An effective wealth building strategy

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.

Rinse.

Repeat.

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.

The difference between a loan broker and a direct lender

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.

 

When to lever up, and when not to

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.

Unsafe leverage building up (again!)

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.

 

The relationship between foreclosure and the availability of credit

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.