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.
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2 Responses to “Who Wants To Buy Some REOs?”
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