Posted on May 3, 2007 @ 11:01 am - Written by BawldGuy
Let’s take a quick look at how sometimes a loan with negative amortization can be a legitimate choice for an investor. The extreme viewpoints on both sides of this type loan are well known. Either folks go for the relatively lower payments, damn the torpedoes, or, citing the increasing loan balance proclaim to one and all it’s the devil’s loan.
Let’s take a quick, down and dirty look.
There are a couple neg-am loans out there today — what I’ll call the traditional, and a recent creation, the hybrid.
Here are the significant differences. Traditional — T Hybrid — H
T has slightly lower payments than H
H often has a lower indexed rate (actual interest rate) than T
H has fixed payments & indexed interest rate for 5-10 years
T has bigger spread between payment rate and indexed rate
T’s payments adjust annually & their interest adjusts monthly
Here are the numbers. I’ll use purchase price of $120,000 and a loan amount of $100K to make the numbers a little easier to follow. A 30 year term will be applied to both. MTA (moving treasury average) will be used as the index with a margin of 3 for the Traditional neg-am. The hybrid is an unchanging fixed index rate and payment. ‘Spread’ is the difference between the payment rate and the indexed rate. This difference is the unpaid interest which is added to the loan balance.
Excuse the format — I’m having tech problems.
Traditional / Hybrid
Payment Start Rate 2% 3.99%
Payment $370 $477
Indexed Rate 8.32% 7.25%
Spread 6.32% 3.26%
1st YR Neg-Am +/- $6,300 $3,250
Loan Bal EOY 1 $106,300 $103,250
That’s just a snapshot of the first year’s differences of a traditional neg-am and a neg-am hybrid. Now let’s look at this from the investor’s decision making viewpoint.
What does the investor have to believe to choose either one of these loan types? They have to believe the area in which the property is located will rise in value during the holding period. And not just rise, but rise by a minimum annual rate.
But what rate would that be?
There are two factors at work here. First, and most obvious is the property’s appreciation rate. However, the other factor is just as important — tax savings provided by the property’s depreciation. For this example we’ll use an easy figure to account for the combined tax rate of state and federal — 1/3. For some that won’t be enough, and for others it will be a little too much. It works.
If your annual depreciation is $9,000 annually, your tax savings is $3,000/yr. This means the necessary appreciation rate (to account for the added loan balance) in this example will be reduced by that amount each year.
At what rate must the property appreciate in order to at least offset the increased loan balance? Don’t answer yet — it’s a trick question. First, we need to apply the $3,000 tax savings towards offsetting the loan balance increase.
Traditional / Hybrid
1st yr neg-am $6,300 $3,250
- Tax Savings $3,000 $3,000
Net Loss $3,300 $250
The net loss figures for the two loans show the dollar amounts by which the property values need to rise. The traditional neg-am must increase in value at least $3,300, while the hybrid must go up by only $250.
Using the original purchase price of $120,000 — the following is true.
The traditional must appreciate 2.75% the first year to ‘break even’. The hybrid must appreciate .002%. Pretty risky, eh? Yeah, and I’m a Yankees fan. 
Now go back and read all the media hype about those devil neg-am loans. The higher of the two required appreciation rates an investor had to have to stay even was a lousy 2.75% - the hybrid essentially didn’t need any appreciation that first year. The thing is, because the margins on the traditional neg-am loans are so high these days, the required appreciation is way higher than it was even two or three years ago. As a matter of fact, I clearly remember several clients with aged loans sporting indexed interest rates under 5%! And this was lower than owner occupied home loans then. Wow.
The BawldGuy’s Point: Clearly, these loans allow for significantly lower down payments due to their low, low monthly payments. This can, if an investor is so inclined, (smile developing) buy extra properties here and there. If you are skeptical, take this same $100,000 loan - and use the typical 30 year, 7% fixed rate approach. Then figure what your down payment would have to be to ensure you didn’t end up with negative monthly cash flow.
It’s not always the way to go by any stretch of the imagination. Just like low down payments aren’t the way to go every time. Heck, I used to think investing in San Diego would be a forever thing. Now I’m screaming from the mountain tops for investors to grab their equities and get outa Dodge.
If you come away from this post with nothing else, come away with this: Neg-am loans are not inherently good, bad, ugly, or dangerous. They’re a tool in your workshop. A hammer is just a tool — until it’s used for something for which it’s not intended — at which time it can indeed become lethal.
Common sense — go figure.
Posted on March 23, 2007 @ 10:48 pm - Written by BawldGuy
The paradigm shift is in motion — not. There’s really no sea change happening. What’s happening is the lenders are writing their version of Back To The Future. When the so called ‘exotic loans’ (a media description if ever there was one) came into being in the mid to late ’80’s that was a sea change. Of course even then a slightly more than cursory analysis would clearly show neg-am loans were an extension of the original adjustables.
