The Mortgage Meltdown Fallout Continues

Reuters reports that American Home Mortgage Investment, a REIT, could no longer fund loans and may be forced to liquidate its assets. This comes after last Friday's announcement that it would not be paying its quarterly dividend to shareholders. The company is unable to fund $300 million of loans it already committed to make on Monday. It is expected to be unable to fund another $450 to $500 million in loans today. Shares of the REIT closed at $1.04 on Monday, down from a high of $36.36 in December. But this is the important part of the article:

"It is raising concerns about the whole mortgage market because American Home really didn't do anything in subprime," said Sam Rahman, a portfolio manager at Baring Asset Management Inc.

Stop and think about the full ramifications of this. On the personal level, how many home buyers are going to not be able to purchase their houses now because AHM can't fund the loans? How many shareholders have lost substantial chunks of money due to the drop in the share price - never mind the stopping of the dividend. And how many mutual funds had positions in this company and will also lose money? And all this from a company that had very little, if anything, to do with subprime lending and accounted for roughly 2.5 percent of the U.S. mortgage market.

And then there are the collateral effects. Mortgage insurers are getting hit. MGIC Investment Corp. and Radian Group Inc. said they were going to write off a combined $1.03 billion investment in the subprime mortgage arena. Add this on top of the other $1.4 billion loss I wrote about a couple days ago and we are starting to talk about some serious money. Does anyone still think this isn't anything to worry about? That it won't have ramifications in our broader economy? Just think about those people whose loans won't get funded. Their purchases will probably fall through. This may cause them to cancel the sale of their existing homes. Moving companies won't get hired, new furniture won't be bought, money stops changing hands. The effects trickle down.

So what's a real estate investor to do? If you invest in REITs or other real estate related stocks or mutual funds, take a close look at the company's portfolio and how much exposure they have to adjustable mortgages. Check to see how much cash they have on hand and how close they are to being maxed out on their credit lines. Check the rate of defaults and late payments on their loans. Are they rising? All this information is available in the reports companies are required to file with the SEC. If you prefer to invest in properties, now is the time to stick to basics - buy below fair market value (significantly below if possible because FMV can drop like a rock in some places). Be sure the property will positive cash flow when rented at or below market rates. Don't count on appreciation or tax deductions to turn your negative cash flow into a positive cash flow. Like all else, this period will pass, but you need to make sure you can weather the storm.

Foreclosures Skyrocket

According to this report on CNN, the number of foreclosures rose 58% during the first half of this year. One in every 134 households is going into foreclosure. In Nevada, it's even worse - 1 in every 40 houses.

Louisiana Update

Another conference call for the Louisiana investment just concluded and it looks like TMG, the investment group that is taking control of this project, is giving us investors a pretty good deal. As usual, there are lots of details, but I'll try to keep it simple here.

Those of us that are currently on the first mortgage for the commercial properties in Louisiana have the following options:

1. Get cashed out. Your investment will be paid off and you'll get your money back.
2. Roll your investment into a new second mortgage. The second will be collateralized not only by the two buildings in Louisiana, but also a couple of other commercial properties in Houston (a strip mall and some apartment complexes). The second mortgage will be for about a year, although it is likely it will be refinanced and paid off early. (We will be guaranteed at least 6 months interest though.) The second will be at the same interest rate we are getting now (12%). In addition, we will be getting 4 points cash up front.
3. If we decide to stay in the investment, we will also get the option to convert our investment into an equity position in about a year (a "right of partnership of ownership"). The terms for this will be worked out later, but it is likely equity position holders will get monthly payments at 9% APR plus a preferred position on the investment, which means they will get their money back before anyone else when the places are sold. So even if everything goes south and the properties need to be sold at a loss, the preferred positions will have an excellent chance of getting all their money back. This is optional, so if we don't want to become equity holders, we don't have to. They expect to sell all the properties after an additional year for a profit of around $10 million dollars and investors could be looking at doubling their investment.
   

This whole deal is set to close the end of next week. The original investment was originally set to end in March, 2008 and this new one will expire a year from close of escrow. So if I decide to keep my money in the investment, I'll be paid 4 points to extend my investment by about 5 months. And that money will be paid upfront at the close of escrow in a week or two.

To me, this is a no-brainer. The slumlord who took over control of the investment will be gone. The new first mortgage holder will be TMG, the group that already has about $400,000 invested in the current second. The president of TMG also will be personally responsible for $1 million of the new mortgage and he is putting his personal residence up as collateral.

This investment is turning out to be pretty profitable for me. I had some months where there were no payments, but we are now current and have been paid late fees. So my return including the late fees is around 12.6%. Now I'll be getting another four points, which jacks the ROI for this year up to 16.6%. Then there is the prospect of getting 9% for another year plus a 100% or more return on our principle when the buildings are sold.

But technically, my ROI is infinite now, since my investment cash came from my HELOC, so it's not even my money I'm using. But it's just not the same to say my new ROI will be infinite-er :-)

Summertime Slowness

Nothing much seems to happen in the summer. Here in Arizona, it's just too hot to go outside and do anything and with vacations and family visits, it seems like real estate has taken a back burner for a moment.

