Add Back Depreciation To Free Cash Flow Because It Mortgage Lenders Are Dropping Like Flies With Their Little Legs Turned Up And Kicking

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Mortgage Lenders Are Dropping Like Flies With Their Little Legs Turned Up And Kicking

Negative news after negative news fills page after page of the print media, and the public is left wondering what is going on when news broadcasts with a negative outlook on radio and TV. Fear can be a crippling emotion for many investors who would have thought nothing of buying a high-priced property a year ago and have little chance of breaking even. All were to be made upon arrival. A savvy investor who has experienced a cycle or two now recognizes opportunity knocking at the door. Yes, some areas will get a bigger bounce than others, but the worst economically depressed areas have deals that make sense. There are some areas where the affordability index is still good. What if commercial and other income producing properties that used overextended poor projection models on the part of developers and now the situation brings them to the brink of financial ruin.

As per the past anticipatory actions, this class of investors avoids the madding crowd as much as possible. Arriving late to the party and staying too long is a common public mistake. Whether it’s stocks, real estate, dot com or other hot and flash investments, public investors, in most cases, lose. An exception would be in the case of real estate for long-term investments if they can hold it. Many parts of the country have high lists of foreclosures with more coming. Distressed commercial and residential properties are suitable for acquisition. Now, if the price is right, the debt service ratio and capitalization rate can actually mean something. In many areas, rents have held back, albeit slightly unappreciated. There are exceptions, of course, but overall, returns are possible at a fair price. Banks and mortgage lenders are forced to quickly dispose of a real estate owner (REO). Thus with a market saturated with foreclosures (in much of the country) and other unproductive properties and a slow real estate market it is worth something to work with lenders. Bank or mortgage lenders take ownership of the property after all efforts to continue residential defaults have failed and foreclosure action has taken place, and opportunistic litigants can take action here.

Here, the rent for a single-family home is charged for a longer holding period to determine the “strike price” of the contract. At this point there is no shortage of properties to offer to buy under contract on real estate owned properties. Working from the back end, the contrarian investor will plug in the estimated rent based on the current market rent, taking into account monthly maintenance and upkeep, hazard insurance, taxes, professional management, a 5% or more vacancy factor, and other costs. Large portfolio investors moved to low to moderate leverage positions, similar to the major tax changes in the depreciation schedule in 1986. The reason these properties become REO properties is because the loan has the ability to exit the life of the return based on value compared to similar investments. The same can be said in this situation. A buy and flip strategy can work if the acquisition price is low enough for a quick flip, the strategic price of the property is 10% to 15% below market, and it is kept in fair or great shape. In this instance a little bit more leverage can be considered, but this could be worse unless the market strengthens. Deep discounts can treat many risky investments.

Return to the paint drying method of renting and holding. It’s slow and steady and not as flashy as the buy and flip program.

As an example: Bob the “Neighborhood Contrarian” is looking at an REO owned property serviced by an out-of-state lender in bankruptcy. A court-appointed trustee is temporarily handling the loan portfolio, where the loan is disbursed. Bob is interested in a property listed by a local realtor. The home was originally purchased two years ago for $250,000.00. The previous owner placed a piggyback first and second mortgage loan with an 80% LTV (loan to value) first mortgage of $200,000.00 and a 20% LTV second mortgage of $50,000.00. The first and second mortgagees were two separate lenders. The house has been empty for more than five months and the grass is mowed periodically. Open houses and marketing efforts have been fruitless with zero results. Bob and his sharp pencil begin to draw returns. A foreclosure action on the part of the first mortgagee foreclosed on the second mortgagee who chose not to bid at the auction. When the gavel fell on a court house sale of foreclosure sale, the first mortgage holder was the only one left subject to real estate taxes as superior.

After careful due diligence, Bob determines that the market rent for this property will be $1,800/month. Taxes are currently $3,600/year or $300/month. Hazard insurance is quoted at $1,800/year or $150/month. The commercial property manager’s fee will be 75% of the first month’s rent and 10% of the rent collected per month. A 5% void factor is applied to the equation. The home has four bedrooms, two baths, 2,000 square feet of ranch style, and a two-car garage with a pool. The pool has a security fence and a child alarm system. Schools and employment and shopping centers are close by. Carpet and paint need immediate attention. Equipment needs to be upgraded. The roof was replaced five years ago. Bob figures new carpet and tile will run $6,400.00 and a total interior painting color scheme change at $3,900. New refrigerator and stove and updated microwave over stove will be installed $2,800. Tenant will pay all utilities and pool and lawn maintenance and minimum repairs.

