The Cheese is Moving – Again!

It’s 2012, and the cheese is moving.  Again.  And it will affect everything you do.  In the classic story “Who Moved my Cheese,” Spencer Johnson describes the plight of the characters caught in a maze who discover that their supply of cheese had disappeared.  Their dilemma — commence a search for new cheese, or wait for the old supply to be replenished — offers a wonderful parable for investors and entrepreneurs alike.   To the extent that our economic recovery is tied to job growth, the relevance to investors — indeed to everyone — cannot be overemphasized.

In a very carefully detailed case study, NYTimes authors Charles Duhigg and Keith Bradsher describes why the US lost out on the opportunity to manufacture the iPhone.  The answer is not simply that the cost of labor in China is less than in the US; the problem is much more complicated, and worth a careful read.  The story details how the need to make critical design and manufacturing changes in a timely manner required a coordinated effort involving setting up efficient supply channels, recruiting qualified engineers, and converting large manufacturing spaces in order to meet production timelines.  A key component — finding an adequate number of qualified engineers — a process which would have taken up to 9 months in the US — took only 15 days in China.  Adding to the problem is the fact that critical supply components, such as the hardened glass needed for the hundreds of iPhones, were being manufactured in the US.  But the cost and logistical complications of getting these components to the manufacturing site forced Corning to move its operations closer to the assembly floor.

Some will accurately point out that many of the product innovations created by companies like Apple do, in fact, create jobs in the US.  But the real crisis is the critical shortage of properly trained and educated individuals available to meet the demand.  We go to great lengths to urge every high school student to apply for college, and each year about this time, parents all over the country sweat in anxiety that their child will get accepted, and then wonder how to meet the ever-growing tuition demands.  But the larger crisis looms even beyond that horizon — will there be a job opportunity that will help pay the ever-increasing student loan debt load?  How will the student who majors in Poetry with a minor in Philosophy find a job that will allow him or her to make those payments?

While we accept the conventional wisdom that our current economic crisis depends on job growth, and certain sectors argue against imposing taxes on CEOs earning millions and millions of dollars on the assumption that they will stop creating jobs, we miss the real point — we are not doing enough to train and prepare our youth to qualify them for the very jobs we hope will be created.  Other countries are miles ahead of us, and it explains why most of these major companies have no choice but to move their operations where they can find qualified employees.

The anecdotal story of the iPhone illustrates what has become an all-too-familiar refrain:  we would prefer to be here (in the US), but we cannot do what we do here.  To stay ahead of the innovation curve requires a combination of speed, flexibility, adaptability, and fiscal intelligence.  Sitting back and waiting for the cheese to come back is not only pointless, but could result in starvation.  Training people how to make new types of cheese would be a much more productive use of our resources.

“No Money Down!” Too Good to be True?

Can a clever entrepreneur realistically expect to make money in today’s market with no money down? Each year, thousands of people sign up for real estate seminars to learn about wholesaling and similar techniques that promise to make them wealthy with limited demands for time or cash. These programs are sold at seminars and workshops, along with books, CDs, and tapes, along with the opportunity to sign up for “coaching” and “mentoring” programs.

Many people ask me if these programs are legitimate, or if they are “too good to be true.” Sometimes promoted as “wholesaling,” they have been around for years. For the new investor with little or no money to invest, these concepts offer an opportunity to get started, learn a lot, and if you land the right deal, make some money. Here’s how one approach works: you search for a property owner who is highly motivated to sell for substantially less than the market value, make an offer to purchase, and get the seller to sign a legally binding contract. You then sell the contract to an investor – most likely a “rehabber” – and take the profit on the sale. Basically, you make up for your lack of cash with hard work – searching lists, making phone calls, and knocking on doors – to get the deal: a binding contract to purchase the property for substantially less than the market value. In theory, you could earn a fair income in real estate without having to pay a dime of your own money, replace a roof, or install a toilet. Slick marketing brochures and flashy web sites promise to teach you all the tricks, provide all the forms, and for only a few dollars more, be your Coach or Mentor.

Does it work? Like most programs that promise you the chance to make money in real estate, it depends on a number of factors, not the least of which is the integrity and reputation of the program and the people behind it. Other factors include the state of the real estate market, and changes to laws and regulations affecting the investors. Things have changed since the housing collapse in 2008, and wholesaling was being promoted by individuals like Robert Allen and Carelton Sheets. In a rising housing market, bad decisions and sloppy management will often be forgiven or ignored if there is still sufficient profit in the deal. But in a declining market, with tight credit and an overabundant supply of properties with little or negative equity, qualified buyers are scarce – and cautious. This is not to say that you can’t make money wholesaling, but you’ll have to work twice as hard for half the profit. You should be very skeptical of any claims or testimonials made before 2008!

Making the task even more challenging are many laws recently enacted by the California Legislature, mostly in response to reports of fraudulent schemes which were designed to take advantage of homeowners facing foreclosure. Many real estate programs from out-of-state failed to address the new California laws into account, while others merely provided lip service to the new California regulations. Unfortunately for the investor, the consequences for making a mistake could mean heavy fines or even going to jail! It is very common for these programs to recommend that you “get a lawyer on your team” as part of setting up your wholesaling business. Of course, the cost of legal advice is not included in the price charged for the seminar or “coaching” program! Also not included: the cost of legal representation if you decided to guess and guessed wrong!

