The Due Diligence Problem
A recent Housing Wire headline reads:
Returns for REO-to-rental investors could reach $100 billion.
In the article CoreLogic is quoted with the following opinion:
“According to CoreLogic, West Palm Beach, Fla. (12.4%) offers the most attractive cap rate, followed by Cleveland (12.3%), Fort Lauderdale, Fla. (12%), Chicago (11.6%) and Las Vegas (11.4%).
The markets with the lowest cap rates include Honolulu (5.4%), Raleigh, N.C., (7.3%) and Austin, Texas (7.7%).”
As Treasury yields head toward zero, even Honolulu at a 5.4% cap rate looks like a bargain. I should better go get myself some of these distressed properties. Coincidentally, Fannie Mae is having a big bulk sale of 2,500 properties in Atlanta, Chicago, Las Vegas, Los Angeles, Phoenix and Florida. Since I am greedy, I am going to start with Florida (West Palm Beach) and check out some of these 12.4% cap rate investments.
From the Fannie Mae REO website, known as , there are 182 listings in West Palm Beach ranging from $10,000 to $444,900 in asking price. The $444,900 price may be misleading, since only 14 of the 182 listings are above $200,000 and almost two thirds are below $100,000. I think I can safely assume that what Fannie offers in the bulk sale would be similar to what they have currently on the market, and likely tilted towards the lower end.
I am going to pick this property on Executive Center Drive to start my due diligence. The asking price of this 3 bedroom beauty is only $18,500. Again, from the article linked above:
“After making certain adjustments such as the normal REO 30% distressed-price discount, the cap rate for the nation's overall single-family rental market in January was 8.6%, down slightly from 8.8% a year earlier, but up about 3% from 2006 during the heath [sic] of the housing boom.
“If bulk sales do come to market, investors are likely to gain some concessions that are deeper than 30%,” CoreLogic said. “If the price discount rises to 40% to 50%, cap rates would increase to between 10% and 12%.”
It is such easy money, maybe I should be generous and pay $15,000 for this baby and start from there. A quick and dirty rent survey using miscellaneous rental websites suggests a rental value of $700 to $900 per month. Working backwards, to generate a 12.4% yield, all I need is $155 per month in net income from this $15,000 purchase price, so I should have plenty of room for profit.
Next, I need to inspect the property and budget how much is going to be needed to make the unit rent ready.
Since this is a condo, I would need to do the usual analysis. How solid is the HOA [homeowner association, ed.]? Is there any deferred maintenance not covered by reserves? How many units are delinquent in their dues, and by how much?
Fannie is not offering financing for this unit. That is probably an indication that the owner occupancy ratio is not high enough, or there may be other reasons. It is also not likely going to be on the FHA approved list. In spite of its low price, a first time buyer may not be able to find financing for this unit.
By my buying this unit as an investor, I am exacerbating the problem by adding yet another non-owner occupant, reducing the likelihood of future agency financing for the project. Furthermore, as the price that I am paying is likely to be far less than what the other owners in the building paid for their units, would it trigger more strategic defaults? These are all sticky issues, but let me put that aside for now.
Then I noticed it was constructed in 1971, before asbestos was banned. That would be another check on top of the other usual stuff like mold or radon gas. While I am at it, I might as well check out lead based paint and ADA compliance issues.
Finally, there could be loose ends that may pop up as I inspect the property and read through the files. Since I am such an experienced professional, I estimate that I can complete all of the above in just one eight-hour day, a task that I am sure would take a rookie several days, if not weeks. Upon my findings, I make the necessary price adjustments and put that number down on my master bid list. I determine that not only should I have a 12.4% annualized yield, I may even have tremendous upside if the market recovers. Job well done.
Damn, wait a minute here. It takes me one day to do a thorough analysis on this one property. $15,000 invested at a 12.4% cap rate would yield me a whopping $1,860 per year, which seems hardly worth the effort. For this 2500 properties bulk sale from Fannie, it would take me seven years with no days off to complete my thorough due diligence.
