Many people would like to invest in real estate.  Housing prices have plummeted; rates are at historic lows.  You can actually buy cash-flow investment property in California!  It’s a great time to buy real estate.  But how do you get started?

There are several ways to invest in real estate.  You can buy investment rental property, or purchase in an interest in an investment company.  You can buy single family homes, apartment buildings, REOs, fixer-uppers, or even raw land.  Or, you can purchase tax liens, options, or notes.  Thanks to the credit crunch, you can also invest by loaning money secured by real property.  There are several strategies, such as:  “buy and hold,” “leveraging,” “flipping,” “wholesaling.” for maximizing profit:  flipping, “buy and hold,” leveraging, wholesale contracts.    For the new investor, it’s like learning a new language.  There are literally dozens of books and articles in the library, the bookstore, and on the Internet - it can seem very overwhelming!

A word (or two) about risk.  All real estate investing involves risk.  There is no such thing as a “risk-free” investment.  You can learn to manage risk, and take steps to reduce risk - you cannot eliminate it.  Each individual has their own personal risk tolerance level.  While getting started, consider what would happen if you lost your entire investment.  As you gain experience and confidence, your tolerance for risk will probably increase, along with your ability to reduce the risks inherent in any investment.  An important element of risk management is to avoid problems, whether they are of an economic or legal nature.

There is not enough room here to explain everything you need to know about real estate investing, but a few pointers will help you get started.  I strongly recommend new investors should attend real estate investment seminars, talk to other investors, and read books and articles on real estate investing.  Learn the language.  Consider a low-risk, short-term investment and try it.  You will learn more “by doing” than anything else.

First Step:  Make a Plan.  The most important step is to consider both your personal and your financial goals, and develop a Plan.  A good Plan will focus on your goals.  Goals must be realistic.  Your plan should be flexible, and contain an exit strategy.  Be sure to have a Plan before you write your first check!

Your financial goals should support your personal goals, not the other way around!  Determine where you want to be in a few years down the road:  in a new home; retired; or not worrying about the kids’ college tuition.  Your financial goal should be to earn enough to help you reach your personal goals, plus a little extra for emergencies.  Remember, good investment plans take time - there is no single perfect investment, despite what some promotional ads try to make you believe!

Second Step:  Do your Research.  You don’t need to be a genius to make money in real estate investing, but you need to be smart.  And you can get smarter.  Again, I recommend that you attend real estate investment seminars (like SJREI) and talk to other investors.  Warning: Be wary of motivational seminars that try to sell you investment products, books, software programs, and CDs.  Listen.  Learn.   But don’t buy everything they sell -or say!   Invest in real estate - not gimmicks!

Remember, there are many different types of ways to invest in real estate.  Focus on those that you understand and are comfortable with.  When you are getting started, avoid complicated schemes, and stick to simple.  Achieving a level of comfort and success with one type of investment activity or another requires practice and patience.  Smart people learn from their mistakes.  Really smart people learn from other people’s mistakes!  (Hint:  everyone makes mistakes.  Try to make small ones, not big ones!)

As you learn more and gain confidence, you may choose to modify your Plan.  Make adjustments to keep your Plan realistic and achievable.  Establish a realistic timeline for your financial goals.  Modify your Plan to help ensure that your Plan will remain current and relevant.  For example, you might choose to modify your plan to invest out of state, or to team up with other investors.  The key to survival is adapting to a changing environment, and a smart investor must be prepared to adjust their investment strategy in response to changing economic conditions.  Remember: It is important that your Plan include an exit strategy.   In addition to doing Research on your strategy and a more specific investment proposal, you should develop a reliable “team” of professionals you can rely upon for timely, relevant advice.  Most successful investors have a team of tax specialists, real estate agents, attorneys and other professionals they work with on a regular basis.  They are often well-worth the cost of their services.  You can use the knowledge you gain from your professional advisors over and over.  The rate of return on your investment in professional advice is priceless!

Other steps to take:  Research the market and local conditions.  Fact-check information you get at seminars.  Remember: If it sounds too good to be true, it probably is!  Don’t rely on obsolete  information.  A lot has changed in the past two years - check the dates.  Learn as much as you can about the local market, demographics, and conditions.  Get local information:  use the Internet, but don’t rely on what you see online.  Find local newspapers, churches, and realtors, and talk to someone “on the ground.”

Finally, as part of your research, don’t forget to make sure the investment is consistent with your financial and personal goals.  If not, STOP.  Ask yourself:  “Will this investment get me closer to my financial goals?”  If the answer is “No,” step back slowly from the checkbook!  If you don’t have enough information to answer the question, you need to do more Research, modify your Plan, or find a new investment.

Third step:  Action.  Invest, don’t spend, your money.  If your ultimate plan is to make money investing in real estate, invest in real estate - not in sales pitches.  Remember, there is no such thing as the “perfect” investment. When getting started, it is okay to proceed slowly and deliberately, but you need to proceed.  Take a deep breath, get going, and keep an eye on your exit strategy!

