Moses Kagan on Real Estate

Archive for the ‘Debt’ Category

The economics of buying a home in an improving neighborhood

leave a comment »

You can now get regular financing on a house under $419,000 for up to 95% of the purchase price.

These aren’t FHA loans with high mortgage insurance payments; they’re relatively standard bank loans.

Thought I’d run the numbers on a standard, $350k house in an up-and-coming neighborhood to determine if it makes sense for renters to dive in.

Obviously, this post comes with my standard caveat about using lots of leverage: Leverage magnifies outcomes, both good and bad. So, if you’re going to use 95% LTV leverage you better be damn sure that either the value of the house is going to increase or that you will be easily able to cover housing payment even in a down economy.

That said, let’s get to the numbers on a hypothetical $350,000 house with 2 beds, 1 bath and a bit of land:

  • Put down $17,500
  • Borrow $332,500 at 4.125% fixed for 30 years
  • Monthly mortgage payment of $1,611
  • Monthly property taxes of ($350,000 x 1.25%)/12 = $364
  • Monthly insurance of $1500 / 12 = $125
  • Reserve $100 / month for repairs
  • Total monthly payment of $2,200

Now, for most of the neighborhoods in question, $2,200 is a bit more than it would cost to rent the same property.

But owning is a bit more tax efficient than renting. Of your $1611 x 12 = $19,332 in mortgage payments in the first year, ~$13,620 is mortgage interest, which is tax deductible. Assuming your marginal tax rate is 30%, that $13,620 in mortgage interest saves you $4,086 in taxes, or $341 / month.

So, after taxes, you’re actually paying out $1859 / month to live in a 2 bed / 1 bath house in an improving neighborhood.

In my opinion, that is a deal worth doing. If you’re interested in doing something like this and you have good credit and around $25k-30k in cash, get in touch.

Written by mjkagan

12/18/2014 at 12:56 pm

Posted in Buying, Debt

Where are interest rates going?

leave a comment »

I have no idea and anyone who says they know for certain is either:

  1. A liar; or
  2. Should be trading interest rate futures on Wall Street

That said, having a view on interest rates is pretty important in our business.

Why? Because the price of income producing real estate is highly dependent upon the cost of borrowing money.

If interest rates move up, cap rates (the “unlevered return”) move up, and the price of income producing real estate falls. If interest rates drop, cap rates drop, and the price of income producing real estate rises. (For more on this subject, check out this post.)

Given that the future prices of the assets I invest in are heavily dependent on interest rates, I have to have a view, so:

  • Believe we’re in for a period of sustained low rates
  • This is due to a huge glut of savings (worldwide, but also among baby-boomers who are all at peak net worth right now) chasing returns… eg competing to loan money
  • Also do to sustained weakness in almost all of the major developed economies, with the exception of the US
  • Persistently low inflation in the US, causing the Fed to fear deflation (as happened in Japan)

I have no idea if the above is correct. And, even if it is, it doesn’t mean rates will stay as low as they are now… just that it will be a long time before mortgages are 6-7% again.

Written by mjkagan

11/25/2014 at 2:58 pm

Posted in Buying, Debt

The problem with banks

leave a comment »

I’ve been working on a simple bridge loan for a month.

We bought the property all-cash and are capitalized with additional cash to fund the rehab (which has already begun).

We paid $2,051,000 for the building and intend to spend another $700k renovating.

I have asked a bank to provide the following loan:

  • $1.2MM
  • 5% interest only
  • Term of 12 months
  • They asked, and I agreed, that we keep $700k in an account at their bank and use it to pay for the construction

This is a very, very safe loan for a bank to make. Why?

Well, first of all, they’re loaning $1.2MM on a $2.05MM property. That’s $1.2/$2.05 = 59% LTV.

Second: A whole bunch of the cash is staying at their bank during the rehab.

Third: I’ve done this a million times (though never with a bridge loan).

Fourth (and most importantly): We have investor commitments for the $700k we need for the construction, so they’re not loaning to 59% LTV… they’re loaning to $1.2MM / ($2.05 + 0.7MM) = 44% of the total capitalization of the project.

The above is pretty much all you need to ascertain that, yes, there is plenty of security for the loan.

Do you know what would happen if I didn’t pay back the loan:

  1. They would take the building back from me at a basis of $1.2MM plus whatever it would cost to foreclose. They could turn around and sell it for $2-2.1MM that day;
  2. I would lose the ability to work with this investor ever again; and
  3. I would have a foreclosure on my record, dramatically increasing the difficulty of accessing capital for a long time to come.

In light of the above, what are the chances I don’t pay this loan back? Zero, right?

You’d think this would be a simple “yes”. But you’d be wrong. Do you know what they’re doing as I write this? They’re messing around with my (very complicated) tax return trying to figure out what my income is. Look back at the information above… where does my personal income come into the security for the loan? It doesn’t.

