Asset Protection: A Rational Approach

“You’re going to lose everything you own,” the speaker solemnly warned the audience at a recent real estate investment program.¬† “We live in a very litigious society,” he continued; “you need asset protection.”

Real estate investors, as a group, will flock to hear speakers talk about the need for what is commonly known as “asset protection.”¬† They will spend hundreds, if not thousands of dollars setting up elaborate business entities (the LLC – “Limited Liability Company” – being the most popular), in an effort to avoid “losing everything.”¬† Ironically, many new investors spend more money on “asset protection” than they do on real estate.¬† Sometimes they end up with all sorts of asset protection entities, but no assets to protect.

There is a more rational and practical approach to asset protection.¬† Setting up the correct business entity to allow you to achieve your real estate investing objectives is both important and necessary.¬† The correct entity will allow you to take full legal advantage of tax benefits and provide a structure for running the business.¬† Properly established and registered, the entity will allow the investor to work with investment partners, obtain financing, and provide a basis for determining the relative percentages of ownership and allow for succession and continuity for a successful operation over a period of time.¬† And yes, the entity will provide a measure of “asset protection” for the benefit of the principals, if the entity is properly established and capitalized, and has complied with the appropriate level of corporate formalities.

However, no form of entity is a substitute for good risk management.  The fundamental components of a good risk management program are (1) good management practices, (2) adequate insurance coverage, and (3) regular review and oversight.  For real estate investing, good management practices include using the services of a reputable, licensed, professional property management company.  The relatively small cost (usually 6 Р8%) will be more than justified by the savings from avoiding disasters.  Good management includes proper screening of tenants; regular and thorough inspection of the investment property, arranging for prompt and competent repairs, and if necessary, timely initiation of eviction proceedings.

In addition to standard form “all risk” fire insurance policies, adequate insurance coverage should include, where appropriate, flood, earthquake and other forms of disaster coverage.¬† I recommend that tenants be required to carry renters insurance, which can cost as little as $12 per month, but will cover the tenant’s personal belongings, relocation costs (if necessary), and injuries sustained by their guests.

Last, but not least, good risk management practices includes regular review and oversight.¬†¬† “File and Forget” is not a smart way to manage anything.¬† Prudent owners make sure they manage their property managers, and take steps to ensure that their expectations are met.¬† Do not just sit back and hope the checks roll in every month.¬† Be proactive. Pay attention.¬† Ask questions.

But what about “asset protection.”¬† What if something “bad” happens, the tenant sues, and the investment property is in your name and not buried under an onion’s worth of layers of special entities?¬† What can happen?¬† Indeed, what DOES happen?

First and foremost, the type of liability that owners need to be concerned about involve claims resulting from personal injury, either to the tenant or their guest.¬† Injuries can range from a sprained ankle caused by a crack in the walkway to serious brain injury (or death) resulting from a collapsed balcony or similar structural failure.¬† There are also potential claims based on acts of discrimination, for example, but in terms of monetary damages, the “big ticket” issues usually arise from personal injury cases.

In such cases, the first and best line of defense is good property management, as discussed above.¬† In terms of avoiding catastorphic loss, investing in good prevention can yield a very high rate of return!¬† The next line of defense is your insurance policy (or policies), which should include comprehensive general liability coverage.¬† In the event of a claim, the insurance company will provide legal counsel and will pay for investigation and other costs arising from the incident.¬† If early settlement does not resolve the issue, and the matter proceeds to litigation, your insurance company is most likely under an obligation to provide a defense in most cases.¬† There are general exceptions, such as for willful or deliberate acts, and specific exceptions, such as where the policy does not cover certain types of loss unless a special “rider” has been obtained; i.e. flood, earthquake, etc.

Statistically speaking, it would be extremely rare if you found yourself facing a full-blown lawsuit with a prospect of a large jury verdict that might exceed the limits of your insurance coverage — the type of catastrophic “lose everything” outcome that promoters of “asset protection” programs use to sell their services.

Let’s look at the reality — not the hype.¬† It is fairly well established that close to 90% of all lawsuits that are filed will settle before going to trial.¬†¬† So, if your insurance company has not been successful in resolving the claim and the plaintiff (i.e., your tenant) proceeds to file a lawsuit, the probability of the matter going to trial before a jury is 1 in 10.¬† Arbitration, mediation and other forms of formal dispute resolution are mandated by most State rules governing litigation.¬†¬† In California, the parties are required to participate in a Mandatory Settlement Conference the week before the start of trial.¬† Statistics vary, but in one County, the Court noted that one-third of all remaining cases settle at the Settlement Conference, usually held on the Wednesday before the start of trial; another one-third settle on the Friday before trial, and a percentage settle even after the jury has been seated.¬† Again — as a statistical fact — very, very few cases make it all the way to the end of trial.¬† And even after the Jury renders a verdict, there are appeal procedures, that work to modify the outcome.¬† Many headline-grabbing jury awards are often reduced — drastically — by these types of procedures.