Getting started is important.  Getting started on the right foot is even more important!

“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 - 8%) 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.

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.

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.

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.

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.

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.

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.

A bad situation is about to get much worse.  Two bills pending before the California Legislature, AB 764 and SB 94, will apply criminal penalties and fines to real estate brokers and attorneys who charge advance fees or take retainer fees to handle loan modifications.  The primary basis for this approach appears to be the continuing assumption that homeowners can get these services for free from the lenders themselves, or from HUD authorized nonprofit loan counselors.  Any broker who wishes to charge for these services must first obtain approval from the Real Estate Commissioner and comply with the new provisions of the law.   Violation of these provisions by an attorney would constitute grounds for disciplinary action.  Unfortuately, this legislation — like many other recent regulatory actions — attacks the wrong problem.

On the surface, this consumer-protection legislation appears to address a serious problem:  the rash of scam artists seeking to profit from the thousands of homeowners facing hardship and possible foreclosure.  It is too early to predict whether these bills will pass, but the trend is clear.  Authorities are clamping down on the widespread abuses and scams that have plagued distressed homeowners for the past couple of years.  One company recently shut down by the FTC in Southern California had 400 employees, seven attorneys, and claimed a 98% success rate at “modifying” loans.  In one of these, the lender increased the mortgage payment by over $300 per month — even though the homeowner was current on their payments!  The “loan mod” company charged the homeowner $3,600 for this “modification.”  This was not an isolated case — approximately 60% of all “loan mods” approved by lenders in the first three Quarters of 2008 resulted in either no change or an increase in the borrower’s mortgage payments!  To no one’s surprise, a majority of these “modifications” failed and the properties went back into foreclosure, prompting renewed efforts by the Federal government to offer incentives to lenders to actually lower monthly payments.  (These Guidelines were released on March 4, 2009).

Nonetheless, thousands of homeowners, facing foreclosure and fearful of losing their homes, were scammed into paying money to unscrupulous individuals and companies who promised to “stop foreclosure” and “save your home.”  Responding to the problem, the California Department of Real Estate (DRE) issued a “Consumer Alert” and established a program which would allow real estate brokers to submit their Advanced Fee Agreements for review and the opportunity to be listed on the DRE web site if the DRE issued a “no objection” letter.  The DRE now lists hundreds of brokers on their web site who have been “approved” to charge advanced fees.  The DRE also list over 240 individuals and companies against whom the DRE has filed a “Desist & Refrain” Order and/or Accusation for loan modification activities.

On June 1, 2009, the California Attorney General issued a press release directing anyone who acted as a “foreclosure consultant” to register with his office and post a $100,000 bond by July 1, 2009.  The press release also lists several enforcement actions taken by the AG in relation to prosecuting loan modification scam artists.

Earlier, in February, 2009, the California State Bar had released an “Ethics Alert” that contained a fairly comprehensive discussion of the background leading to the current foreclosure crisis, and warned that attorneys who offered their names to non-attorney companies in order to allow those companies to collect advance fees were in violation of the Rules of Professional Conduct, which prohibit licensed attorneys from assisting non-attorneys in the practice of law, and prohibit attorneys from splitting fees with non-attorneys.  Also, the Ethics Alert reminded attorneys that it was a violation to file lawsuits to delay a foreclosure sale without good cause.

These and similar measures are designed to protect consumers and homeowners, ostensibly from the potential scams of companies seeking to profit from the chaos in the housing crisis.  However, as distasteful and outrageous as these practices may be, they are not the real problem.  A blanket attack on real estate agents and attorneys will invariably sweep up many professionals who, by virtue of their expertise and training, are in the best position to actually provide much-needed assistance for these distressed homeowners.  At the same time, this regulatory approach does nothing to make the task easier for the homeowner to handle the task themselves — the legislation directs them to go to a local HUD office or to their website at  www.HUD.gov to get a list of approved nonprofit housing counseling agencies.

The real problem is two-fold.  First, the process whereby these loans were securitized, fractionalized, sold, and resold means that in any given instance, the “lender” is merely a loan servicer for an investor two, three or four times removed from the original institution that originally approved the loan.  Each investor has specific restrictions and requirements beyond which the “lender” may not modify the terms of the loan.  There is no ability to negotiate directly with the investor, and the process for reviewing each application in light of these requirements takes anywhere from a month to 90 days or more.  The second aspect of the real problem is there is no real incentive to provide meaningful relief in the form of principal reduction, or otherwise offer modifications that will make a difference.  “Loan Mods” that simply shift the debt load to the back end of the loan, or offer insignificant adjustments (i.e., a 27-cent monthly reduction), as an alternative to foreclosure, really do not accomplish anything.  Forcing a distressed homeowner who has suffered a sudden loss in wages or other genuine hardship to endure three to four months of back-and-forth with an unnamed and undisclosed “investor” just to receive an unacceptable or meaningless proposal is bad enough.  Limiting — if not eliminating — their range of options to seek competent assistance merely adds insult to injury.  Making it virtually impossible for competent professionals to charge for legitimate services will only force them to refuse to participate, and do little to address the real problems.

