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Real Estate for Dummies

July 2011 How to Invest in Real Estate in today's financial environment

I do not think my readers are Dummies, but they may be bamboozled by Bank Lending practices. Real Estate prices are still heading lower, at the rate of 1% per month, since the beginning of 2011. Since buying a house remains risky, can you, the home buyer, minimize your risk?

Answer: Yes! Don't deal with banks. Find private financing.
The key point: Suppose you borrow $300,000 from a bank with a 30 year mortgage at 4%. You pay 1432/month, of which over 90% is interest for the first five years. A private investor may lend you the money at 2%, or 10 times more than they can currently earn on their bank savings accounts.. You would pay $500/m. You would save $932/m. Even if the investor wants 4% simple interest you would still save $432/month over an amortized Bank loan at this rate.

A bank will force you to pay back the amount borrowed over the life of the mortgage (30 years is typical in the U.S) under the guise of “amortization” (if you can even qualify for a mortgage loan - most people don't) If you fail to make payments as agreed, even if only10% of your payment is
towards interest), you will lose your home to foreclosure. As you build up equity, your risk increases if foreclosed. The bank's risk, however, decreases with each payment you make.

Would it not be better for you, if you, the borrower, had control over the equity? For example, you could agree to pay just interest and invest at least some of the savings in the property you purchased. Remember: A trip to Europe or a new car is not an investment in your property but a remodel of your kitchen or bath, or improved landscaping is. Such improvements add value and reduce the risk for you and your investors, even if home prices continue to fall. On top of that, your improvements would create work for the benefit of your community You would still be able to deduct interest payments from your taxes.

However, use caution. Spend wisely. Do your homework.

What does the bank do with the money you pay it back every month? It invests it where and how it pleases, for example on Executive bonuses or Speculation (see comments on some of the more outrageous “investments” banks make later under “Bank speak”) Will these “investments” help you or your local community? Do they increase the value of your property?
No.

.A private investor may be interested in lending on your property for only 3% or even 2% interest annually, since bank saving deposits pay only 0.2%. You could also offer your investor equity participation. Of course, if the investor keeps his money in a savings account, even at 0.2% annually, the funds are more liquid and can be withdrawn at any time. Anyone concerned about liquidity should not even consider investing in real estate. Not today. Your investor should require only a reasonable return on his money.

Your investor will also want to be repaid his principal at some point. Every 5 years, the contract could come up for renewal (as is often done in Canada, for example). . At that point, if you borrowed at 2%, interest, you will have been able to invest almost $56,000 of savings in the property. If prices haven't changed in 5 years, your house is now worth $56,000 more, but you still only have to refinance the original $300,000. You own a 56,000 cushion (equity), not the bank. If your investor does not want to renew his loan, you will have multiple refinancing options, for example a new private investor, because the $56,000 has actually increased the market value of the property even if prices have stayed flat.

One more point (no pun intended): Banks charge points and fees at every turn. When Loan brokers get involved they charge commissions on top. If you find a private investor yourself, it costs you nothing. Closing costs are a necessary evil, but can be included in the money you borrow

Alternative:
Your investor does not have to invest his money in you, he can invest the money in the real estate itself, and lease it back to you on a long term lease with an option to renew. He can claim depreciation on his tax return, thus increasing his yield. The amount of the lease is decided when it is signed. The interest is added to the Investor's income, but the interest you pay can still be deducted from your taxes. Property taxes and insurance usually become your responsibility but are negotiable. The investor can include a clause to allow you to purchase the property from him when the lease renews should you both wish. An option to extend the 5 year lease by two more five year periods, is common in commercial leases, and the concept could easily be expanded to include residential leases.

A bank gives you no option. It dictates the terms. All 15 pages of them. In fine-print legalese. If you are prudent when signing a Bank mortgage loan agreement, you will have to hire an attorney to decipher what the bank's attorneys wrote. You will find out that all the terms (late fees, cancellation clauses, prepayment fees etc) are in the bank's favor. When your lender is the Bank, it will also demand a substantial down-payment, of course! When home prices go down, you lose your job and the bank forecloses, you lose this down payment and the Bank keeps all your money. For more details, see my topic The mortgage pit.

The only way you can come out ahead is if real estate prices go up a lot. Even in this rosy scenario if prices do not go up enough, you may lose your down payment anyway! If you are forced to sell, for whatever reason, don't forget to consider the transfer costs (10%?). Good luck with a Bank financed mortgage loan! The risk is entirely yours. How banks still manage to lose money when all the odds are in their favor says something about their management skills, but that is another matter for another post!.

You and your private investor must lay everything on the table and negotiate a fair contract. Whatever is mutually beneficial can be written into a simple contract creating a win-win scenario without the need for adversarial (read “expensive”) lawyers on both sides. Remember, you must both win. Not just you. Not just your investor.

If you and your investor manage to put together mutually a acceptable agreement, you will have accomplished far more than first meets the eye.: You will have done on a small scale what needs to be done throughout the economy, i.e.make money more productive and take a giant step towards ending this recession. You will have converted non-productive bank dead weight (fees and more fees, legalese, penalties, commissions) into productive assets. You will be creating value, work and jobs. I promise that Banks won't like this approach.
Vivat, Crescat, Floreat
If you have any questions, please call me at 530-472-3697

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