Real estate investors should consider the actual threat of “losing everything” in considering how best to protect their investment and their personal assets.¬† Sadly, many new investors spend more time focused on so-called “asset protection” measures than they spend doing their due diligence in relation to the investment itself.¬† Investors pay money to set up elaborate LLC entities only to find themselves locked into a bad investment with other partners they did not take time to know.¬† If one added up all the personal injury jury verdicts that exceeded insurance policy limits over a 10-year period in the United States, I wonder if the total amount would come close to matching the losses caused by Bernie Madoff and his scheme.

This is not to say that forming a LLC or a C-Corporation is not a good idea.  Properly done, the appropriate business entity provides the means to manage your investment assets, entitles you to certain tax benefits, and manage your investment partners.  But a business entity should never, ever be a substitute for good management practices.

Loan Mod Catastrophe Can Be Avoided

Is the glass half full or half empty?¬† Or is it the wrong glass?¬† On October 8, Treasury Secretary Geitner announced that the Administration’s loan modification program was on target to help 500,000 households avoid foreclosure.¬† On October 9, a Congressional TARP Oversight Panel released a crtical report that predicted the Administration’s program would, “in the best case,” prevent “fewer than half of the predicted foreclosures.” (NY Times 10/10/2009).¬† Who’s right?

The problem, of course, is that no one really knows.¬† The program, which requires completion of a three-month “trial” period for a homeowner to qualify for a “permanent” loan modification, is still in the infancy of the implementation period to provide any meaningful statistics.¬† According to the NY Times article, as of September 1st, only 1.26% of trial modifications had become permanent, and the plan had produced only 1,711 “permanent” loan modifications.¬†¬† Many of these so-called modifications involve only a short-term reduction in rate with no reduction in principal, and leave the homeowner upside down with no hope of qualifying for a refinance.¬† With many Option ARM loans due to reset, and thousands of new homeowners who just entered the market to take advantage of the 3.5% FHA down payment and the $8,000 tax credit, the stage is set for a new wave of delinquencies if the job market continues its current trends.

Another problem is the so-called “shadow inventory” – the homes that should be on the market at a trustee or foreclosure sale, but are not.¬† The evidence is empirical but not necessarily reliable.¬† Stories abound of homeowners who have not made their mortgage payments for months, but who have yet to receive a Notice of Default fromt their lender.¬† Perhaps some lenders are waiting to see how their first round of “trial” modifications play out.¬† In some cases, the sheer volume of applications has overwhelmed the loan servicers, forcing delays stretching into months while the applications are “under review.”

Bruce Norris recently attempted to calculate more precisely the extent of this phenomenon, noting that the number of Trustee Sales had dropped despite the ever-increasing number of delinquencies.¬† In July, 2009, he reported the number of Trustee Sales in California had dropped to slightly more than 17,000, compared to almost 29,000 in July of 2008.¬† Based on the number of deficiencies, the number of Trustee Sales should have been almost three times as many – 52,700!¬† Running the numbers over the past year, comparing delinquencies vs. trustee sales, Bruce Norris calculates that there are approximately 306,329 additional homes that should have gone to trustee sale in California.¬† If the rumors about delinquent homeowners who haven’t even been added to the list are even partially true, the discrepancy would be even higher.¬† And if the best the Administration’s Plan can hope to achieve is “less than half” of the predicted foreclosures, the prospects for success are indeed dismal.¬† Any grade less than 50% would not be considered acceptable under any circumstances.

Rising unemployment, overwhelmed and untrained loan servicing agencies, and a continuing refusal to provide adjustment for actual market value, are all ingredients for failure.  Add a few scoops of Option ARM resets, continuing chaos in the appraisal system, and a whole new crop of FHA-backed minimum-down mortgages to the mix, and you have the classic recipe for a catastrophe.  On the national level, the conflicting statistics only generate fuel for debate over policies and programs.  But at street level, families and neighborhoods continue to suffer from the collapse of a complicated securitized mortgage marketing scheme that should not have been allowed to take over and replace a more fundamental but functioning system.