So, what has changed? For one, the entire housing market. In the typical wholesaling transaction before 2008, a “no money down” deal would involve finding a homeowner with a large amount of equity willing to take less profit in exchange for the convenience of a quick, “as-is” sale. In a rising market, the property value continues to rise, and there is a good probability that the investor or rehabber will recover their purchase price and repair costs and still make a profit. Since the housing crisis struck in 2008, the percentage of sellers being forced to sell because they are underwater, facing foreclosure, unemployed, and unable to refinance or modify their mortgage, has steadily increased. Today, almost half of all home sales on the market are short sales, which not only means a much longer and contentious escrow, but the profit margins no longer exist. As housing prices drop, investors can afford to stand back and wait. For the wholesaler, it most likely means losing the deal altogether! To make it work, the wholesaler must cast a wider net, and inevitably will find themself facing compliance issues under the new regulations.

As a result of many fraudulent scams, California enacted new laws and toughened others intended to protect homeowners facing foreclosure from unscrupulous individuals trying to take advantage of homeowners. For example, a homeowner who had been issued a Notice of Default has a 5-day right of cancellation of a sale, and must be provided a special Notice of this right (CC §1695). The Attorney General requires individuals who offer “foreclosure assistance” to register as a “Foreclosure Consultant” and post a special bond (CC §2495). Violations could result in steep fines and even jail. In addition, the California Department of Real Estate started issuing Cease and Desist orders against unlicensed individuals for activities that were deemed by the DRE to require a real estate license. New and tougher laws, tougher penalties, and stricter enforcement definitely increases the risks and challenges for the wholesaler operating in California.

In addition, to protect homebuyers against unscrupulous “fly by night” rehabbers, the Legislature enacted AB2335, which requires local municipalities to enforce provisions requiring that all work be done by licensed contractors. An exception was allowed for an owner/rehabber, but only if they certified that they were an owner-occupant for 12 months. Further complicating matters, all States were required to enact provisions to implement provisions of the SAFE Act, which seeks to strictly regulate private lending practices by requiring those who originate or arrange loans to take courses, register and report all lending activities. Making the challenge even tougher, new reporting and disclosure requirements effectively make it difficult, if not impossible, for the wholesaler to claim a fee, let alone complete a double-escrow.

In short, these challenges, coupled with the evolving nature of real estate transactions, makes wholesaling a considerably more difficult way to get started in the real estate business. However, this has not appreciably reduced the number of individuals and companies from promoting seminars and sell books and CDs, and offer attractive discounts for “coaching” and “mentoring” programs. Before you write a check or given them your credit card, do your due diligence. Read the reviews. Make sure they are based where you want to invest your time, especially if it’s in California. And check the date – make certain the materials are current and relevant for today’s real estate market! There are a few legitimate and honest programs out there that do a good job of teaching new investors how to get started and survive in this turbulent market, and those who take the time to adjust and adapt to the new regulations will stay ahead of the curve.

The bottom line. Many factors have changed real estate investing. “No money down” deals – if they ever really worked – are complicated and scarce, and probably not the best choice for the new investor just getting started. At the same time, changes in the real estate market have created new opportunities not previously available, so keep your eyes and ears open. Join a reputable REI association; get to know other members, and listen with a critical ear. If a particular investment strikes you as interesting, apply the following tips.

Tips. Rule No. 1 is to do your due diligence. If the claims and promises sound too good to be true, they probably are. Rule No. 2 is to plan ahead, and be patient. In a turbulent market, everything takes longer. Delays can end up costing you money, if not the whole deal. Rule No. 3 is to be realistic. Get the facts from professionals – don’t rely on something your weekend buddy said, or something you got in an e-mail. Double-check and verify the facts. Ask yourself – do you have all of the relevant facts to make an informed decision?

Using a Checkbook LLC to Invest your IRA Funds

Six months ago, I wrote: “Real estate prices are at bargain levels.  Many individuals seeking to recoup their stock market losses, or who are considering a career change, are seriously considering real estate as an investment opportunity.  However, despite the fact that rates are at historically low levels, lenders are still reluctant to loan money, and with the overall drop in appraised values, it is harder than ever to get an equity line of credit.  Even those with great credit scores find that lenders are reluctant to loan money for some of the more challenging types of investment opportunities, such as bulk REO sales, foreclosures, rehabs, and flips. This is where you might consider using your retirement plan — your 401(k) or IRA – as an alternate source of funds.”  For whatever reason, the situation has not changed: real estate is still a bargain and lenders are still not lending.

If you haven’t already done so, you might consider using your Self-Directed IRA to fund a real estate investment.  For some people, it might even make sense to set up a “Checkbook LLC” so you can control the speed of the transaction process.

Based on some examples I’ve encountered over the past year, I want to emphasize that the use of your SDIRA must be compatible with your investment objectives. Restrictions on the use of your IRA — sometimes referred to as “Prohibited Transactions” under IRC Section 4975 — may be incompatible with your objectives.¬† For example, if you plan to purchase an investment rental for your son or daughter to live in while they attend college, you cannot use your IRA funds.¬† Another example is where you plan to use your IRA to fund a business where you are the key decision-maker (CEO, COO, etc.).¬† IRS and DOL restrictions will often make these types of investments impossible or extremely complicated.¬† But if you are simply looking for a bona-fide, arms-length investment that will provide a decent ROI, consider using your IRA.