There is no question but that there have been outrageous abuses by scam artists seeking to profit from the crisis.  Existing regulations govern the conduct of licensed real estate and legal professionals, and if properly applied and enforced, would address most of these types of problems.  What is needed even more is meaningful and effective regulations to allow lenders the ability to modify existing loans without the hidden restrictions imposed by silent investors lurking in the background.   Focus on the real problem — don’t attack the lifeguards and ignore the sharks!

According to an article that appeared in CNNMoney on Monday, May 18, lenders are overwhelmed by a flood of applications; mortgage investors are threatening to sue loan servicers for modifying loans, and unemployment is the newest threat to stabilizing the housing market.  This article comes on the heels of an announcement on Friday, May 15 by the Obama administration, announcing a new, standardized process and incentives for short sales and “deed-in-lieu” transfers of ownership.   The newest initiative is aimed at homeowners who cannot get loan modifications. These newest actions follow by two weeks the Government’s announcement that it would provide incentives to lenders holding second liens to reduce interest rates and/or release second mortgages.

Anyone involved in the loan mod process would have to acknowledge that the entire process is bogged down.  CNNMoney noted that even though it has been three months (to the day) since President Obama announced the Housing Affordability and Stability Plan (February 18, 2009), and Guidelines were issued on March 4, many (if not most) loan servicers have been slow to get up to speed to respond to the requests.  Borrowers frustrated by the lack of clear guidance and inconsistent advice are tempted by robo-call operations offering to “help” homeowners for hefty fees.  Ironically, it turns out that investor contracts arising from the securitization and sale of the loans, which was part of the problem in the first place, are restricting which loans can be modified and how.   Congress is working on a bill to provide a “safe harbor” to allow loan servicers to use the Federal mortgage relief programs, but some investor groups are lobbying hard against passage.  It is no secret that many loan servicers are using the “investor contracts” as excuses not to make prompt and effective modifications.  Unfortunately, the borrower has no way of knowing whether or not the excuse is valid.  One gets the same feeling one gets when the car salesman returns from the back room to report the General Manager’s “last, best and final” offer, but you never even see the guy behind the curtain.

Compounding the problem and undercutting efforts to stabilize the mortgage crisis, many lenders have yet to sign up for the Federal program.  According to CNNMOney, 14 of the mortgage service companies, including Bank of America, Citgroup, J.P.Morgan Chase & Co., and Wells Fargo.  Others claim to be implementing their own versions, and still others are evaluating the program.  At the application level, each lender and loan servicer appears to have their own processing requirements.  Some permit the borrower to send the required documentation electronically, while others insist the documents be sent by fax.  One loan agent told me their fax room was a complete mess, with different applications getting mixed up with others like a crazy game of 52-card pickup.  Another loan agent told me they had no way to confirm receipt of the electronic transmission of the application documents.  Still another e-mailed me within 24 hours to confirm receipt, followed up 5 days later with a request for a missing piece of information, and provided an estimated time of review and affirmed that the foreclosure status was being suspended pending review of the loan mod application.  Simply stated, there is no uniformity or standarization.

As I’ve reported before, the fact that some of the lenders and loan servicers are only now just beginning to implement the Guidelines first released on March 4, and others are still “evaluating” the program, calls into serious question any claims or reports of successful loan modifications.  Sixty percent (60%) of all reported “loan mods” approved in the first three Quarters of 2008 resulted in mortgage payments that were the same or higher than prior to the modification.   I saw one “approved” loan modification that reduced the monthly payment by 27 cents!  And that lender insisted the borrower was foolish to reject it!  This type of chaos and confusion will only serve to further destabilize the process; create additional opportunities for fraud; and worst of all, erode any sense of confidence that the Federal program might otherwise have a chance to work.

In addition to the impact of rising unemployment cited by the CNNMoney article, there is another growing threat to the Federal effort to stabilize the situation — credit card debt.  Broke, facing unemployment, and no longer able to tap their home equity for relatively inexpensive funds to make up the difference, many homeowners have tapped the most costly source of revenue remaining — their credit cards.  Unfortunately, the card companies, who reset the loan rates faster than you can say “charge it,” have started charging cardholders the highest possible default rates of 29.99%.  Behind the wave of home foreclosures working their way through the so-called “trial periods” and voluntary moratoriums is a second wave of crushing credit card debt.

Sadly, the situation is bound to get worse before it gets better.  Unless and until the loan servicers get clearance from the investors, or simply clear directions from their managment, and free up the backlog of applications, the confusion and frustrations will continue to mount.  One problem is that no one knows what will work, and therefore everything is approached with the same level of risk aversion.  It would be a great service if the U.S. Department of the Treasury could simply select a statistically significant cross-section of different types of loans, fund the modificaion, and see what would really work to increase the probability of success.  Hindsight, of course, will teach us all many lessons.  The question is whether we can wait long enough.