What most homeowners facing default fail to grasp is that the investors who hold or control their mortgage have absolutely no incentive or interest in “saving” the homeowner from default.¬† All that matters is the value of the Note, and in any particular situation involving a portfolio consisting of hundreds or thousands of individual Notes, which in turn comprise security for an investment held by shareholders, the decisions whether or not to modify the terms are made — not for the benefit of the individual homeowner — but purely and simply on the basis of the impact on the value of the portfolio overall.¬† Complicating this process are multiple layers of IRS, SEC and similar regulations and restrictions that limit the extent to which the portfolio managers can make adjustments without putting the shareholders — or themselves — at risk.¬† As it is, the best a lender can tell a homeowner in distress is that they will do a “charge off,” effectively shifting the financial burden for the loss from the lender to the borrower.¬† While it sounds like a huge break if the lender “forgives” a $100,000 Note, the lender gets to write off the loss against other gains, while the homeowner faces the prospect of a $40,000 tax bill via a Form 1099.

There are solutions out there.¬† Modifying the tax codes and restructuring the securitized mortgage market dynamics would take too long and would offer little in the form of timely relief.¬† I like Bruce Norris’ concept of returning to the days when an investor could buy a property by assuming the existing loan.¬† It would be a simple transaction, and return control of the housing market to people willing to work to make it succeed, instead of faceless institutional speculators amassing unmanageable volumes of security instruments that bear little relation to the properties they represent.¬† Investors would be permitted to manage their risk more directly, and more importantly, homeowners would have the opportunity and the incentive to participate in the process for a successful outcome.¬† It provides the opportunity for a classic “win-win” that would save families, preserve neighborhoods, and restore communities.

Forecast: 100% Chance of Uncertainty

In a recent article published on September 18 in Forbes Magazine, “Where Home Prices are Hitting Bottom,” author Francesca Levy attempts to make sense out of recently compiled housing price data produced by a Mountain View research firm, Altosresearch.com, in effect trying to explain where and how different Metropolitan Statistical Areas (MSA) would be hitting “bottom.”¬† The data focused on whether the number of homes selling at a discount had declined or held steady.¬† Presumably, if the number of homes selling at a discount was declining, the argument could be made that the housing market in that specific MSA was close to the “bottom” — and a signal to investors to buy.

Four days previously, Ms. Levy had authored another article in Forbes, entitled “Where Home Prices are Likely to Rise.” ¬† In that article, Ms. Levy reported on a housing price forecast produced by Moody’s Economy.com.¬† As reported, Moody’s calculations were based on long-term demographic and economic fundamentals, changes in income and population, and supply and demand.¬† Overall, the prediction was for a nationwide 16.08% decrease in prices by the end of the year, but by 2014, prices “will have nearly reverted to their pre-2009 state.”

For San Jose, the article says that the five-year forecast calls for a 23.04% jump in prices; however, that will follow another 25.14% decrease within the next year!¬† Housing markets in Texas will not see much of a climb, but then they also won’t experience much of a decrease.

As I’ve fondly quoted Yogi Berra:¬† “Making predictions is difficult, especially about the future.”¬† The Forbes articles make for interesting reading, and the online graphics are impressive.¬† But the “small print” caveats continue to provide the harsh reality check.¬† No one knows the full extent of the number of homes that will go into foreclosure, whether Congress will extend (or increase) the first-time homebuyer’s tax credit, scheduled to expire on November 30 of this year, and certainly no one knows if the banks will relax credit and start making loans again.¬† FHA, which has been providing a substantial number of loans, recently announced it has to tighten credit due to low reserves.

All of this makes for interesting reading, but one has to question where it takes us.¬† There are a number of unprecedented anomalies that makes me wonder if the forecast models are valid.¬† At least one real estate expert noted recently that there were over 2 million excess housing units in California — a shocking number given the number of programs designed to address housing shortages in this State.¬† California recently hit 12.2% unemployment.¬† Add to this a “shadow” inventory of properties that have not yet been foreclosed, due either to voluntary moratoriums or deliberate efforts to control inventory.¬†¬† The Wall St. Journal reports there are approximately 1.2 million homes where the foreclosure process has not begun, even though the mortgages are more than 90 days past due. ¬†¬† The repercussions on local governments across the country have yet to be fully felt, let alone measured, yet are causing unprecedented cutbacks in services. ¬† Ultimately, the entire process will come down to buyers’ ability to purchase homes, whether as first-time buyers taking advantage of tax credits and other incentives, or property owners selling their existing property and moving up.¬† Without jobs, this simply will not happen.