And that’s the problem with banks: They fall all over themselves to make risky loans that fit into their cookie-cutter boxes, but can’t get out of their own way on the simple ones where the risk is miniscule.

Written by mjkagan

11/04/2014 at 10:47 am

Posted in Debt

Avoiding a pretty painful “oops”

leave a comment »

A reader wrote in to ask me a question about yesterday’s piece, which argued for refinancing and holding, rather than selling, completed repositioning projects.

The question: “Only thing I don’t understand is why not refi on a LTV more than 60% to get back all of your original 2million dollars.”

It’s a reasonable question. After all, with a property value after stabilization of $3.2MM, you might be able to get a bank to loan you as much as 75% LTV, or $2.4MM.

Remember that we invested $2MM in the hypothetical property, so a $2.4MM loan would allow you to get all of your money out and then some. That seems like a pretty great deal, right?

The reason I stuck to a 60% LTV loan in the example is simple: Risk avoidance.

When you have a fully-renovated property with very high rents, you need to be conscious of the fact that rents can fall in the event of a recession. For example, in 2008-9, rents at our 16 unit building on Reno fell roughly 20%.

Recall our example property, which has net operating income (“NOI”) of $160k. Let’s assume that equates to rents of $220k / year (if you think a 72% operating margin is unusually high, you’re right – our unusually high rents make our properties’ margins unusually high). Now imagine the economy tanks and rents fall by 20% to $176k.

In recessions, expenses don’t fall by nearly as much as rents… the tenants are still going to use as much water / sewer as they did during the good times, right? Let’s say expenses decline by 10%, from $60k / year to $54k / year. What happens to your NOI, the money available to service the debt? Well, it falls to $176-54 = $122k.

Recall that at 60% LTV, our annual debt service was $116k. So, even with the 20% decrease in rents, our NOI still exceeds our debt service and we can still pay our loan and even have cashflow (albeit microscopic).

What would have happened if we had borrowed to a 75% LTV? Our debt service on that $2.4MM loan would have been $146k, which would would have serviced with our NOI of $122k… Ooops.

We at Adaptive get paid a lot of money to avoid “oops” moments. So that’s why we wouldn’t ever lever up as high as 75% on a property with maxed-out rents.

Written by mjkagan

10/31/2014 at 10:32 am

Posted in Debt, Development, How to

An effective wealth building strategy

leave a comment »

One couple, two incomes.

Live on one, save the other.

Buy first 4plex FHA.

Live in one unit, accelerating savings.

Accumulate downpayment for building #2.

Buy building #2 with 25% down.

Resist temptation to increase spending; saving accelerates due to income from building #2.

Buy building #3.



Assuming we’re talking about 4plexes that cost in the range of $800-900k, repeating the above strategy four times results in you retiring with $3+MM (maybe much more, depending on how good the deals were) in equity in today’s dollars 30 years from now.

Written by mjkagan

08/05/2014 at 11:32 am

Posted in Buying, Debt, How to

The difference between a loan broker and a direct lender

leave a comment »

In our business, we frequently have clients come to us with pre-approvals from direct lenders like Bank of America, Wells, etc.

The clients love the banks because they promise high loan amounts and low interest rates.

And, on simple deals where there are no real issues with the borrower or the property, the direct lenders do fine.

So, why do we strongly recommend to our clients that they use a loan broker instead of a direct lender?

Because, when problems come up in a deal, which they almost inevitably do when you’re wading through shit, the direct lenders just decline the loan and head for the hills.

Why do they do this? Bank of America does not care about closing your loan. They’re going to close a million loans. All the bank cares about is not doing anything non-standard so as to avoid upsetting regulators. So, when a problem pops up, it’s much better for the bank to run away. There’s always another loan to do.

Contrast this with a loan broker who gets paid to close deals. All he cares about is closing the loan. If the lender raises an issue with the property or the borrower, the loan broker is there to figure out a creative way to jam the loan through. Because, if she doesn’t, she doesn’t get paid. And, if she does jam a questionable loan through, it’s the bank’s problem, not the loan broker’s.

Now, it should be noted that you’re going to pay for a loan broker’s services. The loan may be a hair more expensive.

But you’re paying for a greater certainty of closing. And, in our business, where the problem is the lack of reasonable deals, the last thing you want to happen as you near the finish line is to have some drone at a big bank tell you they can’t close.


Written by mjkagan

06/04/2014 at 1:14 pm

Posted in Brokerage, Buying, Debt

When to lever up, and when not to

leave a comment »

Regular readers know that I’m not a fan of using lots of debt. Debt (“leverage”) magnifies outcomes… so if you’re highly levered and the deal goes well, you do REALLY well, but if it goes badly, you get crushed.