How about if I find a few partners of equal competency and split up the work? Now the due diligence is down to a couple of years, still way too long. Maybe I should farm out the work to less qualified employees/contractors, but then my risk will increase commensurately. I need to reduce the risk. Maybe I should find some investors to bear some of the risk instead of using my own capital. With less of my own skin in the game, I could cut the analysis short, but it would still take way too long.
Making Money with Other People's Money
As I was sitting here procrastinating, a few big Wall Street firms called. They said they have tons of OPM (other people's money) burning a hole in their pocket. "What is expected of me?" I asked.
They said they needed some song and dance about how experienced I am regarding distressed properties. I should just make sure that I mention that I have some type of proprietary computer model. That one is easy.
Then they needed a bunch of fancy looking charts, preferably in color. The charts do not really need to say anything, they just have to look convincing. That one is also easy.
Finally, they needed some fancy looking spreadsheets. Once again, the content really doesn't matter. They only need the last spread sheet to clearly say that the proforma yield is over 15%.
How simple. My real estate investment model just turned into an OPM fee model where I will make money off all the fees, make more money if somehow the investments pay off and do not have to risk a dime of my own capital.
Come to think of it, I think these Wall Street firms are the very same Wall Street firms that told Countrywide to make as many subprime loans as possible because they could sell them to managers of OPM from all over the world.
How much OPM is out there chasing distressed assets? One recent Housing Wire article hinted that there may be 300-400 bidders submitting qualification packages for this 2500 properties sale by Fannie Mae. A recent "invitation" only auction of 500 properties by Bank of America supposedly attracted 175 qualified bidders. With so much interest from all these cash buyers, do I really stand a chance in picking up a bargain?
Not all properties are suitable for a rental pool. By the time you sort out the list, it is obvious that OPM and entry level buyers are in direct competition for the same properties. Is it the Bernank's intent to make money so inexpensive that Wall Street fat cats are throwing in cash to compete with the Joe Six Packs who cannot qualify even at these low prices and sub 4% mortgage rates?
Lenders are not complaining because it is a golden opportunity to dump the junk that has been sitting in their REO inventory for months, if not longer.
Builders are delirious. All the entry level buyers are forced into the new homes market via FHA financing! In addition, the Ma and Pa investors who cannot compete with the Wall Street fat cats are also forced into new homes, once again hoping to have an asset that may appreciate in value a little more than what Bernanke's zero interest rate policy offers for their savings.
Under these circumstances, prices at the low level should be experiencing a sharp ascent. Yet, all we see so far is at best a degree of stabilization. I eagerly await the results of the bulk sales. They should be very revealing.
Case-Shiller 10 and 20 city composite home price indexes: still declining, but at a lower rate of change.
Dear Readers! We are happy to report that we have reached our turn-of-the-year funding goal and want to extend a special thank you to all of you who have chipped in. We are very grateful for your support! As a general remark, according to usually well informed circles, exercising the donation button in between funding drives is definitely legal and highly appreciated as well.
Bitcoin address: 1DRkVzUmkGaz9xAP81us86zzxh5VMEhNke
2 Responses to “Who Wants To Buy Some REOs?”
Most read in the last 20 days:
- A Historic Rally in Gold Stocks – and Most Investors Missed It
Buy Low, Sell High? It is an old truism and everybody has surely heard it more than once. If you want to make money in the stock market, you're supposed to buy low and sell high. Simple, right? Successful stock market investing in two simple steps Photo via slideshare.net As Bill Bonner once related, this is how a stock market advisor in Germany explained the process to him: Thirty years ago, at an investment conference, there was a scalawag analyst...
- Gold and Negative Interest Rates
The Inflation Illusion We hear more and more talk about the possibility of imposing negative interest rates in the US. In a recent article former Fed chairman Ben Bernanke asks what tools the Fed has left to support the economy and inter alia discusses the use of negative rates. We first have to define what we mean by negative interest rates. For nominal rates it’s simple. When the interest rate charged goes negative we have negative nominal rates. To get the real rate of...
- Why is the Stock Market so Strong?