Therefore, I question what it means to say that housing prices in any specific MSA will rise or fall over any projected time period, given the current turmoil in the market, particularly the inability of the typical person to borrow money.¬† At the special Norris Group event held on September 11, 2009, “I Survived Real Estate 2009,” the various speakers were remarkably eloquent if not cautious.¬† David Kittle, 2009 Chairman of the Mortgage Banker’s Association, and John Young, Vice President of the California Builders Industry Association, along with other panelists, were quick to point out that for every new home purchase would result in an additional expenditure of $7,500 for furnishings and supplies, and noted that Congress is considering a $15,000 tax credit.¬† They claim that if enacted, this would result in over 400,000 home purchases, significantly reducing the backlog of troubled inventory.¬† Interesting concepts, and worthy of consideration as a means to jump start the economy.¬† But such a move by Congress, if enacted, would definitely throw another wrench in to the forecasting models.

It’s easy to be a skeptic, and I won’t claim to know of a better methodology or model.¬† But I would caution investors to adopt a healthy dose of skepticism when reviewing the ubiquitous “Top Ten Cities” lists as a basis for making an investment decision.¬† Concentrate on cash flow, a strong and diverse job market, and local conditions.¬† A good cash flow investment in a bad market will be a better investment than a negative cash flow investment in a good market.¬† An outdoor enthusiast once told me, “there’s no such thing as bad weather – only bad clothing.”¬† A corollary maxim would probably be that “there’s no such thing as a bad market — only a bad deal.”¬† Good gear can get you through the worst of storms.¬† A good deal will beat a bad market.

Investors need to look deeper into the background information provided by these articles, and REALLY understand the dynamics and demongraphics.  Communities with diverse economies and industries will fare better than those without.

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.

Get Legal Advice BEFORE You Invest

Why should you seek legal assistance as part of your due diligence when considering an investment opportunity?¬† For starters, it might be a lot less expensive than seeking legal assistance after something goes wrong.¬† To be perfectly honest, I would really prefer not to hear a client tell me “I wish I’d talked to you sooner.”¬† Actually, there are several ways an attorney can be a valuable member of your real estate investment team.¬† Here are a few points to consider when making the decision how to maximize the return on your legal dollar.

For starters, you need to focus on your goals.¬† Most successful real estate investors have a clear focus on their financial objectives.¬† If you have a plan and are focused on clearly defined and realistic objectives, you’ll be able to communicate these objectives to your investment team.¬† By staying focused, you can avoid distractions and concentrate on your goals.¬† How can you expect your advisors to help you get where you’re going if you don’t know where you want to end up?

The next step is to make sure you consult with an attorney familiar with real estate issues.¬† Not all attorneys are equally knowledgeable in all areas of the law.¬† You wouldn’t hire a plumber to do your electrical work, or consult with a foot doctor for a head injury.¬† For the same reason, a brilliant patent lawyer may not be the best choice for evaluating a real estate investment opportunity. ¬† If you are not sure — ask.¬† It will save both you and the attorney time — and money.

Next, heed the age-old maxim:¬† “You get what you pay for.”¬† Don’t start the conversation “Do you give free advice?”¬† The right attorney is going to provide you with valuable advice that will be worth the cost.¬† The attorney – client relationship is not only privileged, and over a period of time your attorney can become a very valuable and trusted member of your investment team.¬† Work on developing a long-term professional relationship with your attorney, and you will realize a good return on your investment.

Spend wisely.¬† Let the attorney know your budget.¬† Most attorneys will work with you, so long as you have realistic expectations and take a reasonable approach.¬† At the same time, recognize that the true measure of value of professional advice is avoiding the loss of your investment.¬† If you are investing $50,000 in a project that promises to yield a 10% return, you need to measure your legal costs against the risk of losing the entire $50,000, not as a percentage of your profit.¬† Remember, you will hopefully be able to apply good legal advice over and over — thus maximizing your return on your legal investment.

Avoid litigation.  One of the reasons to do your due diligence is to avoid situations that will result in litigation.  Unfortunately, there are many:  poorly drafted investment contracts; easement disputes; zoning violations; and overzealous promises, to name a few.  No one benefits from litigation except trial attorneys.  Aside from the costs, there are the inevitable delays, fractured relationships, and lost opportunities.  Again:  Avoid litigation.

Follow the advice.¬† You paid for it — so use it!¬† Of course, it’s your choice.¬† But you should at least give the legal advice some consideration before you take action.¬† Many times, an attorney cannot unequivocally state that a particular real estate investment complies 100% with all applicable state and federal laws, tax codes, SEC regulations, etc.¬† Each investor should recognize that there is no such thing as 100% certainty, and adjust their risk tolerance accordingly.

