
a great benefit. Plus, when market interest rates go up, a lower-
rate assumable VA loan gives your sales efforts a big competitive
advantage over other for-sale properties.
VA REOs provide an excellent source of properties and financing for
beginning and experienced investors alike. Investigate this opportunity.
FANNIE MAE AND FREDDIE MAC REOs
Fannie Mae and Freddie Mac are the two largest players in the nation’s
secondary mortgage market. These mortgage companies don’t make loans
directly to buyers, but they do provide the loan funding for more than
50 percent of the one-to-four family properties that are made by other
mortgage lenders.
Sometimes when these loans go bad, Fannie (or Freddie) may force
the lender to buy back its loan. Then the primary lender ends up with
a foreclosed property in its REO portfolio. Typically, however, lenders
who faithfully met Fannie’s (or Freddie’s) underwriting guidelines can
require Fannie (or Freddie) to take ownership of the foreclosed property.
(At this time, just in the state of Florida Fannie holds nearly 1,000 properties
for sale.)
Agent Listings
Fannie and Freddie do not often use the sealed-bid sales procedure that’s
common to HUD and VA. Instead, both companies choose a realty firm
and give that firm an exclusive right-to-sell listing. The realty firm then
places that REO into MLS. The realty agent who takes on responsibility for
a foreclosed property first inspects it and then recommends the best way
to fix it up to maximize its sales price.
Price to Market. Fannie and Freddie might spend thousands of dol-
lars to recondition and repair a property, and then price that property
aggressively. So, typically, you won’t buy Fannie or Freddie properties at
a steep discount to market value.
But these times are not typical. Fannie and Freddie hold record num-
bers of REOs that they must sell. Especially in markets hardest hit, Fannie
and Freddie are open to offers. Talk with local foreclosure pros. You will
likely find some bargains.
First-Time Homebuyers—Special Financing. Fannie and Freddie di-
rect their marketing efforts toward credit-qualified homebuyers (especially
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FEDERAL GOVERNMENT AUCTIONS 137
first-time homebuyers). In addition to the bargain price appeal, these com-
panies attract buyers with well-presented homes and special financing.
Freddie even permits homebuyers to “customize your Homesteps
home.” Under this option, Freddie invites buyers (for a price, of course) to
upgrade their home’s carpeting, padding, vinyl, appliances, and window
blinds. Freddie also sells most of its owner-occupied properties for
5 percent down, no private mortgage insurance (which saves buyers $50
or $80 per month, possibly more), lower closing costs, and an attractive
interest rate.
All Properties Sold “As Is.” Even though Fannie and Freddie often
fix up their properties, neither warrants nor guarantees the condition of a
property. Unlike buying from HUD or the VA, though, as a Fannie/Freddie
buyer, you may submit a purchase contract offer that includes an inspection
contingency. You can purchase a home warranty plan, too, just as you (or
the sellers) can with most other property sales.
Investors Invited
Both Fannie and Freddie invite offers from investors with no priority-
listing period that applies only to owner-occupants. Both companies
also offer favorable financing for credit-qualified investors. You pay just
15 percent down (in contrast to the conventional down payment of
20 percent to 30 percent for investor-owned properties). Closing costs may
come in a little lower, too. Investor interest rates usually sit on the low
side of market. You can locate Freddie and Fannie properties, and their
latest loan programs, at www.homesteps.com and www.homepath.com.
You can also access them through links at hud.gov.
FEDERAL GOVERNMENT AUCTIONS
Each year the federal government (in addition to HUD/VA) sells seized
and surplus real estate, including houses, apartment complexes, office
buildings, ranches, and vacant and developed land. Among the most ac-
tive sellers are the Internal Revenue Service (IRS), Government Service
Administration (GSA), and the Federal Deposit Insurance Corporation
(FDIC). On occasion, you can also find properties offered by the Small
Business Administration (SBA). You can locate government agency prop-
erties and sales procedures at the following web sites:
Internal Revenue Service at www.treas.gov/auctions/irs Govern-
ment Services Administration at http://propertydisposal.gsa.
gov/propforsale
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138 PROFIT FROM REOs AND OTHER BARGAIN SALES
Federal Deposit Insurance Corporation at www.fdic.gov/buying/
owned/real/index
Small Business Administration at http://app1.sba.gov/pfsales/dsp
You can also find links to agency-listed properties at hud.gov.