Dismal Earnings, Extreme Valuations The current earnings season hasn't been very good so far. Companies continue to “beat expectations” of course, but this is just a silly game. The stock market's valuation is already between the highest and third highest in history depending on how it is measured. Photo credit: Kjetil Ree Corporate earnings are clearly weakening, and yet, the market keeps climbing. The rally is a bit of a “all of worry” type of...
- Weekly Resistance Levels in the HUI
Options Expiration Ante Portas - Just as a Resistance Level is Reached After we had penned our little missive on the breakout in gold stocks on Monday, it dawned on us that an options expiration takes place this week. Normally, gold stocks decline into the expiration date. Don't hold us to this, but the last time we remember call writers being forced to delta-hedge their way out of trouble in gold and silver stocks right at the end of an expiration week was sometime in 2006. Given...
- Cultural Marxism and the Birth of Modern Thought-Crime
What the Establishment Wants, the Establishment Gets If a person has no philosophical thoughts, certain questions will never cross his mind. As a young man, there were many issues and ideas that never concerned me as they do today. There is one question, however, which has intrigued me for the longest time, and it still fascinates me as intensely as it did back then: Does spirit precede matter or is it the other way around? In other words, does human consciousness create what we...
- China – A Reversal of Urbanization?
Economic and Demographic Changes We have discussed China's debt and malinvestment problems in these pages extensively in the past (most recently we have looked at various efforts to keep the yuan propped up). In a way, China is like the proverbial “watched pot” that never boils though. Its problems are all well known, and we have little doubt that they will increasingly find expression. China's credit bubble is one of the many dangers hanging over the global economy's head, so to...
- State of Fear - Corruption in High Places
Mr. X and his Mysterious Benefactors As the Australian Broadcasting Corporation (ABC) reports, a money-laundering alarm was triggered at AmBank in Malaysia, a bank part-owned by one of Australia's “big four” banks, ANZ. What had triggered the alarm? Money had poured into the personal account of one of the bank's customers, a certain Mr. X, in truly staggering amounts. A recent photograph of Mr. X. Photo credit; Peter Foley / Bloomberg via Getty...
- Why All Central Planning Is Doomed to Fail
Positivist Delusions [ed. note: this article was originally published on March 5 2013 – Bill Bonner was on his way to his ranch in Argentina, so here is a classic from the archives] We’re still thinking about how so many smart people came to believe things that aren’t true. Krugman, Stiglitz, Friedman, Summers, Bernanke, Yellen – all seem to have a simpleton’s view of how the world works. A bunch of famous people with a simpleton view of how the...
- Russian Aggression Unmasked (Sort Of)
Provocative Fighter Jocks Back in 2014, a Russian jet made headlines when it passed several times close to the USS Donald Cook in the Black Sea. As CBS reported at the time: “A Pentagon spokesperson told CBS Radio that a Russian SU-24 fighter jet made several low altitude, close passes in the vicinity of the USS Donald Cook in international waters of the western Black Sea on April 12. While the jet did not overfly the deck, Col. Steve Warren called the action "provocative and...
- US Economy – Ongoing Distortions
Business under Pressure A recent post by Mish points to the fact that many of the business-related data that have been released in recent months continue to point to growing weakness in many parts of the business sector. We show a few charts illustrating the situation below: A long term chart of total business sales. The recent decline seems congruent with a recession, but many other indicators are not yet confirming a recession - click to enlarge. Wholesale...
- Gold Stampede
Stampeding Animals The mass impulse of a cattle stampede can be triggered by something as innocuous as a blowing tumbleweed. A sudden startle, or a perceived threat, is all it takes to it set off. Once the herd collectively begins charging in one direction it will eliminate everything in its path. Better get out of the way... stampeding bisons Photo credit: Surface Niusance The only chance a rancher has is to fire off a pistol with the hope that the shot...
- Getting it Wrong on Silver
Erroneous Analysis of Precious Metals Fundamentals We came across an article at Bloomberg today, talking about silver supply troubles. We get it. The price of silver has rallied quite a lot, so the press needs to cover the story. They need to explain why. Must be a shortage developing, right? At first, we thought to just put out a short Soggy Dollars post highlighting the error. Then we thought we would go deeper. Here’s a graph showing the price action in silver since the...