There are, however, some nuances to my view and it has to do with where you are in a given real estate cycle.

If you are at or near a bottom, for example the years 2009-2011, then you want to load up with as much leverage as possible. The reason is simple: You’re going to have relatively strong cashflow (cap rates usually go up when the economy is recessed / depressed), so you will be able to service the debt. As the economy improves, your cashflow is likely to improve, too, because rents will grow. And the likelihood is that prices will increase over time as the market heals, meaning that your equity will increase and your loan-to-value will decrease.

If, as is the case now, you’re in an up-market, where rents and prices are high, you want to be very careful. It’s going to be tempting to lever up, because banks are loose with debt. But, whether you’re at the actual top or just approaching it, the likelihood is that you will experience rent and/or price decreases within some relatively short period after making your acquisition. If you are highly levered, you will be at risk of defaulting on your debt.

Obviously, the problem with the above advice is that it’s very hard to call the top of the market. You might follow my advice, under-lever, and then find that the market continues to rise for years, meaning you missed out on returns you could have got had you used more debt.

But our game is about longevity. It’s about hitting singles and doubles, lucking into the occasional homerun and, most importantly, avoiding striking out / hitting into double plays. It’s about the certainty of being rich in the long run and not about staking it all on a roll of the die.

Written by mjkagan

05/01/2014 at 5:04 am

Posted in Buying, Debt

Unsafe leverage building up (again!)

leave a comment »

Here’s an interesting piece re the systemic risk being created by FHA loans.

For those just joining us: FHA is a program through which the federal government insures banks against losses on loans for 1-4 unit properties, allowing banks to make loans up to 97.5% of the purchase price and to people with beat-up credit.

During the worst days of the recession, in 2009-2011, FHA was incredibly important. It was the only way a lot of people could buy and, if you used it correctly, was an incredible source of leverage. (For example: I have clients – hi N&J – who bought a duplex is Echo Park with 5% down and have probably made $200-250k on their $35k investment in a few years.)

At the time, I was a big cheerleader for the FHA program. The reason was pretty simple: Using lots of leverage is always pretty risky, but it’s least risky when prices are low.

As prices have increased over the past few years, it has become riskier and riskier to loan up to 95-97.5% LTV, because the chance of a price drop putting the home underwater is high.

FHA was a great lender of last resort during this past crisis. But, now that those loans are risky and there is private capital in the marketplace, the government should absolutely not be in the business of making very high-leverage loans to people with bad credit.

Let private capital take that risk (and be compensated for it!), not the taxpayers.


Written by mjkagan

04/25/2014 at 1:22 pm

Posted in Debt

The relationship between foreclosure and the availability of credit

leave a comment »

As a result of the huge number of foreclosures across the country over the past five years, numerous states and the federal government have created all kinds of road-blocks to foreclosing on a delinquent borrower.

This is feel-good stuff… no one likes to hear about families being kicked out of their homes and politicians absolutely love the press they get from standing up to the big bad banks.

So, why do I think the government is crazy and that foreclosing should, if anything, be made easier? Am I some kind of hard-hearted jerk?

Let me ask you a question: Have you ever stopped to consider what happens when you borrow money to buy a property? You get in touch with a bank, often one with which you’ve never done business before. You submit to a credit check and supply some documentation. Then, you sign some paperwork and they lend you hundreds of thousands of dollars.

Again, let me repeat: They hand someone they’ve never met hundreds of thousands of dollars. Would you be willing to do this?

The reason banks are willing is because they know they can get the property back from borrowers who don’t pay. The process, foreclosure, isn’t cheap. Depending on the state, it can take a bank anywhere from 3-4 months to years to get a property back from a defaulting borrower, with legal bills running the whole time.

Because they aren’t stupid, banks assume a certain percentage of borrowers will default. They have good estimates for the costs / delays inherent in the process. So, banks are in a good position to price the risk of default into their loans (to ensure that they make enough money on the loans that perform to make up for those that default).

Now you can see why making foreclosure easier, rather than harder, makes sense: The cheaper it is to foreclose, the less the bank has to charge borrowers. I prefer to live in a world where ambitious people can get relatively easy access to cheap credit (until those people screw up), I want foreclosure to be relatively easy.

Written by mjkagan

03/27/2014 at 10:23 am

Posted in Debt

What’s the best way to buy with a small downpayment?

leave a comment »

Today’s NY Times has an interesting comparison of 5% down FHA and conventional loans. (For more about the basics of FHA loans, read this.)

It turns out that the increased mortgage insurance premiums currently demanded by FHA make FHA loans a worse deal than 5% down conventional.

If you’re considering buying with little money down (always a risky move, by the way!), it’s worth reading this article and then asking your lender or loan broker some tough questions.

Written by mjkagan

12/06/2013 at 2:31 pm

Posted in Buying, Debt