“No Money Down!” Too Good to be True?

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

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

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

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

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

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

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

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

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

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

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.

Welcome to Loan Mod Purgatory — please take a number.

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.

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!

Loan Mods and Deep Breathing

Upside down on your home loan?¬† Real estate investment property vacant?¬† Don’t know what advice to follow?¬† Should you walk away or let it go to foreclosure? File bankruptcy?¬† Hire a loan mod specialist?

Homeowners and real estate investors are scrambling to cope as the economic crisis hits home — literally.¬† Even in California, property owners are waking up to the harsh reality that their homes and real estate investments are worth less than what they owe on their mortgages.¬† Add the misery of a layoff or news that an investment has gone sour, or the fact that your 401(k) has suffered a 30% drop in value, and you cannot make the payments.¬† What can you do?

Three steps to get out of the muck

First, CALM DOWN, don’t panic.¬† The threat of losing one’s home is certainly grounds for concern, but if you panic, you are more inclined to do do the wrong things.¬† People who panic tend to listen to bad advice, especially when it comes in the form of a promotion making ridiculous promises.¬† Most of this advice comes from people who are trying to make money, not people who are trying to help you.

Second, GET BUSY!¬† The process of working through a loan modification takes time, and requires a lot of hard work on your part.¬† You will need to demonstrate that you will be able to make the payments if and when the real estate loan modification is approved.¬† This will require you to make some tough financial decisions, get your financial records and documents in order, and probably make some adjustments to your plans.¬† Don’t blame yourself — or others.¬† It only serves to waste time and energy that you will need to develop a solution.¬† Instead, make a Plan.¬† Ask yourself, “What do I want to do?”¬† “Where do I want to be?”¬† Chances are, if you are facing the prospects of a layoff, or have been unable to make mortgage payments, or are facing the prospect of foreclosure, you’ve been caught up in the chaos of the moment, and haven’t taken time to focus on the future.¬† Working through a loan modification process only makes sense if you have a clear idea where you want to end up.¬† In the end, it may make sense to short sale a property, or let it go into foreclosure, but only if it helps you to get where you want to end up.

Third, take ACTION.  Get help now!  Consult with a professional and explore your options.  I recently received a call from a distraught individual reporting she had been evicted that morning by the Sheriff from the home she had owned for 20 years.  Not an ideal time to start getting legal help!

Before you sign up with someone advertising loan modification services, find out exactly what they will do for you. Look for a real estate attorney or a specially registered real estate broker.  Pursuant California law, in many instances real estate brokers cannot charge you a fee in advance unless they have been approved by the Department of Real Estate (DRE).  Attorneys licensed to practice in California are exempt from this requirement, but make sure they are experienced in real estate law. For more information, see the Consumer Alert by the DRE: http://budurl.com/DREAlert

Fourth, reread step three and take ACTION.  Too many individuals become paralyzed by worry.  Your circumstances will not improve without action.  So, take a deep breath and pick up the phone. Contact a professional experienced in loan mods who will get started right away.  The sooner, the better.  It may cost you some money, but with the right help, you will be able to avoid even more costly mistakes.

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.