Does anyone have any experience working with a self-directed IRA (Roth or otherwise)? I'm looking to head down this route and I have questions about the day-to-day operations - does it need a custodian (other than me), does the custodian write the checks and sign contracts, etc.
I've heard about using self-directed IRAs for several years, mostly about how they can be used for investing in real estate. I was always intrigued by this, but never really was in a position to set one up. A couple of changes going into effect in 2010 have made now seem like a good time to get going with this. In 2010, the income limits for who could convert a traditional IRA to a Roth IRA are going away. Additionally, if you convert in 2010, you can spread the taxes you'll need to pay over 2 years*. When I was laid off of my job over a year ago, I took my 401(k) and converted it into a rollover IRA. With the stock market down, now is good time to convert since I will have a lower amount I'll have to pay taxes on. (I should note that the current law applies to traditional IRAs converted to a Roth IRA. It's unclear if the IRS will decide that the law also applies to rollover IRAs converted to Roths. After talking to my CPA, I've decided that to be safe, I'll convert my rollover IRA to a traditional IRA and then convert it to a Roth.)
My point for doing this is to use the self-directed IRA funds to make hard money loans, which I have been doing for the last couple of years, earning between 10% and 12%. Getting that return tax free would be very nice.
* If you declare the conversion in 2010, you'll have to pay taxes on the converted amount in 2010. But if you don't, you must declare one half of the contributions in each of 2011 and 2012. What I will do in those years is calculate how much I will owe in taxes and simply adjust my W-4 withholding at my day job to spread the tax burden out over the entire year. Of course, it's likely that tax rates in 2011 and 2012 will be higher than 2010, but of course, that's anyone's guess. Lots can happen between now and then and I'm a fan of delaying paying taxes as long as you can.
Strategic Mortgage Defaults Revisited
Back at the end of September, I wrote about strategic mortgage defaults - purposefully defaulting on your mortgage on a property that has a mortgage for more than the property is worth. A story in the L.A. Times reported that these types of defaults were on the rise.
Now, University of Arizona law professor Arizona Brent T. White has published a paper (pdf) stating, contrary to news reports, not many people are doing this - but they should. He cites people's emotional fears as the driving force preventing them from acting in their own financial best interests - the fear of the shame and guilt of foreclosure and an exaggerated sense of the consequences of foreclosure. He also argues these fears are actively encouraged by the government, lenders, and other social agents to induce borrowers to ignore what might be the wisest financial decision for them.
I found this paper very interesting, mainly because it presents almost the complete opposite picture of human behavior that Freakonomics does - namely that people will NOT act in ways which benefit them financially the most. I think the difference here is due to the amounts of money involved, as well as social pressures. The actions looked at by Freakonomics dealt with relatively small amounts of money and with actions whose consequences have fewer social repercussions.
White states:
I find his arguments to be well-thought out and worth thinking about. There is a definite basis against people who walk away from their mortgages:
What I find particularly interesting in the concept of how the lender-borrower relationship is an example of a asymmetric relationship - one side, the lender, has all the power. The lender is free to walk away from the loan (by selling it to another company), is free to make loans based on over-inflated property values (without doing any significant research to verify those values and then expect a government bailout when their lack of due diligence catches up to them), and is free to, in effect, modify the terms of the mortgage to include more than just the property as collateral, without any legal or moral ramifications, yet the borrower has no such options. In fact, even though the mortgage document specifically states the lender's SOLE COLLATERAL for the loan is the property, the lender is able to also use the borrower's credit score and self-image as collateral as well.
So what does he propose be done to help homeowners? One suggestion is to prevent lenders from reporting foreclosures to credit reporting agencies. This sounds crazy, but he makes a good case:
There are many more arguments he makes, which I don't have the space to go into here. I encourage people to read his paper with an open mind. Needless to say, the banking industry fiercely opposes his ideas.
Now, University of Arizona law professor Arizona Brent T. White has published a paper (pdf) stating, contrary to news reports, not many people are doing this - but they should. He cites people's emotional fears as the driving force preventing them from acting in their own financial best interests - the fear of the shame and guilt of foreclosure and an exaggerated sense of the consequences of foreclosure. He also argues these fears are actively encouraged by the government, lenders, and other social agents to induce borrowers to ignore what might be the wisest financial decision for them.
I found this paper very interesting, mainly because it presents almost the complete opposite picture of human behavior that Freakonomics does - namely that people will NOT act in ways which benefit them financially the most. I think the difference here is due to the amounts of money involved, as well as social pressures. The actions looked at by Freakonomics dealt with relatively small amounts of money and with actions whose consequences have fewer social repercussions.