BUY FROM FORECLOSURE SPECULATORS
A speculator wins the bid for a foreclosed property at $135,000. The prop-
erty would sell for $195,000 if it were fixed up and marketed effectively.
Soon after the foreclosure sale, you offer the speculator $150,000 (or what-
ever). To minimize risk, you attach several contingencies to your offer that
permit you to get the property thoroughly inspected, evict any holdover
owners or tenants, clear up title problems, seek title insurance, and arrange
financing. If the property checks out satisfactorily, the sale closes, and the
speculator makes a quick $15,000 (more or less). You obtain the property
at a big discount without costly surprises that can turn a superficially
promising foreclosure into a loss.
PROBATE AND ESTATE SALES
Probate and estate sales present another potential source of bargain-priced
properties. When owners of properties die, their property may be sold
to satisfy the deceased’s mortgagee and other creditors. Even when the
deceased leaves sufficient wealth in cash to satisfy all claims against the
estate, most heirs prefer to sell the property rather than retain ownership.
Probate
To buy a property through probate, submit a bid through the estate’s
administrator (usually a lawyer) or executor. Then all bids are reviewed
by the probate judge assigned to the case. Depending on local and state
laws, the judge may then select a bid for approval or reopen the bidding.
Because of legal procedures and delays, bidding on probate properties can
require you to persevere. Judges wield discretion about whether to accept
a probate bid. You cannot know for sure where your bid stands.
For example, a probate property came up for sale in an area of
$150,000 houses. The probate administrator listed the house for sale at
$115,000. A flurry of bids came in that ranged from a low of $105,000 up
to a high of $118,000. Several months later the judge looked at the bids,
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PRIVATE AUCTIONS 139
announced the high bid at $118,000, and then solicited additional offers.
Eventually, the judge approved the sale at a price of $129,850 to someone
who had not even been involved in the first round of bidding. You cast
your bid and take your chances.
Estate Sales
Sometimes, an estate’s assets need not be dragged through the probate
process. You can buy directly from the heirs or the executor of an estate.
Some investors regularly read the obituary notices, contact heirs, and try
to buy before the property is listed with a real estate agent. To succeed in
this approach, develop an empathetic approach.
Estate sales frequently produce bargain prices because heirs eagerly
want cash. They may also need the money to pay off a mortgage, other
creditors, or estate taxes. Out-of-town heirs (especially) may not want to
hold a vacant property for an extended period until a top-dollar buyer is
found. Once again, pressures of time or money can lead to sales prices that
fall below a property’s market value.
PRIVATE AUCTIONS
In these times of REO stress, Freddie/Fannie, HUD/VA banks, and other
owners of distressed properties are increasingly holding auctions. Attend
one. Observe. You’ll have fun. Often a band is playing, and food and
drinks are served. A festive mood prevails. The auction company works to
make potential bidders feel good. Beyond this display of cheer, though, the
auction company is really setting up its prey. The auctioneer wants to sell
every property at the highest possible price. Auctioneers earn a percentage
of the day’s take, plus, perhaps, a bonus for exceeding a certain level
of sales.
To gain a bargain price, enjoy—but remain aloof from —the festive
frenzy. Attend the auction armed with market and property information.
Prepare to walk out a winner—not merely a buyer. Here’s how you can
make that happen:
♦ Thoroughly inspect a property. During the weeks before most pri-
vate auctions, the auction company will schedule open houses at
the properties to be sold. If you can’t visit an open house, con-
tact a real estate agent and ask for a personal showing. (Many
auction companies cooperate with Realtors. If an agent brings a
winning bidder to the auction, that agent earns a 1 percent or
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