First, you need to find a qualified IRA custodian who will allow you to invest in real estate, and not just “traditional” investments such as stocks, bonds or mutual funds. A truly “self-directed” individual retirement account  (“SDIRA”) custodian will allow you to “self-direct” your retirement funds into “alternative” assets, such as real estate, notes and deeds of trust, and business opportunities.  This isn’t new – it has been available to investors since 1974 when Congress enacted ERISA.  What is new is the nature of investment opportunities that are available.

Several custodians offer the opportunity to use your SDIRA to invest in real estate, but there are restrictions and regulations. The transaction must be arms length: the account holder may not receive any direct or indirect benefit (i.e., commission); and they may not sell or buy property that is owned by a direct relative or themselves (i.e., you cannot purchase your mother’s house or buy a condo for your daughter while she’s attending college).  In addition, you may not make personal use of the property purchased with retirement funds. Real estate investment property is generally ideal for using SDIRA funds.

With a SDIRA, your Custodian must control the disbursement of funds, and all proceeds (i.e., rental income or sale) must be returned to your IRA in order to maintain the special tax treatment provided for retirement plan accounts.  This means that all transactions must be processed through your SDIRA Custodian, which can result in fees and, in some cases, delays.  In some types of transactions, such as bulk REO sales, foreclosure sales, rehabs and flips, not only are there multiple transactions, but time is of the essence!

This is where a “Checkbook LLC” can help.¬† The process involves setting up a separate LLC funded and owned entirely by your SDIRA, and deposited directly to a checking account held in the name of the LLC.¬† As Manager, you would have the authority to issue checks to disburse funds for both minor and major expenses, pay fees, and generally manage the funds according to the time requirements imposed by the type of investments you are working with.¬† A classic example is the need for prompt disbursement when purchasing foreclosure property at the courthouse steps.

The “Checkbook LLC” is not for everyone, and there are some disadvantages when using SDIRA funds to invest in real estate.¬† The investor must be fully aware of and take special measures to ensure that the investments comply with the special restrictions, or risk losing the special tax benefits provided for retirement plan funds.¬† “Boilerplate” or “Internet” format LLC documents will often not be acceptable to SDIRA Custodians.¬† At the same time, don’t be fooled into paying thousands of dollars for unnecessary services, books and tapes.¬† Remember, your primary goal should be to invest your retirement funds in real estate, not gimmicks!¬† Always consult with a qualified professional, and take the time to learn more.

Local Government Financial Crisis – the next subprime?

Reading Michael Lewis’ shocking account of Wall Street’s apparent deliberate effort to destroy the housing market in The Big Short got me to thinking “what’s next?”¬†¬† Apparently, I am not alone, as indicated by this NY Times article noting that many states are facing unprecedented debts due to pension obligations and severe revenue shortages.¬† Headlines trumpet the crisis of city after city across the country facing unpopular choices of cutting police and fire positions, closing libraries, terminating services and deferring maintenance in desperate attempts to address the shortfall.¬† For many cities, it may be a case of too little, too late.¬† With the States and Federal government in similar straits, there is no one to bail the cities out.

Like the housing crisis, the tremors of doom ripple through the bond market, and it is very likely there is a “big short” in play by some investors who are betting against the cities, just as they bet against the subprime market and walked away with billions of dollars in profits when the inevitable collapse of the house of cards came down in September, 2008.¬† Meanwhile, the fallout of the housing collapse continues to drag the entire economy despite the infusion of billions of dollars by the government.¬† Now, the lender of last resort is in trouble; the cities are drowning in debt and the lifeguards have been laid off.¬† Unfortunately, the confluence of these two disasters feed on each other in a negative way:¬† foreclosures cause a widespread drop in home prices, destroying neighborhoods while reducing revenue that would fuel job growth;¬† lowered prices chokes new development that would produce fees that would pay for government services; the loss of revenue threatens municipal bond ratings that would otherwise help fund the debt.

Whether municipalities will file for bankruptcy or default on their bonds is a more complicated question than predicting whether millions of homeowners would eventually default on the ridiculous “designed to fail” subprime mortgages that were issued in the early years of the past decade.¬† Only a few defaults have actually occurred, and municipal bankruptcy is much more difficult to accomplish, in many cases requiring State approval.¬† However, just at the ill-fated government programs designed to help homeowners avoid foreclosure failed in spectacular fashion, municipal efforts to halt the slide towards bankruptcy are facing stiff obstacles.¬† At the front are the unions, who understandably vigorously oppose any cuts to pension benefits or wage concessions.¬† Immediately behind them are the taxpayers, who just as understandably reject any proposal to increase taxes, unless it’s levied against someone else, like marijuana dispensaries, alcoholic beverage establishments, or tobacco stores.¬† And then there are the residents themselves, who demand not only that the city maintain police and fire services, but also understandably want potholes filled and streetlights replaced quickly.¬† Last, but not least, are the multitudes of elected officials who, while dedicated enough to hold office in turbulent times, lack the knowledge, training or experience to ask the right questions and make the right decisions.