Ultimately, the decision whether to proceed with an investment is up to the individual investor.  Seeking advice from financial planners, tax advisors, real estate professionals and attorneys, as well as from experienced investors, is all part your due diligence.  Getting legal advice before you invest is often a smart investment strategy.

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.

Real Estate Investing – Getting Started

It is not surprising that we are seeing larger audiences at real estate investing programs.¬† People are looking for ABS investments ‚Äì Anything But Stocks ‚Äì after watching their 401(k) plans drop 40% in value.¬† Housing prices have plummeted, and rates are historically low.¬† It’s a great time to invest in real estate.¬† But how does one get started?

The task can seem confusing.  There are so many variables, the decision process can be overwhelming.  First, there are several different ways to invest in real estate:  buying rental property, purchasing tax liens, options, and notes, even hard money lending and investing in REITs.  There are different types of real estate:  single family homes, condominiums, apartment complexes, commercial properties, and raw land. 

And there are different strategies for maximizing profit:  flipping, “buy and hold,” leveraging, wholesale contracts.  For the new investor, it almost seems like you have to learn a new language:  “ROI,” “REO,” “flip,” “cash-on-cash,” “CAP rate,” “OPM,” “PITI,” “asset protection,” “LLC,” “TIC,” “triple Net,” “CAME,” “cash flow,” and so on.  Going to the library or bookstore won’t necessarily help – there are literally dozens of books on the subject – which one do you choose?

There is simply not enough room in this blog to do justice to the entire scope of information necessary to explain real estate investing, but a few key points are worth mentioning.  For more information, I strongly recommend that the new investor attend real estate investment seminars, talk to other investors, and yes, read the books and articles on real estate investing.  Most importantly, I urge the new investor to choose a small, low-risk investment and try it for a short duration. You will truly learn more “by doing” than what anyone else can ever hope to teach you!  You will also learn more about your tolerance for risk!

First Step:  Make a Plan.  The first and most important step is to consider both your personal and your financial objectives, and develop a plan based on these two factors.  You can do this while you are reading some books and attending seminars.  Just be sure to make a Plan before you write your first check!  For example, your personal goal may be to focus on raising your family, taking more vacation time, and getting more involved in community activities.  Your financial objective may be to earn enough through a combination of salary and investments to support your chosen lifestyle, and set aside enough for a retirement at a specified age.  Your financial objective should support your personal objective, not the other way around.

From this important step, you can start to determine how real estate investing can help you achieve your goals.  You need to consider how big (or small) a project you want to tackle, so that you can achieve your financial objectives without sacrificing your personal goals.  You also need to consider how involved in the process you intend to be – it’s the difference between “involved” and “committed.”  Think “Ham and Eggs.”  The chicken is “involved;” the pig is “committed.”  New investors who become Landlords quickly start to learn a lot more about plumbing, eviction procedures, and dumpsters than they ever thought they would.  One of reasons many people choose not to become Landlords is because they don’t want to be dealing with “toilets, tenants, and trash.”  It can be time-consuming, frustrating, and if you don’t manage it properly, the investment project can take over your life!   (Hint:  Hire a good Property Manager!)

There are basically three ways the investor makes money by investing in real estate.  The first – and some would argue the most important – is cash flow.  The formula is simple:  Income minus Expenses = Cash Flow.  Income from rents or leases need to be enough to cover your costs, which include your mortgage payments, taxes, insurance, maintenance and management fees.  The second way that the investor makes money investing in real estate is through appreciation – assuming that the property value increases over time.  An increase in value combined with the amount you are able to pay down the mortgage results in “equity,” which is simply a measure of the difference between the value of what the property is worth and what you owe on it.  The third way that an investor makes money investing in real estate is through depreciation – a pro-rated tax deduction that you use to offset a portion of the income over time.

Most real estate investors focus on the first two factors:  cash flow and appreciation.  As it turns out, you generally get one or the other – not both.  In areas where housing prices tend to climb steadily over time, purchasing at any price will result in a gain in value just by holding onto it for a long enough period, provided that the cash flow is not too negative.  It’s a relatively simple math problem, provided you factor in the tax considerations.  (Hint:  Learn to do some math and get a good tax advisor on your team!)  In some housing areas around the country, especially where there is good job growth, rents will be strong enough to generate positive cash flow.  Even if the value of the property does not increase all that rapidly, an investor can realize regular income from cash flow.  (Hint:  if the amount of rent is equal to or greater than one percent of the purchase price, it generally will have a positive cash flow.)