My Louisiana investment has finally been brought current. Actually, more than current since I've already received the payment for August. That brings the mortgages up to date. The other aspect of this investment - buying out the old majority owner and possibly getting an equity share of this and several other properties - is still in process. I think escrow is supposed to close by the end of the month, but with a deal this big, I wouldn't be surprised if it took longer. No more details yet either, so I am not entirely sure how good of an investment this may be and if I'll want to stay in it or cash my money out and move to something else.

My tenants in Rental #1 still have yet to pay their $200 from May that they were mistakely undercharged by my management company. The tenants told the management company last Tuesday that they wouldn't have that money until August. If they have not paid everything by August 10, I've instructed the management company to evict them. Their lease is up on November 1 and I am 95% sure I will not be renewing their lease. It might cost more to evict them now than to simply keep dealing with their issues until their lease expires, but I would rather be trying to rent the place in August and September than in November and December.

The investors I was rehabbing and flipping properties for are evaluating their options right now. I think all the media coverage about the housing meltdown has got them a bit worried about flipping and they aren't sure if they want to keep doing that. They are looking into getting a rental property, perhaps something in the Payson area that they can rent out part time and possibly use for themselves other times, or perhaps just a straight rental somewhere in the metro Phoenix area.

Personally, I'm saving up my funds for my next REI purchase, which will definitely be a multi-unit property. I'm not saving as much as I'd like, mainly because I've been hit with a rash of big expenses lately (well, that plus a losing vacation to Las Vegas!), so I'm not sure when I'll be ready to pull that trigger. Just a few months, hopefully.

Subprime Mortgage Meltdown Begins To Gather Steam

The meltdown in the subprime mortgage market is gathering steam and beginning to be widely felt. Yesterday, Bear Stearns told its clients that two of its hedge funds were now worthless.

Bear Stearns, the nation's fifth-largest investment bank, began disclosing in March that the two hedge funds had sustained heavy losses tied to subprime loans extended to risky borrowers. At the time, its High-Grade Structured Credit Enhanced Leveraged Fund was worth about $638 million -- and now has no value.

Meanwhile, the larger and less-leveraged High-Grade Structured Credit Fund lost 91 percent of its value. It was worth about $925 million before taking on losses in March.

Ouch! That's a total loss of 1.4 billion dollars! At this is just at one firm - and a firm that was considered the "pre-eminent Wall Street firm dealing in mortgage-backed securities." And those funds were "High Grade", meaning they was supposed to invest mostly in "highly rated" securities. Wait until the other firms start reporting. Wait until more of these subprime mortgages have their interest rates reset in the next couple of years.

Rental #1 Final Numbers

As I promised a while back, now that the refinance of Rental #1 is done, I'm able to post the final numbers for the property.

Purchase Costs	Earnest Money Deposit	$1,000
	Funds Due At Purchase	$1,438
	Funds Due At Refinance	$13,335
	Property Management Maintenance Deposit	$250
	Total Purchase Costs	$16,023
Monthly Income	Rent	$750
Monthly Expenses	Management Fee	$75
	PITI	$486
	Maintenance Reserves	$25
	Total Monthly Expenses	$586
Monthly Profit		$164
ROI		12.28%

And now for some discussion of the numbers..

Purchase Costs: This is pretty straightforward. The first entry is my earnest money deposit that I paid to open escrow. The next entry is the amount I needed to bring to the title company when I purchased the house. In other words, this figure includes all the title fees, taxes, appraisal costs, etc. Since I was buying this property using a hard money loan from another company I own, the costs were pretty low. The last figure is the amount I needed to bring to the title company when I refinanced my hard money loan with a conventional lender. This amount includes all appraisals, title fees, taxes, loan fees, and funds the lender required for their escrow account (about $400). This amount also includes my down payment on the property so that I could get the loan to value ratio down to 80%, thus avoiding private mortgage insurance. The Property Management Maintenance Deposit is the amount the PM company required me to give them to hold as a deposit against any repairs that might be needed on the property going forward. The total of these fees, therefore, represents all the money that came out of my pocket to purchase this property.

Monthly Income is, of course, the rent the tenant pays.

Monthly Expenses: The management company charges me 10% of the rent, or $75, for their services. PITI represents my monthly mortgage payments and includes principal, interest, taxes, and insurance. Maintenance Reserves are funds that are saved to pay for any repairs that might be needed during the year. In the past, this has been a big point of contention with some readers, who feel this amount is too low and unrealistic. To each his own. This is a number you can make whatever you want. I chose $25 a month. Keep in mind, I have already put $250 into a maintenance reserve fund when I hired the property management company, so I actually have more saved for maintenance than this monthly number would indicate. Since it's not actually a real expense until you have to spend the money on a repair, it's possible I won't even spend this money at all this year and will therefore, end up with a higher ROI. (OK, unlikely, but still possible!)

Monthly Profit is simply monthly income minus monthly expenses.