Back in the day, circa 1984, we were funding investment purchases and 1031 exchanges with loans indexed for the most part, to the 11th District Cost of Funds. They were nicknamed ‘coffee loans’ (C.O.F.I. cost of funds index) back then. Investors loved them. In a market with upward trending interest rates, COFI loans rose too, but much more slowly than the market because the index itself was a relatively slow responder. However, as the ’80s moved on and interest rates continued to fall, happy smiles turned into irritated scowls. Seems the 11th district was just as slow adjusting to falling rates as when they were rising.
Fast forward to today. Underwriting is seriously tightening up, as in some cases it absolutely should. The so called subprime market will cause not nearly the problems the media has proposed. 1/3-1% losses in a single industry inside an economy as large and as wealthy as ours just isn’t a Force 5 storm. It will clean itself up, some lenders will disappear, some might even have to deal with the court system. But it will blow over. To put this in perspective, the S & L fiasco of the early 90’s was a problem. What’s happening today is like having a boil on your butt. Having it lanced isn’t exactly a walk in the park, but you probably won’t miss bowling night tomorrow either.
In my experience clients have done ’stated income’ (barely documented loans) loans on neg-am products. But they typically had FICO scores in the range of 720-800, plus reserves up the kazoo. How are loans like that bad risks? Many of those investors could literally have gone the ‘full doc’ (tax returns, the whole drill) but the shortened, much reduced paperwork of the stated income approach was just easier. Same terms, payments, costs, etc. Yet it seems those loans to those kinds of responsible borrowers are still being lumped in with the no down stated income 660 FICO crowd, buying homes they knew going in they couldn’t afford.
Lenders won’t sit on the sidelines for long with the new underwriting dogma. No siree. They’re like the kids who found out their grandparents have been feeding them ice milk all these years. Once their friend’s mom gave them some real honest to goodness ice cream, they wondered how their own grandparents could do that to them. The lenders have been given a taste of good ‘ol sweat and creamy Häagen-Dazs and they’re not gonna be dishin’ up enforced ice milk for long.
When making the switch from homes to investments in the ’70’s I attended a seminar put on by an old and very respected investment broker named Royce Ringsdorf. What a font of unending knowledge that guy was. He said many things those three days, much of which I still practice today. One of them said, “In the real world you need to remember this — investors buy with borrowed money, and lenders lend to investors.”
His point in illustrating the painfully obvious was that lenders, contrary to what some may believe, want to lend as much money as they can. That’s how they earn their income. Why do you think the original adjustable loan was created in the first place? Why did 20-30% down become 0-10%? Because they were running out of folks who could borrow under normal circumstances, that’s why. Duh, Jeopardy is harder to figure out than this.
Once this blows over and Wall Street (with Goldman Sachs leading the way) has both rid themselves of the subprime mess, and found a way to profit from it, lenders will begin to find new ways to loan money.
How do I know? The same way I know the sun will set in the west, my wife’s always right, and six beers make a six-pack. Lenders lend. Just like in Back To The Future, we know what’s going to happen. We’ve seen this movie before.
Today’s post was ghost written for BawldGuy by Captain Obvious.
Posted on February 25, 2007 @ 3:00 pm - Written by BawldGuy
Have you noticed that the more the media pours it on about sub-prime loans beginning to go under, that rates in general keep trending slightly lower? Lenders, in the end, will do whatever they can to avoid taking back properties. It’ll be interesting to watch how they do it.
Right now there are some attempts to create neg-am hybrids. The actual rate is at least 1-2% lower than current traditional neg-ams, which of late have been transitioning from pig to hog status. It seems folks like WAMU have forgotten the age old wisdom that says pigs get fat and hogs get slaughtered. It’s my contention that their greed will come back to haunt them.
Tax deferred exchanges are being successfully avoided these days by investors who have been barred by the IRC from using depreciation to offset ordinary (job) income. Many of them are surprised to learn they have six figures worth of this unused write-off available to offset capital gain. It’s like finding a key to a new car in your Christmas stocking.
Here’s a quick and easy formula. If you’ve owned an investment property long enough so that you have a 40% equity position, it’s time to make a move. Maybe way past time. Your growth rate is pretty much stalled. If you originally put 10% down, you now need four times the appreciation to equal your first year’s growth rate. You can’t win by keeping it, if growth is your purpose. Those who insist on holding high equity properties while needing growth, will end up losing hundreds of thousands. Yet I see it all the time.
For the real estate pros out there who read me every now and then, I have a question. When was the last time you helped a new or young agent? I don’t mean by answering a question or two. I mean real help. Be honest and remember all the help you got when you could barely spell real estate. Pay it back. You never know how much your advice helps, or who will take it to heart, but it’s the right thing to do. I always get a big kick out of it. So many old vets helped me along the way, I couldn’t possibly pay it all back. But I try.
This week I’ll be talking about cost segregation. It’s a boring subject. Using that process can increase your after tax cash flow like the Golden Goose. So when you see the term in a title this week — read it. You’ll be glad you did, I promise.
