Guest post by Brian Blum, Operating Manager, Maverick Structures LLC
I’m a real estate investor. I see opportunities in buildings – and in numbers, and I use those opportunities to create income and equity. What I do benefits society, but I’m not going to lie to you – I am driven to do it for my own benefit, and society’s gain is a side effect. Nonetheless, I can’t do it without society – I can’t charge more rent than the market will bear, else I won’t find tenants.
If I find a vacant building, foreclosed, neglected, and being sold off at a discount, I can buy that building, rehabilitate it, and offer it to society as additional housing options. When I rent an apartment to a family, they have choices. They could rent an apartment elsewhere, or they can rent mine. If they choose to rent mine, it’s because it benefits them – it is the best choice being presented to them. I have helped them by making that apartment one of the choices for them to consider, whereas it did no one any good by being vacant and uninhabitable. To make that choice available to them requires an investment on my part; I have to see the opportunity. I have to recognize that the building is being offered at a price that, after repairs, taxes, utilities, insurance, and legal costs, will earn me a profit. I have to believe that the ratio of risk to reward makes that investment option a better choice for me than other investment opportunities; else I’d be better off choosing another investment opportunity.
If I’m too greedy, some other investor will snatch the buildings out from under me at a higher price, but if I’m too naive, I’ll pay more for a building than I have to, and my profit will be lower. There’s something of a “survival of the fittest” element at play here, in that stupid investors tend to be out-performed by smarter investors, and that gives the smarter investors more of an opportunity to make more investments. Even a smart investor, however, can’t possibly be a party to every deal in a geographic area, so there may be multiple investors in a given pond.
If I see a building that another investor has renovated, rented, and is offering for sale, I can alleviate him of his future risk by buying his building from him. He might have to deal with slow-paying or even non-paying tenants, he might have to repair damages or ordinary wear-and-tear, or he might have to fight with his insurance company if his building is burned to the ground. I undertake and relieve him of these risks, and in doing so, I create liquidity for him by redeeming his investment and a fair profit so he is encouraged and enabled to reinvest it elsewhere. He can then buy and rehabilitate another neglected building, making it available to rent, and his motivation is that it will be a profitable endeavor for him, too, else he would make different investment choices. When I buy it from him, although he has already done all the work to make it inhabitable and profitable, I am still undertaking risks, and I will be responsible for maintenance and management, so I still need to be compensated for my investment. Consequently, before I will buy his building, I need to determine that the anticipated rent income will more than cover my expenses, and so much so that I will be rewarded for my investment more so than I would be rewarded in other investment choices at my disposal. He wins, I win, and the tenants win … and the government taxes all parties to it.
Just as I can help another investor with his investment in a property, so, too, banks can help investors playing the property investment game. Banks pay interest on deposits and charge interest on loans. Nowadays there are many other ways for a bank to earn money, such as fees and various other investments, but the difference between the interest they charge and the interest they pay is one of their primary sources of income. If a bank offers too low of an interest rate on savings, they won’t have money to lend, and if they charge too much interest, no one will want to borrow it. On the other hand, if a bank pays too much interest on savings or charges too little on loans, they will not be as profitable as they could, and they will be out-performed by smarter banks. Again, “survival of the fittest” comes into play.
Depositors are not, however, the only source of funds for bank loans. The government also lends money to banks. When the government lowers that interest rate, it compels banks to lower the rates they charge borrowers (in order to compete with other banks), and that makes borrowers borrow more money. During the housing boom of the early 2000s, that was a major factor in the low interest rates banks were charging, which encouraged people to buy and refinance homes, and to take out new mortgages. When the government raises that interest rate, (or when teaser rates expire in anticipation of that rate going up,) banks raise the rates they charge their borrowers, and that is one of the reasons that so many people can’t afford their mortgages today.
But there’s more to it than that. There are limits to how much the government will lend banks, which is a function of how many funds they have on deposit. When a bank lends money for a mortgage, they move towards that limit of how much they can borrow, so instead of keeping that loan on their own books and servicing it, taking perhaps 30 years to recoup their money, another government-related firm, Fannie Mae or Freddie Mac, buys those loans from them, replenishing the bank’s pool of funds for lending. Without Fannie Mae and Freddie Mac, banks would run out of liquidity themselves and be unable to continue lending money to new borrowers. Fannie and Freddie were chartered by Congress to buy loans, bundle them together into “mortgage-backed securities” and resell them to investors.
