8/10/14: Ask The Guys – Getting Started, Using Leverage and Strategic Default

One our favorite things to do is answer listener questions!  And as the show grows (now up 3.5 million downloads!) we get lots of them.

So we asked our email room manager Walter to send us a stack of emails and we picked some fun questions to talk about for this edition of Ask The Guys!

In the studio for another episode of powerful pontifications:

  • Your brainiac host, Robert Helms
  • His brainless co-host, Russell Gray
  • The oldest brain in the business, The Godfather of Real Estate, Bob Helms

How to get started as a real estate investor is…by FAR…the most popular question we get.  But there are always variations on the theme.

This one is about…

Finding a Mentor

In this episode, a listener wants to know how to persuade an experienced investor / developer to mentor him.  Now that’s a GREAT question!

Of course, this isn’t really an investing question.  It’s a sales question.  And that brings up the whole topic of sales as an essential skill for everyone…including real estate investors.

Sadly, many people consider sales simply as a vocation…and not a very noble one at that.

They think just as some people know how to cook, do carpentry, perform brain surgery, or program computers…that salesmanship is simply something people do to make a living.

Wrong.

Salesmanship is a LIFE skill.  Like reading, writing, arithmetic, budgeting and tying your shoes.

In other words, EVERYONE needs to know how to do it.

Think about it.  If you’ve ever tried to get a job, win a lover, negotiate a good deal on a car, ask for a raise or promotion, etc….you’ve been using salesmanship.  And the better you are at it, the more good things you can attract into your life.

Okay…off the soapbox…

So in this case, the answer to getting into a relationship where someone who doesn’t need your money (that is, you can’t pay them to mentor you even if you could afford it), is to uncover some unmet need, want or desire.  This requires asking good questions and listening carefully.

Most inexperienced people will go in talking…pitching all the features of whatever they’re offering.  Or worse, they lead with their own needs…like a beggar.  Ugh.

Don’t be that guy or gal. Look for things that you can do to help your prospective mentor, investor, lender, seller, employee, partner, vendor…and then negotiate a relationship where you exchange benefit for benefit.

We know.  It sounds so simply and obvious.  But watch the people around you.  Most do not do this consistently or effectively.  So they don’t attract as much into their lives as they could or would like to.

Using Leverage…

In case you hadn’t noticed, equity happened to a lot of folks smart enough to acquire properties when everyone else was scattering like cockroaches.

So a question came in about what do with the equity…leave it, reposition it, or sequester it?

Another GREAT question!

So we dusted off some of our old equity optimization strategies and shared some thoughts.

First, it’s important to remember that equity is wealth on paper.  It’s based on a differential between the market value and the loan balance.

The challenge is that market values can change, and because the loan balance doesn’t change, when it comes to equity, the market giveth and the market taketh away.

Unless you beat the market to it.Cash out refinancing cen be used to reclaim equity before the a market down turn takes it away.

If you don’t like the future prospects of the particular property or local market, you may decide to sell the appreciated property and 1031 exchange the equity into a more promising market and property.

But if you still like the current property, you may decide to reposition the equity by refinancing the existing property and using the proceeds to purchase another property.

Of course, the downside of this is that you potentially negatively impact your cash flow.  Usually, a bigger loan means bigger payments (unless you replace a higher rate loan with a lower rate loan).

But if the property’s income has increased, your net cash flow may end up being the same.

And if the new property cash flows at a rate higher than the cost of the loan on the first property, you could create positive cash flow on the loan proceeds.  That is, if you take $100,000 out at a 5% rate, your cost of funds is $5,000 per year (deductible).

So if you invest the proceeds in a new property that returns 10% cash-0n-cash, you have $10,000 per year coming in.  You just created a positive spread of $5,000 a year.  Nice!

Meanwhile, you own more real estate.  And if values keep going up, then appreciation occurs over a larger base.  That is, 5 % appreciation on $1 million in property is $50,000.  While 5% appreciation on $200,000 in property is only $20,000.

Of course, there’s a dark side…

Your equity is thinner.  After all, $50,000 of equity on a $100,000 portfolio means you have 50% equity.  But $50,000 of equity on $500,000 of property means you only have 10% equity.

So if the market pulls back, you could end up underwater.  A LOT of that happened in 2008.Is strategic default the best answer when a property is underwater?

Of course, if you have good cash flow, and plan to hold long term, it really doesn’t matter.  You simply wait.