The inevitable consequence of all this is that cities will make poor choices.¬† A few have just shut down and contracted out their operations, but that only kicks the can down the street.¬† Unfortunately, officials are still in the early stages of denial — “it can’t happen — it’s never happened before” — just as Lewis documented Wall Street’s initial response to evidence that the subprime loans were doomed to failure.¬† “Housing prices always rise,” they said.¬† And they created complex securities that guaranteed they would make money no matter what happened, until it did.¬† With cities, the story is the same — instead of making the really tough choices, they look for creative ways to avoid the inevitable, from raising taxes and even investing in junk bonds — and increase fees.¬† The problem, of course, is that these are band aids at best, not solutions, and in some cases make the problem worse.¬† Just as Wall Street’s appetite for anything that would generate transaction fees led to the promotion of even more subprime loans, many municipal attempts to create revenue are designed to avoid laying off government employees, not reduce the overall deficit.¬† Worse, such measures could have an adverse impact on the private sector, making it more difficult for small businesses to expand, hire new employees, or otherwise do their part to help the economy.

Robo-Signing, Toxic Titles, and MERS: Oh My!

Even amidst the chaos, the news came as a shock:¬† Ally Financial, parent company of GMAC, announced it was halting foreclosures in judicial foreclosure states due the discovery of technical flaws in their foreclosure procedures.¬† An attorney fighting a foreclosure action deposed a so-called “robo-signer” who admitted he signed thousands of affidavits per month, but never read or reviewed the underlying documents.¬† This story was shortly followed by revelations that similar defects had been discovered by JP Morgan Chase, which announced it was halting foreclosures in 23 states.¬† By the end of the week, Bank of America announced that it, too, was halting foreclosures and reviewing its policies and procedures.¬† UPDATE:¬† Lawsuits filed across the country have yielded inconsistent results, further complicating efforts to determine a clear solution to the controversial MERS program.

10/10/2010 UPDATE:  More evidence is coming to light that the Administration has been aware of the serious deficiencies and problems within the loan servicing industry, but has done little to address the problems.¬† At most, they sent letters advising loan servicers to be more careful.

10/15/2010 UPDATE:  News of widespread defects in foreclosure processing has led to calls by all 50 states for investigations, threatening to shut down the foreclosure process entirely.¬† The Administration’s reliance on the banks to voluntarily solve the housing crisis appears to be misplaced, according to the NY Times.¬† Wall Street’s response has been to blame homeowners for not paying their mortgages.¬† Although this is certainly a valid claim in many instances, it fails to account for the widespread incompetence that allowed or encouraged lenders to make ridiculous loans that exceeded the true value of the properties used as security, not to mention the creation of collateral investment products based on the newly securitized debt, or faulty policies that pushed for homeownership at any price — including no money down loans.¬† Moreover, the industry blaming homeowners for not paying their mortgage overlooks the fact that this same industry — despite billions of dollars in public TARP funds – cut off virtually all avenues of credit, making it impossible for homeowners to remedy the downturn with refinanced loans.

Noting that the decisions to halt foreclosures were only directed at those states that require judicial action to foreclose, California Attorney General Jerry Brown responded by ordering first GMAC, then Chase, to halt all foreclosures in California until they could prove compliance with California law.  It is likely the AG will similarly issue an order against Bank of America.

In a Bulletin issued October 1st, Old Republic Title announced it would suspend issuing insurance policies for REO sales for GMAC and JP Morgan/Chase.¬† Although the Bulletin states that they expect to resume insuring REO sales, it should be noted that the Bulletin was issued before B of A’s announcement.¬†¬† Moreover, there appears to be some difference of opinion whether Citibank and Wells Fargo also have similar issues with their procedures.¬† At least one article implies that despite their initial insistence that their procedures were solid, there was some evidence to the contrary.

Further complicating this situation is the role played by MERS.¬† MERS, is a private company formed by the mortgage banking industry to create an electronic process which allows for the transfer of deeds — hence the name “Mortgage Electronic Registration System.”¬† Approximately 62 million mortgages are registered with the system, and they claim¬† “Our mission is to register every mortgage loan in the United States on the MERS¬Æ System.”¬† However, in the early stages of the housing crisis, attorneys defending homeowners raised the point that foreclosures brought in the name of MERS were¬† invalid, since MERS only acts as the nominee for the lender, and has no standing to bring the action.¬† Judges in judicial foreclosure states agreed, and a scramble ensued to produce affidavits of lost notes, or other forms of proof of standing, and the foreclosure actions would usually proceed with some delay.¬† However, as more and more lending institutions have collapsed, the chain of records and titles have disappeared.

The primary issue today is whether — or how many — pending loan mod, short sale and foreclosure actions in the United States have been compromised by the combination of “robo signing” of affidavits by GMAC, JP Morgan Chase, Bank of America, and possibly others, and the potential break in the chain of title due to defects in the MERS process.¬† Since MERS only operates as the “nominee” of the mortgage holder, the question arises as to its “ownership” of the mortgage itself, and therefore its legal authority to transfer title.¬† In some cases, the courts have found specific language where the homeowner authorized MERS to act as the mortgage holder, but in others, there is a question whether MERS had any authority at all.¬† In July, MERS created a public database that allows anyone to search and find the loan(s) and investors associated with a property.¬† You can search by Mortgage Identification Number (MIN), by address, or by name.