Fannie and Freddie set guidelines of what terms and debt-to-equity ratios were considered “conforming” loans, but as the market heated up, there was little verification of conformity, and ultimately, loans were made to sub-prime borrowers based on “stated income” or “no documentation,” rather than “full documentation” with “income verification.” As long as the banks could unload these hot potatoes to Fannie and Freddie, they didn’t care, and as long as Fannie and Freddie could package and resell them to unsuspecting investors, they didn’t care. Ratings agencies, such as Moody’s and D&B continued to give these mortgage-backed securities high credit ratings, encouraging pension and retirement funds to invest trillions in them, precipitating a disaster for hundreds of millions of average inexperienced investors who simply relied upon their fund managers to make decisions that they hoped would be in their best interests.
When interest rates went up and people started defaulting on their mortgages, the poison had already spread to millions of Americans and even to foreign investors. Fannie and Freddie, who were chartered and funded by Congress, might have been fine if they had followed their mandates, but while the getting was good, they started drinking their own Kool-Aid; they started stockpiling mortgage-backed securities, investing the money that Congress gave them to perform their job – our tax money – in these poison investments. When the ratings finally dropped, they couldn’t unload the loans to investors, so they couldn’t replenish their funds, and couldn’t buy more mortgages from banks. Loan “conformance” guidelines got tougher and banks couldn’t unload their hot potatoes. This meant that they had no replenishment of funds with which to make new loans. Without loans, investors and homeowners couldn’t buy properties, and if you’ve ever studied the most basic tenets of economic theory, the principal of “supply and demand” promises that when demand decreases, prices will decrease, too. Homeowners were now “under water.” Not only couldn’t they afford the increased interest payments, but their home values had dropped, too, leaving many of them owing more than their homes were worth.
If you could buy a home for $200,000, or continue paying your $300,000 mortgage for a comparable home that was only worth $200,000, what would you do? Many of them started walking away from their homes and their obligations. Banks had to foreclose on them, but banks don’t want to be in the real estate management business, so rather than maintain and rent them, banks sell them. Returning for a moment to basic economic theory, increases in supply also depress prices, so the foreclosure auctions further pushed the economy downward. Banks were recouping only a fraction of their investments, making it harder still for them to make new loans.
There were a number of other factors contributing to the current economic downturn. I haven’t even touched on how the crisis affected business loans, and consequently business development. We can draw a clear line to connect the dots between businesses failing, stock market declines, unemployment, the credit crunch, reduced consumer spending, and a lower GDP. That, plus increasing gas prices, tax-funded bailouts of banks and auto manufacturers that were “too big to fail,” the soaring costs of our “war on terror” and military actions in Iraq and Afghanistan, and the ballooning of government (most obviously demonstrated by the behemoth Department of Homeland Security and it’s prodigal child, the Transportation Safety Administration), have devalued our currency against other nations. We could also discuss how inconsistent tax assessment laws and decreasing home values have created a barrage of tax grievances and court cases which have wreaked havoc with many municipalities’ budgets, creating more layoffs, reductions in municipal services (closing fire houses, reducing garbage pickups, consolidating schools, etc) It’s really something of a “perfect storm” of financial catastrophe.
But that’s enough background – let’s get back to the story about me…. The pendulum has swung back too far; banks have become overly cautious. They were encouraged by our government to make too many bad loans, got screwed, and now they’re reluctant to make even good loans. As a real estate investor, that’s a problem for me.
I have three different investment properties in “the funnel” right now, and I can’t afford to close on all of them without help – one or possibly even two, but certainly not all three. One is a six-family building for which we were waiting for the seller’s bank to approve a short sale; we’ve already lined up financing, and we’re hopefully moving forward with that one. One is a seven-family building for which our bank just told us they’re not going to be able to lend us more money. The last is two side-by-side three-family buildings, mostly vacant, which we may be able to buy without direct financing if we can get other ducks in a row. Let me use these last two investments to highlight why I think the banks have gone too conservative.