For a quick primer on some of the other factors you should consider before investing in real estate, I recommend that you read my article “The Five ‘P’s of Prudent Real Estate Investing.”  I also suggest that you find a real estate investment group or association in your area.  Many of these groups provide a wealth of information, advice and networking opportunities.  You will meet others like yourself, as well as experienced investors willing to share their knowledge and tips.  (Hint:  Be careful – everyone is different.  What works for one person may not work for another.  Listen and learn.)  Some investment groups provide bus tours of investment properties in your area, and teach you how to make simple investments.  Still others allow you to pool your money into investments, if that is what you would prefer to do.  Mostly, these groups give you the unique opportunity to meet and talk with experienced investors, learn about investment opportunities, and connect you with the key people who can help you:  lenders, brokers, financial planners, attorneys, tax specialists, and accountants.

Getting started in investing in real estate is really all about getting started.  Thinking about getting started won’t accomplish anything.  Take action.  Go to the library and check out two or three books on real estate investing.  (Hint:  Focus on learning the terminology; ignore the editorializing.  Many authors tend to promote the “one best way” to make money – there is no “one best way.”  And, Big Hint:  most of these books were written before the very recent housing crisis and market crash in 2008.)

One final piece of advice:  Invest, don’t spend, your money.  If your ultimate plan is to make money investing in real estate, invest in real estate.  There are several promoters who make a fortune selling seminars, software programs, CDs, books, and even cruises and board games about investing in real estate.  Some of these are excellent for learning about real estate investing, but choose wisely.  Some people spend all of their money into programs about real estate, rather than invest in real estate itself.  Ask yourself:  will the seminar, books, or materials teach me how to make more money than the cost of the program (including the cost of your time)?  Now, you’re starting to think like an investor!  Get started!

The Five “P”s of Prudent Real Estate Investing

or, How to Avoid Legal Problems in Real Estate Investments

(c) 2009 by Jeffrey B. Hare, Attorney at Law

The only sure way to avoid legal problems associated with real estate investments is do nothing. However, if you want to get involved in real estate investing, you need to follow

Rule Number One: do your Due Diligence.   Although many investors and real estate professionals are familiar with the term “due diligence,” they don’t always follow through. Many real estate agents limit their “due diligence” to a series of checklists concerning the property, such as confirming the zoning, evaluating the condition of the buildings, and looking for evidence of hazardous chemicals, earthquake faults, or underground tanks. These are important considerations, but for the real estate investor, “due diligence” involves a lot more.

To keep this simple and easy to follow, I have summarized the key points into a program that I call the “Five P’s of Prudent Real Estate Investing.” The Five P’s are: Plan, Property, People, Payment, and Patience. If you take the time to understand what each of these five stages involves, you will have taken a major step towards avoiding most of the legal and financial problems that can overwhelm the real estate investor. Let’s get started.

PLAN

There are two aspects of the planning stage: Personal and Financial. You should carefully evaluate your Personal Goal — what do you want to be doing in a few years? Stop. This is a critical step in the process. What do you envision yourself doing in, let’s say 8 – 10 years from now? If you don’t know where you’re headed, you won’t know how to get there.  Form a mental picture of what you see yourself doing in a few years, and hold that vision while you proceed with this article. Then come back and re-evaluate your vision. Ask yourself, “Is it realistic?”

One additional note about the importance of having a clearly defined and realistic personal goal is that it will help you quickly and efficiently identify and eliminate distractions that will NOT get you to where you want to be.¬† Thanks to the Internet, you will be quickly overwhelmed with opportunities, options, and deals, each one promising to be “The Deal You Can’t Miss!”¬† If you know where you’re headed, you will be able to quickly evaluate and eliminate many of these distractions and focus your energy and resources on those deals that will help you reach your goal.

The second aspect of the Plan stage is looking at your Financial Goal.¬†Part of the process of evaluating your Personal Goal is figuring out how to make sure you can afford to do what you want to do: cover the cost of your lifestyle, provide financial security for your family, earn enough to live comfortably. You need to plan for contingencies, medical conditions, and of course, changes in the economy (if the recent downturn wasn’t enough of a lesson!). You should consult with a qualified, professional financial planner.  Each and every person’s situation is different, but your Financial Goal should be designed to support your Personal Goal.

STOP: Keep in mind that you should periodically reevaluate your personal and financial goals. They are targets, not prison sentences. You can modify them to suit your circumstances.¬† But you should keep them both in focus, and know if you are on track to reach them.  If you stray from your path, make the necessary course corrections or reconsider your Plan.