ROI is my annual rate of return, calculated as twelve times my monthly profit divided by my purchase costs. I'm happy with over 12%.

One other item to note is that the current tenant's lease is up on November 1. I expect to be able to slightly raise the rent at that time, which of course, will increase my profit and ROI.

Back in February when I bought the place, I estimated a monthly profit of $200 and an ROI of 20%. The actual numbers turned out a bit lower. This might be in part due to the lower appraisal value that I ended up with for the refi, which required me to add another $2,000 to my purchase costs.

Louisiana Update

I took part in an hour long conference call this morning with the other mortgage holders on the commercial property project we've got going on in Louisiana. There is really too much to cover in a blog entry, but I will attempt to give the highlights. You shouldn't assume these are the complete details.

The majority holder, I'll call him "Joe," that has been causing everyone else so much trouble, has come to us asking to be bought out. Joe is in over his head on many properties, not just this one. In Louisiana alone, he already has a $1 million judgment against him and he has properties in Texas that are also facing foreclosure. Joe's style is that of the slumlord. He works hard, but he is still a slumlord and tries to do everything the cheapest way possible. For instance, one of the Louisiana buildings has three elevators and only one is working. Rather than call an elevator repair company, he took out an elevator motor and took it to a machine shop to have them fix it. That didn't work, so he tried to cannibalize other properties he owns to get the elevators working again. Needless to say, that didn't work. The other investors have also gotten calls and emails from the construction manager saying Joe is not paying all the vendors. Apparently he feels they are padding their bills and charging him for work done on other jobs, so he refuses to pay. There are more examples, but you get the idea.

However, as I said, Joe is also a hard worker. He just tends to piss people off. Despite this, he has still managed to increase the number of tenants in the property since he took over. This is probably due to local economic conditions more than his skill - the area is doing well thanks to an energy boom. Property values have risen, the town has a new mayor, title companies are reporting increases in business (meaning more people are moving in). The other minority investors feel more optimistic about the area now than they did a year ago when they first got into the investment.

Joe is out of money. He is a distressed seller and has come to us for help. He needs to save some of his other properties from foreclosure, as well as this one, so he has agreed to sell a package of properties. The minority holders, including myself, are represented by a company I will call "TMG." (Other people as well, but they are closely related to TMG.) In fact, TMG is one of the entities foreclosing on another one of Joe's properties, so we have a nice amount of leverage here. (Because the deal is still ongoing, I don't want to give names here, but when it is all done, I will if anyone is interested. I am thoroughly impressed with TMG's integrity, skill, and straightforwardness.)

The package deal is we will buy the four commercial buildings in Louisiana plus roughly 475 apartment units in Houston and about 400,000 square feet of commercial property in Houston for just over $12 million dollars. TMG figures to spend another $8 million or so in acquisition and redevelopment costs, and then the properties will be worth about $30 million, at which point they can keep them or sell them for a nice $10 million profit. The nice part about this deal is that there will be little out of pocket costs for the purchase. Remember how I said Joe was a slumlord? Turns out, the city of Houston will loan us $6 million at 0% interest just to get Joe out of there and redevelop his properties. There are all kinds of other financing terms involved in this deal, but it all looks good. Oh, and did I mention this deal should be completed by the end of the month? Just about as fast as a purchase for a single family house!

So where does all this leave me, as a mortgage lender on the Louisiana properties? First, the existing loans will all be brought current. Second, TMG will be offering us three choices:

1. We can get paid off in full, plus accrued interest and late fees.
2. We can trade our mortgage position for an equity position in the whole package.
3. A combination of 1. and 2.

Since all the terms are not yet finalized, TMG can't give us actual numbers yet, but they are estimating the option 2 will require a 2 year investment and come with an 8% - 9% annual return, paid monthly. Also, at the end of that 2 years, your equity is expected to have increased 150% - 200% (not counting the monthly payments).

So things look very interesting. I'll have to wait for some hard numbers of course, but I am very interested in option 3. Since my investment in this project comes from a HELOC, I'll likely take out some of my money to pay that down, but will keep some invested for the longer term and bigger ROI. For those of you that play Cashflow 101, this is turning into a real Big Deal opportunity!

Update On All My Projects

I'm back from Vegas, poorer, but relaxed...

Looks like my feeling that things might be improving at my property management company was correct. I've found out that the company is being bought by an employee and that they have ramped up the staffing and efficiency of the office. That makes me feel better.

I also finally received the Release of Mortgage for my refi of Rental #1. I got that notarized and will send that back today, so my private money mortgage I used to purchase the property will officially be released.

I've got a conference call tomorrow morning about the commercial investment I am part of in Louisiana. Don't have all the details yet, but the good news is that the majority owner that took control of the project midway through and stopped payments and basically screwed everything up has agreed to be bought out at a discount. More details to come!

I think that's about all the info I have on all the projects I've got going now. For the future, I think my thoughts have turned from looking for Section 8 / non-Section 8 single family homes to fourplexes... More investigation is necessary.