If you had $1,000 in a savings account and $1,000 in credit card debt, the math is pretty simple: you have a net worth of $0. However, if you were earning 1% on your savings and were paying 21% interest on your credit card, at the end of the year, you’d earn $10 but owe $210, so you’d end up with a net worth of negative $200. From a purely-mathematical perspective, you’d be better off paying down the debt with the savings to maintain your net worth rather than lose ground every year in interest. The guy who pays it down is clearly the better one at math, and the guy who doesn’t will get himself into worse and worse financial condition every year, probably never understanding why. Overly-simplified, that’s our problem with the seven-family building. We had some cash and a line of credit, and we used the cash to pay down the line of credit until we were ready to buy the building. Now that we’re ready, our bank doesn’t want us to use that line of credit as a down payment for the property that we’re going to purchase with the loan they were otherwise prepared to give us. Had we held onto the cash and not paid their line of credit down, they’d have no problem with us using that cash as a down payment, even though the end result would be the same debt, but we’d be paying interest on the line of credit in the interim. Silly? I think so. If the property upon which we have the line of credit was a good investment and was sufficient collateral for the line of credit, and if the property we’re trying to buy is a good investment and is of sufficient collateral for the new mortgage, what’s the problem? They’d apparently prefer to lend money to the guy who is worse at math. I like my strategy better, but they seem to think they know something that I don’t. I wish they’d clue me in as to what it is…
To fund the two three-family buildings, we’d be happy to get a direct loan, but after all the problems we’ve had with the new lending guidelines, we’ve instead tried to use equity we have on another property. We own another small building outright and tried to get a loan against it. They asked us what we thought it was worth, and we took an intentionally-over-inflated guess, figuring that if we guessed low, they’d never give us more money but if we guessed high, we could always borrow less. Expectedly, the appraisal came back low, but rather than make a counter-offer, they declined our application. I asked if we could be reconsidered at a lower amount, and they said they won’t consider another loan application on the same property until six months have passed. What kind of stupidity is that? To me, it should be quite simple: we have an asset that we now agree is worth $X, and we’d like to use it as collateral against a loan; the only thing left to decide should be how much debt-to-equity ratio the bank can approve, but instead, they’re just saying “No.” I got a free appraisal (at their expense) and a refund of my application fee, and now I have to apply for a loan elsewhere. Does that sound like good business to you? Would you like to own shares of that bank? I’m glad I don’t.
I didn’t want to muddy this article up with too many tangents, but there’s another thing that’s bothering me, so while I’m on a rant, let me get this one out, too. That second bank has different debt-to-equity guidelines for people who are employed (higher) versus people who are self-employed (lower). I asked which category I was, and I couldn’t get a straight answer. I have several sources of income: I am employed and paid on a W-2 by a corporation. I happen to also own that corporation, so when the corporation makes money, I get distributions on a K-1 as a shareholder. I also earn money on my real estate investments, as reported on a Schedule E, and I have various other securities and instruments upon which I earn interest and dividends on 1099s that I report on a Schedule B. If I sell stocks profitably, I earn capital gains, also on 1099s, which I report on a Schedule D. If you’re going to jump to the conclusion that I am self-employed because I own the corporation for which I work, let me point out that lots of IBM and Walmart employees own shares of the corporations for which they work, but you wouldn’t think of them as self-employed. How do you consider the people who have full-time jobs but also have side businesses DJ-ing at parties or taking photos at weddings? Are they not, in that capacity, self-employed? You would argue that those endeavors are but a small component of their income, and that the bulk comes from their regular jobs. If so, then the bulk of my revenue comes not from my self-employed salary (if you insist on calling it that), but from my investments, so my self-employment revenue is also just a small component of my income. As hard as I tried, I couldn’t get them to tell me how I’d be considered, so I’d never know how much debt-to-equity ratio to request, and since they don’t always counter-offer, and won’t let me reapply for six months, they’re basically telling me to take my business elsewhere.
There’s just one last thing along this vein that’s bothering me. My corporation employs one other full-time W-2 employee besides myself. He’s not a part-owner, so he’s clearly not self-employed. He’d thus, be eligible for their higher debt-to-equity ratio loan. If business gets bad, which one of us do you think is going to be fired first? They’ll lend him more money despite the fact that his income is both lower and less secure! Madness, I tell you. I really wouldn’t want to own shares of that bank!
So what’s a real estate investor to do? I’ll keep plugging away, trying more banks and mortgage brokers until I find some that want to make loans. I’ll consider other options, like private borrowing from friends, relatives, and associates, paying them more on their loans than their banks would pay them for savings. I’ll negotiate with sellers to try to get them to hold notes on the buildings I buy from them. I’ll keep my eyes and ears open for other opportunities to finance my investments, and I’ll try to keep my mind open to new ideas. If anyone reading this is or knows of any banks, brokers, or private lenders who want to work with investors buying residential multi-family buildings through limited liability companies, please contact me! I don’t want to publish my email address here, but you can find it at http://MaverickStructures.com. For one, I can’t wait for the pendulum to start swinging back towards center again.
Brian Blum is the founder and operating manager of Maverick Structures LLC, a real estate investment, rental, and management company. He owns, rents, and manages several pieces of investment real estate, and is always on the lookout for good opportunities, reasonable lenders, and rational partners. Brian also founded, owns, and operates Maverick Solutions IT, Inc, a technology consultancy and support provider, serving mostly schools, NFPs, and SO/HOs in the New York Metro Area.