If you own investment property in San Diego, ask yourself a question. To what end? Do you really think there will be a buyer for your rental units in the next 3-5 years? Really? Look at their value today and increase it a bit. Would you buy your own units for more than they’re worth today? Not likely. Get outa Dodge now. Denial isn’t helping.
Posted on February 2, 2007 @ 7:18 pm - Written by BawldGuy
Doug Quance over at BrokerFirstRealty.com in Atlanta asked me the other day if I’d do him a favor, and agree to be interviewed. He wanted me to consult with him on two of his real time clients looking to invest. The first installment was published today under the title, Investing In Atlanta Real Estate - A Tale Of Two Investors - Part One.
I think this will be interesting on many levels, not the least of which is developing behind the scene. More on that as it rolls out. This first installment opens the interview by way of introducing the two clients Doug wishes me to advise. It evolves into a short explanation of why investors might make use of negative amortization loans.
Besides taking care of his own blog, Doug is also a frequent contributor at the well known and much read BloodhoundBlog.
Take a look, and while your there, read some of Doug’s posts. He’s a very intelligent guy who often is able to see what many miss. It’ll be well worth the trip. Plus, at least for San Diegans, you’ll be able to view empirical evidence of a brick duplex for sale for considerably under $200K. In SD that picture would onlly be found in Grandpa’s photo album.
Posted on October 23, 2006 @ 9:27 am - Written by BawldGuy
I was having a conversation with the Bloodhound the other day when he made an observation about investors and their personal income levels. He said, (roughly paraphrased) “Since my investors are professionals like doctors and lawyers and make, as an example, $320K a year, any small bumps in the road, or a sustained slow market for several years doesn’t faze them. They can handle it because of their high incomes.”
Although every bit of that is true, I replied with the fact that the profile of my client is one who makes under six figures yearly. The difference is because of their incomes, I’m very sensitive to ensuring that they have a very high level of readily available cash reserves. They can’t be a client if they don’t buy into that principle.
I make no exceptions. Murphy’s alive and he knows where we all live.
The Greens live in an eastern suburb of San Diego in a spacious home with lots of equity. They were referred to me by a mutual acquaintance who happened to be their mortgage broker. They were interested in what their friend said about what I did for investors, made an appointment, and came in for a meeting.
Dean and Sarah are both teachers at the local grade school, and although they make decent money, between them it still doesn’t quite hit six figures.
Their house at the time, very early 2005, was worth $500-600K with an easily accessible $250K available for executing the Purposeful Plan I developed for them.
They wished to retire before they’d been teaching long enough to be eligible for a huge pension but before they were old enough to forget how to use it. In other words, the sooner the better. A 10 year plan was developed, with growth as the engine.
I couldn’t talk them out of a HELOC (Home Equity Line of Credit), as I wanted them to do a total refi, using a neg-am (link to my blog post on negative amortization loans). In any case, they now had $250K and were ready to roll.
We established that after paying off all of their plastic debt, and a car loan, they’d open an account with roughly $60K in cash reserves. As some of my readers know, I’ve come to call reserve accounts Sominex accounts. Establishing this account shouldn’t be ignored or taken lightly. It is one of the cornerstones of being a successful investor. Best case scenarios are fun to talk about at the BBQ, even better when experienced. Planning for the inevitable market cycles is not only prudent, but akin to bringing water for an extended desert stay.
At that time I was taking my growth clientele to the Phoenix region. The fundamentals were outstanding, especially their job creation, and their population was nearly exploding. Perfect. We found four homes in a few weeks that were deemed suitable. Here’s how we purchased them.
The Greens put 10% down, obtaining an 80% Option ARM (neg-am) 1st, with a 10% 2nd in the form of a HELOC. The numbers showed a tenuous break-even, but as I said before, you plan for worst case scenarios and hope for the best. The homes were located in excellent areas and were in very good to excellent condition. Our policy is always to obtain home warranties with premium coverage when purchasing properties.
Usually we can get the seller to pay for them, but failing that I insist my clients buy them. This proved out when one of my client’s homes lost their A/C ¬ in Phoenix. It cost them a small deductible, not the several thousand dollars it actually took for the repairs.
Including closing costs we spent about $140K acquiring these houses for the Greens. As of October 2006 they’ve seen them appreciate a little over $300K.
Their annual depreciation is about $45K, which has been used to increase take-home pay from teaching. They can’t use all of it because they earn a tad too much according to the IRS. (Once ordinary income hits a magic amount the depreciation a taxpayer is allowed to use against that income is slowly reduced until they can’t use any.)
Since the Phoenix market is now performing like the 1962 Mets, a refinance made more sense than attempting a tax deferred exchange. A move now makes sense because of the temporary stall in Phoenix appreciation. Boise is our destination. I arranged for them to put new loans on all their Phoenix homes, which did two things. Primarily it gave them about $150K to move into Boise for another round of growth. It also allowed them to pay off all the higher interest HELOCs which then insured that the break-even status of the homes was not disturbed. Their reserves will be bolstered a little bit too.
Next: The Greens are poised to acquire several Boise investment properties.
What will they be able to accomplish?