The situation is critical, and adding to the confusion are promises by the ever-present influx of groups promising — for a fee — to save homeowners from losing their homes.¬† These groups admit that this is a “limited time opportunity” due to the fact that the lenders will eventually close ranks and solve the problems. ¬†¬† One group, which charges up to $15,000 to file legal action and 20% contingency for any principal reduction they negotiate, concedes that they have no way to guarantee success, but appear to rely on the fact that the confusion among the lenders and title companies will yield favorable results because the lenders don’t want to litigate.

We will see whether the pending halt to foreclosure actions due to revelations of “robo signing” and faulty affidavits, combined with the legal issues created by MERS, will merely postpone the process or reshape the entire system.¬† Until this gets sorted out, the only certainty we can count on is that there is still no light at the end of the housing crisis tunnel.

Act Before You Lose

Recently, I read Who Moved My Cheese, a popular book by Dr. Spencer Johnson.  For those who have not spent the hour to do so, is about two mice, Sniff and Scurry, and two humans, Hem and Haw, who struggle in the maze to find, lose, then search again for their cheese.  Whereas the two mice are quick to recognize that the delicious cheese they had initially found had suddenly disappeared, they wasted little time launching a new and (plot spoiler alert) successful search.  In contrast, the two humans refused to accept their loss and did not search  for a new supply until their situation became desperate.  The obvious point is that things change, and remaining in denial can be destructive.

A year ago, I wrote a short  article about why people tend to make bad investment decisions.  I cited findings by Dr. Meir Statman, Professor of Finance at Santa Clara University, who has conducted extensive and interesting studies on the psychology of investments.  Reading Who Moved My Cheese prompted me to look back and see if my cheese had moved, and more importantly, what was I going to do about it?  Was I going to act like the two mice and go off in search of new opportunities?  Or was I going to act like the humans and remain in denial; paralyzed out of fear of facing reality?

Studies, such as those by Professor Statman and others, show that humans tend to be “risk averse.”¬†¬†¬†In one experiment, people given a choice between a certain gain of $3,000 as opposed to an 80% chance of gaining $4,000 and 20% chance of gaining nothing chose the certainty of earning $3,000.¬† However, when given the choice between a certain loss of $3,000 as opposed to an 80% chance of losing $4,000 and a 20% chance of losing nothing, people chose to take a chance on losing nothing — even though the odds of¬† losing a lot were four times higher!¬† In other words, we are eternal optimists if there’s any chance we might break even.¬† Risk or loss aversion is a major psychological force that often prevents investors from objectively evaluating a situation.

Professor Statman noted that one reason investors lose  is that they tend to hang onto bad investments too long in order to avoid facing reality.  Selling a house or a stock portfolio in a declining market means converting a paper loss to a real loss.   Even if there is a small percentage probability that the market will recover and the investor will break even, the studies show that the investor will hold off selling a losing stock in order to avoid facing a certain loss.  Of course, the same psychological factors cause the investor to ignore the even higher statistical probability that they will lose even more by failing to take action.  In Who Moved My Cheese, the humans held out hope that their cheese supply would return, ignoring the probability that they would starve to death if they did nothing, rather than face the reality that they had lost their cheese.   These same factors cause investors to stay put rather than sell and take a certain loss.

So, what should one do?¬† Professor Statman urges investors to diversify their portfolios, and to learn to identify and recognize their emotional reactions and their influence on their decision-making.¬† Dr. Johnson’s message is similar — evaluate your situation objectively and take action.¬† Common sense dictates that it’s always a good practice to evaluate your situation objectively and take appropriate action.¬†¬† If you’re not certain what to do, do some homework; consult with a professional; attend an educational program.¬† But take action!

Using a Checkbook LLC to invest IRA funds

Real estate prices are at bargain levels.¬† Many individuals seeking to recoup their stock market losses, or who are considering a career change, are seriously considering real estate as an investment opportunity.¬† However, despite the fact that rates are at historically low levels, lenders are still reluctant to loan money, and with the overall drop in appraised values, it is harder than ever to get an equity line of credit.¬† Even those with great credit scores find that lenders are reluctant to loan money for some of the more challenging types of investment opportunities, such as bulk REO sales, foreclosures, rehabs, and flips.¬† This is where you might consider using your retirement plan — your 401(k) or IRA – as an alternate source of funds.¬† For whatever reason, the situation has not changed:¬† real estate is still a bargain and lenders are still not lending.”¬† If you haven’t already done so, you might consider using your Self-Directed IRA to fund a real estate investment.¬† For some people, it might even make sense to set up a “Checkbook LLC” so you can control the speed of the transaction process.

Based on some examples I’ve encountered over the past year, I want to emphasize that the use of your SDIRA must be compatible with your investment objectives.¬† Restrictions on the use of your IRA — sometimes referred to as “Prohibited Transactions” under IRC Section 4975 — may be incompatible with your objectives.¬† For example, if you plan to purchase an investment rental for your son or daughter to live in while they attend college, you cannot use your IRA funds.¬† Another example is where you plan to use your IRA to fund a business where you are the key decision-maker (CEO, COO, etc.).¬† IRS and DOL restrictions will often make these types of investments impossible or extremely complicated.¬† But if you are simply looking for a bona-fide, arms-length investment that will provide a decent ROI, consider using your IRA.