PROPERTY

As I mentioned earlier, most real estate agents focus their due diligence on the property, which is important. The investor should also evaluate the property as well. There are three key aspects to consider.  They are Purpose, Location, and Condition.

Let’s start with “Purpose.” Is the property you want to invest in suitable for the intended purpose?  Does it comply with existing zoning regulations?  Does it meet building and fire code requirements for the intended occupancy?  Is the lot large enough to allow for sufficient parking, ingress and egress, signage, and even expansion? Does it have adequate sewer, water and access to utilities?  Just because a property is available at a good price does not mean it is suitable for your investment purposes!

Next, let’s consider the all important “Location, Location, Location.” Here, you should consider both the environmental and economic factors.¬† While it is important to consider such factors as the proximity to transportation routes, good schools, convenient shopping, and other amenities, do not overlook the importance of other significant factors. For example, is the property subject to natural hazards, such as flooding, wildfires, tornados,  or other extreme weather?  Equally important (for the success or failure of your investment objectives) are factors such as the diversity of the local job market, stable housing prices, and rental rates.  Does the area have a history of relatively low unemployment based on a diverse economy, or is it overly focused on a single industry that could suddenly collapse? (think Detroit).  Is there an overabundance of housing driven by development rather than housing demand? (think Stockton).  As the saying goes in the Music Man, you “gotta know the territory.”

The third aspect of the Property consideration is, of course, the Condition.  Here, you should focus on the cost to bring the structure to “rent ready” condition, whether the improvements will be paid by the owner or the tenant.  One word of caution:  many older residential and some commercial properties may be eligible for listing on local, state or national historic registers, and may be subject to strict regulations governing modifications of historic buildings.  Modifications can be exceedingly expensive, and local officials may require that the structure be restored rather than remodeled. Last, but not least, do not rely on disclosures. Always insist on conducting your own inspection as a contingency under any purchase and sale agreement.  Watch out for mold, asbestos, vermin, termites, dry rot, and other evidence of deterioration that can be very expensive to repair.  Don’t forget to look for nearby drainage channels, sewer or septic hookups, possible easements, overhead high voltage wires, and possible neighborhood nuisances (under a flight path? backs up to a shopping center or night club?).

STOP: Reality check — this is real estate investment¬†property, not your dream home.  It doesn’t have to be perfect. If it was perfect, you wouldn’t be getting such a deal, right?  Also, at the right rental rate, your tenants will be happy to have a safe, secure and clean place to live — they probably don’t expect or want to pay for a Palace! Be practical — but keep your eyes open and be prepared to deal with these issues.

PEOPLE

As an investor, your intention is somewhat different than that of a property owner. You probably own your own home (or are making payments towards that goal).  In making decisions about your home, you most likely consult with your Spouse or significant other.¬† However, when you act as an investor, you need to consider putting together your team. That’s correct — teamS.  One team will consist of yourself and your Investment Advisors or consultants. The other team will consist of yourself and your Investment Partners.

First, if you are just starting out as a new investor, you should assemble a team of individuals with the professional expertise to provide you with competent advice on different aspects involved in real estate investments. I previously mentioned you should consult with a Financial Planner, someone who can provide an objective and professional perspective on your financial situation and goal, and advise you on how best to structure your financial plan.  You should also use the services of a Certified Public Accountant, commonly referred to as a CPA.  This individual can provide important advice as to the impacts of capital gains taxes, depreciation, deductible expenses, and other financially critical matters that will affect your decisions.  You will need Brokers, both for real estate transactions and to help you get financing for the acquisition phase, and whenever you seek to sell investment property.  The right Broker can be worth many times their commission if they help you get a better understanding of local economic conditions, know the neighborhoods, and even help you get financing. You will also need a Property Manager, a very critical element in the success of your investment structure.¬† Property Managers help you find and screen tenants, help maintain your property, and keep the value of your investment intact.¬† Last, but not least, you need an Attorney.¬† Keep in mind that your family attorney may be great with wills and trusts, but may not have a background or training in land use or real estate issues. Also, they may or may not be licensed to practice law in the same state where your investment property is located.  Together, the primary function of this Team of Advisors is to provide assistance to you in helping you achieve your investment goals, not theirs!  As you become more experienced in real estate investment issues, you will quickly become more selective in both who you have on your team, as well as to how you will use their services.