White states:
Homeowners should be walking away in droves. But they aren’t. And it’s not because the financial costs of foreclosure outweigh the benefits. To be sure, foreclosure comes with costs, including a significant negative impact on one’s credit rating. But assuming one had otherwise good credit, and continues to meet other credit obligations, one can have a good credit rating again – meaning above 660 - within two years after a foreclosure. Additionally, in as little as three years, one can qualify for a federally-insured FHA loan to purchase another home.
While the actual financial cost of having a poor credit score for a few years may be hard to quantify, it is not likely to be significant for most individuals – especially not when compared to the savings from walking away from a seriously underwater mortgage. While a good credit score might save an average person ten of thousands of dollars over the course of a lifetime, a few years of poor credit shouldn’t cost more than few thousand dollars.
I find his arguments to be well-thought out and worth thinking about. There is a definite basis against people who walk away from their mortgages:
This is not to say that there is a grand scheme to manipulate the emotions of homeowners, or even that the government and other institutions consciously cultivate these emotional constraints on default. But, to be sure, the predominate message of political, social, and economic institutions in the United States has functioned to cultivate fear, shame, and guilt in those who might contemplate foreclosure. These emotions in turn function as a form of internalized social control – encouraging conformity to the norm of meeting one’s mortgage obligations as long as one can afford to do so
What I find particularly interesting in the concept of how the lender-borrower relationship is an example of a asymmetric relationship - one side, the lender, has all the power. The lender is free to walk away from the loan (by selling it to another company), is free to make loans based on over-inflated property values (without doing any significant research to verify those values and then expect a government bailout when their lack of due diligence catches up to them), and is free to, in effect, modify the terms of the mortgage to include more than just the property as collateral, without any legal or moral ramifications, yet the borrower has no such options. In fact, even though the mortgage document specifically states the lender's SOLE COLLATERAL for the loan is the property, the lender is able to also use the borrower's credit score and self-image as collateral as well.
One obvious response to the above discussion is that society benefits when people honor their financial obligations and behave according to social and moral norms, rather than strictly legal or market norms. This may be true if lenders behaved according to the same social and moral norms. In the case of lender-borrower behavior, however, there is a clear imbalance in placing personal responsibility on the borrower to honor their “promise to pay” in order to relieve the lender of their agreement to take back the home in lieu of payment.
Given lenders' generally superior knowledge and understanding of both mortgage instruments and valuation of real estate, it seems only fair to hold them to the benefit of their bargain. At a basic level, sound underwriting of mortgage loans requires lenders to ensure that a loan is sufficiently collateralized in the event of default... In other words, in appraising a home the lender should ensure that the loan amount, at the least, does not exceed the intrinsic market value of the home...since lenders generally arrange the appraisal (which home buyers must pay for) and home buyers rely upon the lender to ensure the home is worth the purchase price, one might argue that lender should bear much more than 50% responsibility for the bad investment of the homeowner and lender.
So what does he propose be done to help homeowners? One suggestion is to prevent lenders from reporting foreclosures to credit reporting agencies. This sounds crazy, but he makes a good case:
The suggestion that Congress should amend the Fair Credit Reporting Act to prevent lenders from reporting mortgage defaults is premised upon the underlying mortgage contract, in which lenders agree to hold the house alone as collateral. In the case of underwater mortgages, however, the portion of the mortgage above the home’s present value essentially becomes unsecured. Lenders compensate for this by holding the borrowers’ credit score, and thus their human worth, as collateral – thereby altering the underlining agreement that the home serves as the sole collateral. As a consequence, lenders are often able to reap the benefit, but escape the costs, of their bargain.
There are many more arguments he makes, which I don't have the space to go into here. I encourage people to read his paper with an open mind. Needless to say, the banking industry fiercely opposes his ideas.
Windows 7 Calculator Tip
I've just upgraded to Windows 7 and am still exploring all the new features, but one thing I noticed that could be of use to real estate investors is a new function in Calculator. Now Calculator can easily figure out any one of the following items given values for the others: Monthly Payment, Purchase Price, Down Payment, Term (Loan Length), and Interest Rate. No more messing around with spreadsheet formulas! Below is a picture of how to access this. (Click for larger size.)
Another Hard Money Loan Starting And One Wrapping Up
Got some emails yesterday for two new hard money opportunities from my partner in California. I only have the funds available for one right now, unfortunately.
The deal I chose is a first mortgage on a property in Castro Valley, CA. The property is a 1,500 square foot duet, built in 1979. (A duet is similar to a duplex in that it is two units that share a common wall. However, unlike a duplex, the units can be owned by different parties.) The property was bought at a foreclosure auction by two professional rehabbers. They already have a mortgage on another property with my partner and they are paying on time on that one.