First, you need to find a qualified IRA custodian who will allow you to invest in real estate, and not just “traditional” investments such as stocks, bonds or mutual funds.¬† A truly “self-directed” individual retirement account¬† (“SDIRA”) custodian will allow you to “self-direct” your retirement funds into “alternative” assets, such as real estate, notes and deeds of trust, and business opportunities.¬† This isn’t new – it has been available to investors since 1974 when Congress enacted ERISA.¬† What is new is the nature of investment opportunities that are available.

Several custodians offer the opportunity to use your SDIRA to invest in real estate, but there are restrictions and regulations.¬† The transaction must be arms length:¬† the account holder may not receive any direct or indirect benefit (i.e., commission); and they may not sell or buy property that is owned by a direct relative or themselves (i.e., you cannot purchase your mother’s house or buy a condo for your daughter while she’s attending college).¬† In addition, you may not make personal use of the property purchased with retirement funds.¬† Real estate investment property is generally ideal for using SDIRA funds.

With a SDIRA, your Custodian must control the disbursement of funds, and all proceeds (i.e., rental income or sale) must be returned to your IRA in order to maintain the special tax treatment provided for retirement plan accounts.  This means that all transactions must be processed through your SDIRA Custodian, which can result in fees and, in some cases, delays.  In some types of transactions, such as bulk REO sales, foreclosure sales, rehabs and flips, not only are there multiple transactions, but time is of the essence!

This is where a “Checkbook LLC” can help.¬† The process involves setting up a separate LLC funded and owned entirely by your SDIRA, and deposited directly to a checking account held in the name of the LLC.¬† As Manager, you would have the authority to issue checks to disburse funds for both minor and major expenses, pay fees, and generally manage the funds according to the time requirements imposed by the type of investments you are working with.¬† A classic example is the need for prompt disbursement when purchasing foreclosure property at the courthouse steps.

The “Checkbook LLC” is not for everyone, and there are some disadvantages when using SDIRA funds to invest in real estate.¬† The investor must be fully aware of and take special measures to ensure that the investments comply with the special restrictions, or risk losing the special tax benefits provided for retirement plan funds.¬† “Boilerplate” or “Internet” format LLC documents will often not be acceptable to SDIRA Custodians.¬† At the same time, don’t be fooled into paying thousands of dollars for unnecessary services, books and tapes.¬† Remember, your primary goal should be to invest your retirement funds in real estate, not gimmicks!¬† Always consult with a qualified professional, and take the time to learn more.

Avoiding Bad Investment Decisions

As an attorney, I see the end result of bad investment decisions.¬† As an investor, I’ve made a few of my own.¬† Naturally, I wonder how these mistakes could have been avoided.¬† Would a better understanding of the psychology of investment decision-making¬† decision process help the investors avoid unnecessary losses?

Dr. Meir Statman, who holds the Glenn Klimek Chair as Professor of Finance at Santa Clara University Leavey School of Business, has written extensively on the topic of behavioral finance.¬† In a recent (Aug 23) article in the Wall St. Journal, “The Mistakes We Make – and Why We Make Them,” Professor Statman highlights the emotional impact of our tendency to avoid the “pain of regret.” Professor Statman theorizes that the tendency to hold onto a losing investment longer than necessary is caused by the need to avoid facing the reality that the investment has lost value.¬† As a result, the investor loses even more, even to the point of holding onto the investment until it has become worthless.¬† Professor Statman also notes the human tendency of investors to focus on realizing gain, which sometimes leads investors to sell a good investment prematurely.

In the WSJ article, Professor Statman provides eight “lessons” as a guide for investors to control these otherwise “normal” human tendencies that tend to adversely affect investment decisions.¬† He notes that “most investors are intelligent people, neither irrational nor insane.” But, the study of behavioral finance shows that we are subject to emotional influences that cause us to make decisions that are sometimes smart, and sometimes stupid.¬† “The trick, therefore, is to learn to increase our ratio of smart behavior to stupid.”

Most of Professor Statman’s examples focus on investments based on the stock market, which provides a convenient laboratory for studying reaction to changing conditions on a fairly rapid basis.¬†¬† Would these rules apply in the world of real estate investments, where the valuation is based on different criteria, and the frequency of changes in value — at least in relative terms — is much much slower.¬† I would theorize, however, that the emotional factors are at least as strong as those associated with the buying and selling of stocks, in most cases.

Professor Statman’s lessons and his examples are worth reading.¬† Briefly summarized, he cautions against attempting to time the market; not to mistake hindsight with foresight; don’t let the fear of the pain of regret make you hang onto a losing investment too long; don’t just focus on success stories; avoid being driven by fear or exuberance; recognize happiness comes from gains in wealth, not levels of wealth; and to distinguish loss of wealth from loss of ego.¬† Professor Statman argues for diversifying your portfolio and using dollar-cost-averaging as a smart strategy to reduce regret and avoid losing your mind.

