The Cash Flow Mercenary - Metro Detroit Cashflow Real Estate

A voice of reason in the darkness. Hat tip to LM for the link.

Thomas Paine looks good for a guy his age.

How many times have you heard that OPM is the key to all the riches in real estate?

Seriously - you can’t turn on a single late-night real estate tv infomercial without some fly-by-night “guru” with a Bentley and a bevy of blonde babes screeching at you about using OPM to make you rich beyond your wildest dreams.

I should know - I’ve watched them all. (For the information only. Not the babes. Really)

The question though, is a serious one. Is access to OPM truly the Holy Grail of real estate investing?

Personally I say both YES and NO, because it can be either a tremendous blessing OR a debilitating curse.

Let’s DEFINE it first though so we’re all clear on the concept.

Other People’s Money (OPM) quite simply is money that’s not your own. It includes everything from unsecured business and personal lines of credit to money that you raise from private investors, and every other source like it under the sun.

On the plus side, OPM is very attractive, especially if you have limited (or zero) money yourself. OPM lets you participate in transactions that you wouldn’t otherwise participate in, and if managed correctly it can help you build wealth.

One of the very favorable aspects of using OPM is that you can often set the interest rate that you’ll pay when you use money loaned by a private individual. Right now I pay my private investors anywhere from a fixed and secured 6.0% to a fixed and secured 14% annual interest, depending on the risk involved. They’re happy every point along that range because the returns that I pay are substantially greater than those in the various markets - and my returns are secured.

The down-side of OPM, though, is significant.

While interest rates on loans from private investors are often done with fixed rates and terms, interest rates on unsecured lines of credit are just about always variable.

This generally isn’t a problem if the money is used for short-term projects, but I know of several investors that have used these types of funds for buy and hold investments. And a few of them even went into foreclosure a year ago when interest rates spiked up.

Another unfavorable aspect of unsecured lines is the fact that they’re callable, which means that at any time the lender can demand repayment in full, and they don’t need a reason and you can’t say no. Think about the likelihood of that happening in this economy when banks are tightening up on their secured loans.

But the most dangerous aspect of OPM doesn’t actually involve OPM at all.

The most dangerous aspect of using someone else’s money is the lack of working capital - or in other words the danger is running out of money. Let me show you what I mean.

Let’s take one of my own houses as an example. I have a rental home in Harper Woods that I bought for $69,250. I received a loan for 100% of the purchase price from a private investor.  And let’s say for the sake of this example that I didn’t have any other money.

So what happens if, say, the basement drain line gets blocked and the full, finished basement experiences a minor flood and that causes some water damage?

Well the house wouldn’t be rentable, and I’d be very worried about mold taking over, so something like this would need IMMEDIATE attention.

And the various costs to address this problem would be significant. The plumber would cost $600-$700 to jet out the roots. The water damage remediation people would cost something in the area of $2000. And the repairs after the fact could cost another $3500 or so.

That could easily be a little over $6000 - or more - for a relatively small problem.

But - if I didn’t have any money, how would I pay for this?

And what happens if I can’t pay for it? The downside would be extreme.

The tenant would move out. I then wouldn’t be able to make the payment to the private investor. Mold would start to take hold and spread, and in a few months the investor would foreclose and get a mold-infested house back.

All because I ran out of money. All because I didn’t understand working capital.

The two points that I’m trying to make are these: 

1. Just because you CAN use OPM on a deal doesn’t mean that you always should, and
2. You need to have a reserve set aside for each property, ESPECIALLY if you’re using OPM.

Lack of working capital is the #1 reason why businesses fail. Don’t be a statistic!

The Majority of U.S. Homeowners Thinks Their Home is Insulated from the Housing Crisis

According to Zillow Q2 Homeowner Confidence Survey 62% of homeowners believe their home’s value has increased or stayed the same in the past year yet 77% of U.S. homes actually declined in value

Short-Term Outlook: More optimism for own home vs. neighbors’ homes in next six months although 70% say they are concerned foreclosures will decrease home values in their market within next year; 56% planning home improvements


SEATTLE (August 6, 2008) -  Despite widely covered housing woes and significant market data to the contrary, homeowners reveal high confidence in the value of their own home with even greater optimism for the next six months, according to the Zillow® Q2 Homeowner Confidence Survey of 1,361 U.S homeowners conducted by Harris Interactive®.  Highlights of the survey are below.

“Not My House!” Sentiment Showcases Wide Homeowner Perception-Reality Gap

Nearly two out of three (62%) homeowners think their home value has increased or remained the same in the past year.  Unfortunately, the reality of the market is not quite as bright; in fact, it’s getting worse. Seventy-seven percent of U.S. homes lost value in the past 12 months, according to preliminary analysis of Zillow’s Q2 Real Estate Market Reports, due to be released August 12, while only 19 percent increased and 5 percent remained the same. Whether it’s apathy, confusion or just plain denial, homeowners seem to believe the housing crisis affects every other home but “not my house,” underscoring a wide gap between homeowners’ inflated perception of their home values and the gloomy market reality. 

To monitor this perception-reality gap over time, Zillow has created the Home Value Misperception Index, which is the difference between the adjusted percentage of homeowners who believe their home value increased over the past year and the adjusted percentage of homes that have increased in value.  Nationwide, the Q2 Home Value Misperception Index is 32, reflecting this broad gap.  Those in the West, which has the highest proportion of homes (88%) that declined in value during the quarter, seem to have the best grasp on reality with a Misperception Index of 23, while those in the South have the widest gap at 36.

Not a big fan of his music but Kid is right on point on this.

Hat tip to my buddy Mark for telling me about this.

I read an interesting article this morning on Marketwatch.com. Specifically a piece by Marshall Loeb.

Now as a finance guy I normally skip articles by Loeb and his cohorts at competing web sites, because their content is bland, vanilla, and always so overly general that nothing they recommend or discuss can ever be directly implemented. And after reading them I usually I feel like a cross between the AFLAC duck as he walks out of the barber shop after the “conversation” with Yogi Berra and someone that just got off the phone with Microsoft technical support.

Such is the constraint of trying to dispense deep and meaningful financial guidance in 500 words I suppose.

And the piece that I read this morning was no different, dispensing overly generalized “wisdom” that hasn’t a prayer of being implemented by anyone. So I’ll spare you the  meaningless content.

The title, though was what caught my eye.

It read: “How To Buy Rental Property” and the tag line added “And Take Advantage Of A Down Market”.

????

This is the first time since the real estate downturn started that a mainstream, widely read finance columnist (at least one that I have seen/read) has even remotely suggested that real estate would make a good investment. And in fact most have continued to screech the benefits of continuing to invest in mutual funds and ignore the losses because we should have a “long-term focus”.  (Side note: Have you ever done the math on how long it takes to make back a 30% loss in your portfolio’s value? If not you should – it would be eye opening.)

But this recommendation is really a disturbing development. And it can only mean BAD news for real estate investors.

Why?

Because for most of the last two years investing in real estate, especially in severely distressed markets like we have here in Metro Detroit, was exclusively the domain of the truly contrarian investor. That is, investors that enjoyed swimming against a tide of opinion that was 100% against them, with the exception of other contrarians.

And they have been rewarded handsomely for their resolve.

But now this – this populist columnist – is now suggesting that you need not be a contrarian to invest in real estate?

For me this signals the bottom of the market.