Even if the market NEVER recovers, eventually the properties are paid off.  And no matter what the pricing structure, in any economy, paid off properties are nice to have.

If there’s concern about the cash flows on real estate, you might use harvested equity to invest in some other cash flow instrument or investment.

Even though we aren’t fans of being a creditor in a falling dollar world, if you’re using loan proceeds from property A to make a higher interest loan to on a property with a lot of protective equity (i.e., a $100,000 loan on a property worth $200,000), it can still make sense.

Let’s say you borrow $100,000 at 5% and loan it back out at 10%.  You just created $5,000 positive cash flow with less exposure to falling values.

So if the market drops 20%, you have negative equity on the first property with the cheap loan, but you have positive protective equity securing your loan to the borrower on property B ($200,000 less 20% decline means the property is only worth $160,000).

Now if the borrower defaults,  you foreclose and own a positive equity property.

There are other variations, but you get the idea.

As long as there are better things you can do with your real estate equity than leave it in the property, and it only costs you a modest interest rate and some fees to extract it, it can be a very powerful tool to accelerate your cash flow and equity growth.

However, if you have negative equity AND negative cash flow, you might decide that it’s not worth writing a check each month from other resources simply to save your credit score or hold on to a property you’ve lost faith in…which brings up another question about…

Strategic Default

We had a great question come in from a guy with a nice home in the Phoenix area.  It’s underwater and he can’t rent it out for enough to cover the mortgage and expenses.  Ouch.

So he’s trying to decide if just handing the lender the keys (deed in lieu of foreclosure) might be worth it.

A deed in lieu is a form of strategic default where you simply turn over the keys and deed in lieu of a foreclosure.He’s got a non-recourse loan so the lender can’t ask for anything else besides the house.  So his personal assets are safe.  That’s good.

BUT…it means a big hit to his credit score.

However, he says he hasn’t really used his credit score for anything for nearly 9 years, and he knows that it will heal itself over time, so why not just take the hit and get out from underneath the negative cash flow?

Another great question!  Though not exactly the way he asked it…

He’s looking for reasons to walk away from the property.  Emotionally, he’s done.

We, on the other hand, see the value in a high credit score, and would like to see him keep the property if possible.

Why?

First, about the property…

It’s a very nice executive home in one of the top retirement metros in the U.S.  And last time we looked, over 11,000 baby boomers are retiring EVERY day.  AND…they’re looking for big city amenities at a more affordable price.

In fact, if only 5% of the 11,000 boomers retiring every day want warm weather, big big city amenities, and quality infrastructure (travel, shopping, health care, entertainment, open space, golf, etc…), that’s 550 people each day who may choose a place like Phoenix.

So even though there’s a glut of properties on the market in his neighborhood right now, that probably won’t last forever.

Next, we know the Fed and the government are doing everything they can to prop up the value of homes.  There’s an old saying in investing – Don’t fight the Fed.  You might disagree with their policies, but they’re inflating real estate anyway.

Also, remember that prices fell because of de-leveraging when the mortgage industry imploded.  But recent headlines tell us lending is loosening up…especially at the higher end of the market.

So we think there’s a good chance more purchasing power is headed into his property niche.  That’s positive for long term values.

Also, he’s got a good loan on the property.  Good loans are nice to have.  Especially in an inflationary environment.  Every dollar in debt gets to be paid back with a dollar of lesser value.  Borrowers win when inflation is present.

Second, about his credit score…

Banks are loosening guidelines right now because they want to make loans.  They’re trying to attract borrowers.  But not on the low end.  They want good credit scores, solid balance sheets and documentable income.

This guy has all three.

So, his credit score is valuable asset because he can get his hands on cheap capital. And he can make money with cheap capital.

In fact, he can probably very easily make enough money with just his credit score that he could more than make up the negative cash flow on the underwater property.

But, you say, doesn’t that put his credit score at risk?

Yes.  But he’s already decided he’s willing to throw it away.  So why not go for it?  As long as the future deals are all set up non-recourse, the only thing at risk is the credit score.

And the only thing missing is knowledge about how to do it.

The point here is that before you get emotional and simply throw in the towel, it’s important to explore ALL the options.  And when your focus is on how to make profit versus simply cut losses, a whole new world of opportunities open up to your imagination.

So listen in to yet another imaginative episode of Ask The Guys!

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