The rehabbers bought the property for $254,000. My partner estimates it will take about $20,000 to fix up. Comps are conservatively valued in the $320,000 and up range. There is one comp that is currently on the market listed at $339,000, although it has been on the market for 2 months, so that might be a tad high. Another comp is in the sale pending status with a price of $299,000. Our property is in a better location, however. The defaulted mortgage was in the amount of $325,900, but the lender started the auction bidding at $198,900. The price was bid up to $254,000, which is the price the borrowers got it for. We are writing a mortgage for $192,600, which is a 75.8% LTV, using the conservative comp figure. Terms are the usual - 10% net to me, the investor (borrower is paying 12%, but my partner keeps 2% as a service fee), interest only payments due monthly, loan term is 1 year. There is an incentive for the borrower to pay off the loan early.
The rehabbers purchased this property on 11/16 and on 11/17, my partner visited the property. There were already workers in there rehabbing the place, so they are not wasting any time on this.
I'll refer to this investment as Hard Money #10.
In other news, hard money loan #9 may be wrapping up soon. The property is in escrow now. We estimated the property to be conservatively worth $330,000 to $350,000. It was listed at $389,000 and it quickly got an offer for $410,000. Nice! The borrower bought it for $238,000 and put about $58,000 in improvements. He'll make a bit over $100,000 on this one in 3 or 4 months time. Nice! (of course, this assumes escrow closes..)
The deal I chose is a first mortgage on a property in Castro Valley, CA. The property is a 1,500 square foot duet, built in 1979. (A duet is similar to a duplex in that it is two units that share a common wall. However, unlike a duplex, the units can be owned by different parties.) The property was bought at a foreclosure auction by two professional rehabbers. They already have a mortgage on another property with my partner and they are paying on time on that one.
The rehabbers bought the property for $254,000. My partner estimates it will take about $20,000 to fix up. Comps are conservatively valued in the $320,000 and up range. There is one comp that is currently on the market listed at $339,000, although it has been on the market for 2 months, so that might be a tad high. Another comp is in the sale pending status with a price of $299,000. Our property is in a better location, however. The defaulted mortgage was in the amount of $325,900, but the lender started the auction bidding at $198,900. The price was bid up to $254,000, which is the price the borrowers got it for. We are writing a mortgage for $192,600, which is a 75.8% LTV, using the conservative comp figure. Terms are the usual - 10% net to me, the investor (borrower is paying 12%, but my partner keeps 2% as a service fee), interest only payments due monthly, loan term is 1 year. There is an incentive for the borrower to pay off the loan early.
The rehabbers purchased this property on 11/16 and on 11/17, my partner visited the property. There were already workers in there rehabbing the place, so they are not wasting any time on this.
I'll refer to this investment as Hard Money #10.
In other news, hard money loan #9 may be wrapping up soon. The property is in escrow now. We estimated the property to be conservatively worth $330,000 to $350,000. It was listed at $389,000 and it quickly got an offer for $410,000. Nice! The borrower bought it for $238,000 and put about $58,000 in improvements. He'll make a bit over $100,000 on this one in 3 or 4 months time. Nice! (of course, this assumes escrow closes..)
Existing House Sales Prices for Q3 2009
The National Association of Realtors has released their list of Median Sales Prices of Existing Single Family Homes for Metropolitan Areas. (Couldn't they have come up with a better title?) Here is a link to the list (warning: it's a PDF file). Prices in some areas are still declining, while other areas are beginning to see a rebound. This list could be used two ways - if you are a bottom feeder and looking to buy in places that might be bottoming out, look for the cities that had the largest decline - Cape Coral, FL (-40%), Las Vegas, NV (-34.5%), or my area, Phoenix (-22.9%). Of course, the danger in this is that prices may not have bottomed out and may keep dropping.
Or, if you want to invest in places that may have already bottomed out and might now be on the rebound, look in areas that had the biggest increase - Cumberland, MD (+19.2%), Davenport, IA (+14.3%), or Oklahoma City, OK (+9.1%).
The NAR tried to put a positive spin on this report, saying "To be sure the numbers are mixed and some areas are experiencing reversals, but over all we are beginning to pull ourselves up out of this slump..." That seems like wishful thinking on their part as the vast majority of areas on this list have experienced pricing declines; only 28 of the 155 areas listed have positive changes.
Or, if you want to invest in places that may have already bottomed out and might now be on the rebound, look in areas that had the biggest increase - Cumberland, MD (+19.2%), Davenport, IA (+14.3%), or Oklahoma City, OK (+9.1%).
The NAR tried to put a positive spin on this report, saying "To be sure the numbers are mixed and some areas are experiencing reversals, but over all we are beginning to pull ourselves up out of this slump..." That seems like wishful thinking on their part as the vast majority of areas on this list have experienced pricing declines; only 28 of the 155 areas listed have positive changes.