How could these lessons be applied to real estate investing?¬† The first lesson — avoid trying to time the market — is counterintuitive.¬† Aren’t you supposed to “buy low, sell high?”¬† In real estate, as in the stock market, there is a tendency to chase the market; to follow rumors and hype.¬† Following the herd is obviously a bad strategy for many reasons, but time and time again, you’ll hear someone say “So-and-so said on CNBC that Las Vegas/Miami/Phoenix was going to be the next hot market.”¬† Worst yet, people will claim to avoid chasing rumors, but pay thousands of dollars to so-called real estate “gurus” who will divulge a “secret” to the audience, and off they go.¬† Unless you are adding to an already diversified portfolio, chasing the “next best deal” is simply foolish.

Confusing hindsight with foresight is common, but could be disastrous.¬† Professor Statman states that “Hindsight error leads us to think that we could have seen in foresight what we see only in hindsight.”¬† Yogi Berra put it bluntly:¬† “Making predictions is difficult, especially about the future.”¬† A forecast is just a prediction, and investment involves making an educated judgment about the future.¬† Just because a particular author or speaker claims to have made an accurate prediction does not guarantee that their next prediction will be any more successful.¬† Statistically, each new flip of the coin presents a 50% chance of heads or tails; success or failure.¬† The danger here is overconfidence.

Professor Statman, an expert in the field of behavioral finance, notes that ‘Emotions are useful, even when they sting.”¬† The tendency to avoid the pain of regret leads to hang onto a poorly performing investment with the false hope that it will recover, rather than face the actual loss that will result when the investment is sold or abandoned.¬† He urges investors to not “cry over spilled milk,” and start thinking about today and tomorrow; and not focus on regret.¬† Hanging on to a losing investment only postpones the inevitable and magnifies the pain.

Another lesson involves what Professor Statman refers to as “confirmation error,” whereby we focus only on successes, and look only at evidence that supports or confirms the favorable outcome.¬† By way of example, Professor Statman notes it is human nature to focus on the miniscule, statistical probability of winning the lottery, and ignore the fact that the vast majority of participants lose.¬† In any truly diversified real estate investment portfolio, there will be both winners and losers, and within the range of winners, there will be both big and small returns.¬† The question will be whether the winners, taken as a group, outweigh the total losses, for a net gain, but human nature is such that the focus will be only on the one, super-successful investment deal in the entire portfolio, and the tendency to mischaracterize the entire portfolio as performing at the level of the single biggest performer.

Professor Statman makes the seemingly obvious observation that one should not base their investment on either fear or exuberance.¬† Again, he cautions against trying to “time the market,” and resist the temptation to be motivated by either a fear of losing your shirt, or the exuberance of jumping on the bandwagon.¬† Similarly, he advises investors not to lose sight of your goal.¬† Professor Statman says a stock market crash is like an automobile crash.¬† The key is to focus on whether you can drive to the garage, or need a tow truck.¬† I would add whether you need an ambulance.¬† The point here is to recall what goal you were trying to reach, and evaluate what you need to do after the accident to get back on track.

Last, but not least, Professor Statman is a strong advocate of dollar cost averaging.¬† This strategy is well known as applied to the stock market, where the daily price fluctuations and unpredictable nature makes it almost impossible for the typical investor to outguess the market, so making regular and consistent purchases will balance out the “per share” cost over time, and hopefully reduce the regret factor.¬† Here, I will take a leap and suggest that Professor Statman’s “lesson,” applied to real estate investing, would argue for building a diversified portfolio of different types of real estate investments in different geographical markets, as a hedge against a total failure should any one type of real estate or any particular market suffer a significant decline in value.

The bottom line is we need to learn to increase the ratio of smart decisions to stupid ones, and recognize that the latter are often the result of emotional factors that we failed to recognize or control.¬† Doing one’s due diligence, fact-checking, and staying focused on your personal and financial goals, are all important considerations for the real estate investor.

Foreclosure Crisis: More Info but Less Knowledge

Yet another study — this one released last month by the Federal Reserve Bank of Boston — serves only to reinforce what we already know:¬† lenders were reluctant to modify existing loans during 2007 and 2008.¬† (Wash Post, 7/27/2009).¬† Although some 1.5 million borrowers were subject to some form of foreclosure filings during the first half of this year (2009), only around 200,000 loan modifications have been issued since March, when the Administration launched the new Making Home Affordable Guidelines.¬†¬† Part of the difficulty in evaluating the data is that many lenders have only very recently begun to apply the new Guidelines, while study after study focuses on statistics from 2007 and 2008.¬† Part of the reason for the sweeping new Guidelines was to remedy the shortcomines of the previous programs.

The Washington Post reports that “Modification makes economic sense … only if the borrower can’t sustain payments without it” and the modified terms will allow the borrower to keep up.¬† Duh.¬† Another brilliant conclusion:¬† Borrowers who are likely to fall behind even if the loan is modified are not a good candidate for loan modification.¬†¬† Double-Duh.¬† And this:¬† Lenders have little financial incentive to help delinquent borrowers, who with extra effort and a little luck, can catch up without a modification.¬† Well, you get the gist of it.¬† I hope they didn’t spend a lot of money on that study!¬† If we only had solid information like this back in 2006, we might have been able to avoid the whole problem, don’t you think?

