Hard Money Loan #11

My partner finally found another property to invest my principle from hard money loan #9, which was paid off a little over a month ago. Hard money loan #11 is on a property picked up for one cent over opening bid at a foreclosure auction in San Ramon, California. I normally don't post photos of the properties I am lending on here, but this one is just beautiful, so I have to. For a foreclosure, this is in excellent shape.




This was a rental property and my partner spoke with the owner (who was being foreclosed on). He said he has two tenants living in the property who are paying him $1,600 a month in rent. The lender sent the tenants a letter stating they can live in the property for up to 60 days after the sale. Not sure what authority they have to make that promise since after the sale, it is no longer the lender's property and they should have no say in what is done with it. But anyway, when my partner was there, the tenants were loading a U-Haul, so they don't seem to be planning on staying.

The house was purchased at auction for $577,000 cash and the first mortgage I am a part of will be for $400,000. This gives a LTV of 69% based on the purchase price. The property was purchased in 2004 for $860,000. Current estimate of worth is between $650,000 and $700,000. Buyer is my partner's wife, who has a credit score in the 800s. The interest rate is 9%, which is one percent less than what I normally get. I consider it an employee discount :-) Mortgage is for one year, but we expect it to be paid off in 6 months.

New Year, New Opportunities

The holidays were a pretty busy time for me and I realized I neglected to write about the performance of my Houston apartment complex investment. I also just got the update for December, so I’ll write about both now.

In November, occupancy dropped to 90%, due in part to the declining Houston economy. This property still continues to outperform the other apartment complexes in the area by 3-5%. The manager expected vacancies to remain at this level though December due to the holiday season, but expressed hope that rentals will increase after the first of the year. Cash flow decreased to just under $4,000 for the month and was impacted by higher insurance costs and real estate tax escrow requirements, as mentioned in the last update.

For December, occupancy remained flat, as expected. The submarket we are in declined to an overall occupancy of 87%, so we are still ahead of the curve. Unemployment in the area has increased from 6.5% in Q1 of 2009 to 8.4% in Q4 of 2009. Obviously, that affects the availability of renters. The Managers are cautiously optimistic for 2010 because job losses have slowed and they have increased their marketing efforts to attract new tenants. Cash flow dropped to just around $350, still impacted by higher insurance and tax escrow requirements. The good news is the management has obtained new insurance that will reduce the cost by about 30%, which translates to a savings of about $35,000 per year. The decrease in cash flow means there will be no end of year distribution to investors. For 2009, investors so far have received a 6.75% annual return overall. Management fully expects investor payments to continue next quarter. The semi-yearly investor conference call will be held the first week of February and I’ll have more info then.

I continue to receive on-time payments on hard money loans #10, 8, and 4. HML #9 was paid off at the end of December and that money is sitting with my partner looking for a new investment. We had one lined up, but it was a short sale and at the last minute, the bank decided to reject the offer, so that fell through.

My move towards a self-directed IRA is making progress. I have converted my rollover IRA to a tradional IRA and then to a Roth IRA. The next step is to transfer the funds to the company the sets up the self-directed IRA. I was planning on going with the iTrust product, but after discussion with the company, have realized that the LLC product, rather than the trust, is a better fit for what I will be doing. The only thing holding this up is that I haven't had time to fill out the paperwork yet. I hope to get that done this week. I'm not in a huge rush as it seems the hard money opportunities are slowing down a bit. My partner is noticing increased competition at the foreclosure auctions.

And finally, it’s been over a year since I was laid off from my day job, but I will finally be hired as a full-time employee again come next Monday. The company I have been working as a contractor for for the last nine months or so has decided to bring me on board permanently. While my passive income is not yet high enough to cover my living expenses, it was high enough to cover the expenses of my loans and credit cards during the year I was laid off. (I normally don’t carry a balance on my credit cards, but the layoff changed that temporarily.) It was a huge relief knowing those bills were covered during the times I had no income coming in. My practice of putting 15% of my paycheck into a savings account also helped my ride out that year. This whole experience has taught me the importance of both passive income and maintaining an emergency savings account.

HML #9 paid off

Between Christmas and New Years, hard money loan #9 was paid off. I made a couple thousand dollars on it. I'm leaving my principle with my partner for investing in another loan when he finds a good one.

Over Christmas, we had some out-of-town relatives staying with us and one night, my brother-in-law handed me a real estate listing for a property that was literally down the street from my house. It was listed for $90,000! Being that I live in the neighborhood, I know that property was worth at least $250,000. So we walked down the street to look at the house. It was night, so we couldn't see much, but we could tell it was still occupied. It looked to be in good condition on the outside. The listing said it had a pool. Back at home, I did some more research. Obviously, this was a foreclosure or pre-foreclosure, but I couldn't find anything in my search of public records. No notice of foreclosure auction, no judgments against the owner, nothing. If I had to go based on my research, I'd say the owner was not in any sort of financial difficulty at all.

The following day, I called the listing agent and asked if the $90,000 price was correct. He said it was, although he had received offers so far up to $150,000. He confirmed it was heading to auction. The agent's cell phone cut out, so I didn't get more info, but it sounded good.

The average selling time for properties in the neighborhood is 6 months. I ran some numbers on the conservative side - using an 8 month holding time, below market selling price, etc. and the results looked pretty good. For an all cash deal at $160,000, they could get about a 42% annualized return in that 8 months. Unfortunately, they had no funds available, so they had to pass. I passed as well, since most of my funds are tied up in hard money loans right now. Too bad.

One interesting thing is that I found the original note for the loan on the property and it was for more than $90,000. More than the current high offer of $150,000. That must mean they are trying a short sale, which means the lender would need to approve the final sales price. I would have thought the listing agent, who was a Realtor, would have mentioned this. I also suspect the $90,000 listing price was deliberately set low to attract potential buyers. I'm not sure about the ethics of this and I'm not sure what requirements Realtors have in setting the initial asking price, but it seems like a used-car salesman trick to me.

In other news, my progress towards rolling my IRA into a self-directed Roth IRA is slowly moving forward. For tax reasons, I had to wait until 2010 before I could do the actual conversion. I'm going about this in a couple steps. First, I am converting my Rollover IRA to a Contributory (Traditional) IRA. They are basically the same thing, but my CPA tells me the law that allows me to spread out taxes on the Roth conversion for two years only specifies conversions from a Contributory IRA to a Roth, not a Rollover. The law will probably be changed to fix this, but just to be on the safe side, I'm taking this extra step. The second step will be to convert the Contributory IRA to a Roth IRA. I will do this at the brokerage the IRA is currently at. The third and final step will be to transfer that Roth IRA to a company to who will set up the self-directed IRA. I am currently leaning towards the iTrust offered by NAFEP.

I am currently at the first step in this process and imagine it will take a couple of months to get everything all set up.

Self-Directed Roth IRA

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:

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.