Second, you need to consider assembling a team of Investment Partners.  Many investors lack sufficient capital funds when they are starting out, and need to line up equity partners, lenders, and other investors in order to make their deals work.  This is probably where your Attorney can prove to be the most valuable — helping you determine how best to organize these individuals so that in the end, you achieve your goals. For example, you will need to determine the correct form of entity to use when different people are involved:  will it be a partnership, corporation, Limited Liability Company (LLC), or a Tenancy in Common (TIC) arrangement?  Who will control the decision-making process? How will expenses and profits be allocated? What happens if one of the partners refuses to contribute their fair share of an emergency repair? Is your system set up so you can add additional investment partners in the future?¬† Is the investment structures so that it can take advantage of tax deferral strategies, such as a “1031 Exchange?”  (Note:  if it is held in an LLC, it may not be possible for an individual member to use this common but effective tax-deferral method).

Last, but certainly not least, you must include your Spouse, if you are married. Perhaps nothing is as catastrophic to an investment plan if the Spouse is left out of the loop, or not involved when they should be. More important than providing legally-required signatures and consent, your Spouse often serves as your closest and most trusted investment advisor, someone who knows your goals better than anyone, and can provide a critical “reality check” when you might otherwise get carried away in the passion of “the deal.”

PAYMENT

At some point in every investment decision, there is a bottom line. You will have to make payments (mortgage, insurance, taxes, fees), and in order to do so, you need to receive payments (rent, sale price).  The total amount of the first type must be covered by the second, or your investment goals will not be realized.

To purchase real estate for investment purposes, you need to get financing that is different than thetype of financing that you need for “owner-occupied” property.  For the new investor, especially someone who just purchased their first home, it often comes as a surprise that financing for investment property may include very different terms and conditions than what they expected.¬† At the same time, you may have resources that were not available to you when purchasing your home.  For example, you may be able to use a Home Equity Line of Credit (or HELOC), or a loan from a relative, or even funds from a Self-directed IRA (“SDIRA”).  A qualified Mortgage Broker can provide you with options and opportunities. However, in general, you should expect to have to come up with between 30 – 40% down payment, plus pay a slightly higher interest rate on any loan you may be able to secure.

A quick note about using SDIRA funds to purchase investment property: It is perfectly legal to use your IRA funds to purchase investment property; in fact, it is uniquely suited to such transactions since regulations prohibit you from using SDIRA funds for any property that you would use (such as your home, your office building, or your vacation property).  However, in order for you to successfully use a SDIRA for investment purposes, you need to take steps to set up the account, roll over your exisiting 401(k) or other eligible Pension Plan fund, and work with a Plan Custodian, like Pensco Trust, that will allow you to use SDIRA funds held by them to invest in real estate.

To make the payments, you will need INCOME.  Of course, the ideal situation is an investment property that produces both positive cash flow (rental income is greater than mortgage payments, interest, insurance, property taxes, maintenance, emergency repairs, vacancies, and property management fees), and appreciates in value so that the net proceeds from the eventual sale of the property are more than any existing encumbrances on the property.  To ensure the highest probability that you will receive steady and sufficient rent, you will need to consider all of the factors (and more) mentioned under the Property section, above.  Just because you can get a great price on a property in the central valley of California or in a downtown area of Detroit does not mean you will be able to find qualified tenants willing to pay sufficient rent.  Again, you “gotta know the territory.” And, you have to plan for contingencies … you will experience unexpected maintenance costs, emergency repairs, and periods of vacancy. Plan accordingly.

PATIENCE

As the old prayer goes, “Lord grant me patience, but grant it NOW!” The importance of Patience, the 5th “P” in this article, is underscored by the need to dispel the myth of the “get rich quick” scheme.  Many individuals were, and some still are, successful doing “flips,” where they acquire title to property, do some quick repairs, then turn around and sell the property for a substantial profit.  Is this possible?  The answer is yes, but more and more it is exceedingly difficult. One reason is that with the credit crunch, not many individuals are able to get financing, so the “flippers” are finding themselves holding onto property much longer than they planned.  Since they often used “hard money” loans or other types of “borrowed” funds, they often find themselves owning more and more of the anticipated profits from the planned “flip,” and often must drastically reduce the selling price or start renting it out.  The true “value” of a real estate investment is built over time, both from incremental rental increases and from appreciation in value over time. The smart strategy is to be patient, build a solid investment portfolio, and let it grow in value over time.

Conclusion

The foregoing Five “P”s are intended as a short-hand checklist of the key elements to be considered as part of your overall investment strategy and to help you do your “Due Diligence.”  Of course, you cannot eliminate risk, and you cannot guarantee that you will never have legal issues.  But you reduce the probability of legal problems by taking the foregoing steps.