Compounding the issue is a fundamental lack of critical knowledge:¬† is it more economically advantageous for lenders to foreclose or modify?¬† Even the Washington Post can’t make up its mind:¬† the headline says “Foreclosures are Often in Lender’s Best Interest.”¬† Then, they quote Laurie Goodman, senior managing director at Amherst Securities, saying “In some cases, lenders lose twice as much foreclosing on a home as they did two years ago.”¬† Apparently, falling housing prices — often a direct consequence of foreclosures — cause lenders to lose money in foreclosure sales.¬† Go figure.

So, did we learn anything from the Boston Fed study?¬† Well, we learned that only a small percentage of loan mod applications are actually being approved, as lenders are only just now starting to apply the new Guidelines.¬† The study seems to confirm what we suspected — lenders are focused on their bottom line, not the borrower’s.¬† Lenders are working on finding the right balance of when would be the most optimum time to proceed to foreclosure based on the projected price bid they can get.¬† If the loan mod will only delay foreclosure and housing prices continue to drop, it only makes sense to deny the loan mod and proceed to foreclosure.

Sadly, this often comes as a bitter blow to the hard working borrower who is just trying to get a temporary reduction in their monthly mortgage payment, either through a rate adjustment or an extended term, so they can meet expenses and catch up.¬† Where home values have dropped significantly below the amount of the loan, and the lender refuses to make a meaningful modification, the borrower has little incentive to keep the house.¬† The result — absent any intervening factors — will be more foreclosures, further reducing prices, and causing lenders to prematurely panic and sell before the prices drop further.

Obviously, this will not work.  The Treasury and HUD have summoned industry executives to a meeting to discuss how increase the pace of loan relief.  It would seem that if more loans could be modified, even if only temporarily, there would be fewer foreclosures and less downward pressure on housing prices overall, not just for foreclosure properties.  Achieving stability would be a good objective, but we still have not seen any studies of the application of the new Guidelines.  Maybe if we had some relevant information, we might gain some relevant knowledge.

Foreclosure Crisis — Too Early to Define the Solution?

Another day — another study.¬† Stan Liebowitz, professor of economics and director of the Center for the Analysis of Property Rights and Innovation at the University of Texas, writes in an op-ed piece that “the most important factor related to foreclosures is the extent to which the homeowner how has or ever had positive equity in a home.”¬† He says that his analysis of foreclosure data shows that subprime loans, upward resets, and so-called “liar loans” were not the primary cause of the current foreclosure crisis, and hence current government programs are “misdirected.”

It is interesting to note that Professor Liebowitz’ analysis concludes that 51% of all foreclosed homes had prime loans.¬† He reports that his analysis of foreclosures during the second half of 2008 shows that while 12% of the homes had negative equity, they accounted for 47% of all foreclosures.¬† Professor Liebowitz’ reasons that negative equity, by itself, is not an indicator of a foreclosure, but it implies that the borrower is more likely to walk away from the loan.¬† He argues that current government programs (i.e., Making Home Affordable), and federal efforts to keep interest rate low, are misdirected.¬† Driving mortgate payments down to 31% of income will not have much of an effect, since his study showed that those with higher (38%) ratios were not more likely to face foreclosure.¬† Reducing interest rates induce refinancing, not home purchases.¬† Professor Liebowitz calls for stronger underwriting standards, higher down payments, and clarifying the consequences for homeowners who simply choose to “walk away.” The good news, according to Professor Liebowitz, is that housing prices are approaching a long-term, pre-bubble levels and equilibrium.¬† He singles out Barney Frank for criticism for efforts to artificially increase homeownership levels, which would delay the return to equilibrium levels.

Professor Liebowitz’ analysis is one of many that will be conducted as the data becomes available, and it will be interesting to see more precisely what will actually work.¬† Empirical evidence suggests that while we’re still headed downhill, and the forecasts for continuing foreclosures are dramatic, it is probably too soon to know more precisely what the actual causes of the crisis were, thus too premature to fashion a realistic solution.¬† We know that many of the investors currently holding the notes are largely unwilling to make significant concessions in terms of rates or payments, let alone reduce principal.¬† We know that rising unemployment will continue to threaten the pace of recovery — if we’re even in the recovery phase at this stage.¬† We know that lenders aren’t lending, despite billions of dollars already spent by the Federal Government.¬† And, we’re starting to see the first real wave of the crisis hitting the commercial property markets, where it will be difficult to scapegoat any single demographic factor as a cause.

Professor Liebowitz is correct when he says that “Understanding the causes of the foreclosure explosion is required if we wish to avoid a replay of recent painful events.”¬† That goes without saying.¬† But we just finished the first half of 2009, and studies of what happened during the last half of 2008 may — or may not — tell us all that we need to know.¬† We really need more analysis, more action, and less knee-jerk legislation.¬† Private lending has the potential to fill the gap left by the credit crunch, but there is room for mischief and abuse, and the banking industry lobby is fighting hard to protect its grip on the supply.¬† Ultimately, Americans have proven to be resourceful, creative and most importantly, survivors.¬† The current rush of legislation at the Federal and State levels are based on old data, driven by special interests, and may cause more harm than help.¬† We need to be a bit more patient and get better data before we inadvertently make the situation worse.