The rental agent confirmed Bob’s findings that the rent with upgrades could do $1,800/month. Bob’s investments in the market and certificates of deposit were yielding more than 6% annually. To move quickly, Bob decided to make one

An all-cash offer that can close in ten days or less. Fast cash is better than cash when buying a foreclosure. Bob continues to sharpen his pencil. $1,800 less $293/month for management (includes initial rent), $300/tax, $150/month insurance, maintenance and reserve budget $100/month plus 5% or $1,800 x 12, starting with a vacancy factor of $20 = $21 x 5% = $1,080/12 = $90/month. Total estimated rental offsets are $933/month. $1,800 minus the total rent of $933 gives a total rent of $867.00. If Bob seeks an 8% initial return on his money (not including appreciation or tax benefits), that would be $867 x 12 = $10,404 divided by .08 (8%) for an annual income tax of $130,050.00. income stream. Upgraded carpet and tile is running $6,400 and a new paint scheme is $3,900 and the appliance upgrade is $2,800 for a total of $13,100. So a pencil offer price of $130,050 less $13,100 upgrades and $2,200 acquisition would be $116,950 or $116,000 cash with a ten day closing with just a home inspection, termite inspection, survey and clear title. Counsel will be advised. All figures and calculations may be accompanied by necessary amendments and corrections to obtain the required market rent with the offer to the mortgagee. This would justify massive underwriting of mortgage company cover decision makers in the CYA game.

The important thing Bob found was to offer multiple offers at bargain basement prices on quality that had the opportunity to appreciate with the benefits of appreciation over time.

Dealing with highly motivated REO portfolio holders will result in a final yes on the offer. Assuming a 3% appreciation rate, the numbers might look like this if Bob chooses to view the contract on a five-year basis. Let’s assume the original owners overpaid and the house is now worth $180,000. In five years $180,000 will grow to $208,669 or $208,000 at 3%. In real world contracts, prices will be much higher than this. Here we present a less appreciated scenario. The land is valued at $80,050, leaving $50,000 ($130,050-$50,000) as determined by tax assessment. Let’s further reduce this number by devices and take them over a period of five years. $80,050 less $2,800/5= $560/year. The improvement would be $80,050-$2,800=$77,250/27.5 years = $2,809.09/year in depreciation. The total depreciation will be increased to $3,369/year, including the long term of the improvements and the short term on the equipment. If Bob is in the 25% tax bracket, he will pay $3,369 x 25% = $842.27 per year in taxes or $842.27/12 = $70.19/month. This is the worst-case scenario with a deflated value, less appreciation over a five-year holding period. Tax savings of $70.19/month = $937.19 with surface cash flow of $867. However, there are taxes on the annual cash flow of the property. This net amount would then be $720.44/month. Based on a 30-year mortgage with a rate of 6.5% the principal and /month interest payments would be $113,981.40 or a mortgage of $113,000. This is very close to the acquisition price so an 80% LTV to avoid PMI would allow a mortgage of $116,000 x 80% = $92,800 on a 30 year loan with payments based on a 6.5% rate of $586.56/month.

So Bob, after a cash-out all cash closing can refinance with a low closing cost lender and get his bulk cash to buy another deal. The $937.19 adjusted monthly cash flow less the new $586.56/month principal and interest payments will leave $350.63/month cash flow with tax savings. However, now Bob will also be able to cancel the interest deduction. That would be $92,800 x 6.5% = $6,032 in mortgage interest which would save additional income tax on the mortgage interest deduction of $6,032 x 25% = $1,508/12 = $125.67/month in estimated tax savings.

So how does Bob do at the end of the five-year period? Let’s say the house is now worth $208,000 and Bob decides to sell it with an 8% selling expense for an adjusted sales price of $191,360. Later on capital gains tax would be a starting point for determining the return if improvements are added on the basis of finding capital gains tax. Acquisition cost $116,000 plus improvements for carpet and tile, equipment (*some depreciation may need to be recaptured) and total adjusted basis ($116,000 + $6,400 carpet and tile + $3,900 paint + $2,800* equipment + $2,800 s, equipment expense) ) = $131, 300.00. Capital gains on the surface would be $191,360 – $131,300 = $60,060 x 15% = $9,009 in capital gains tax. A total all-cash purchase with no mortgage: $131,300 investment will return approximately $191,360 in adjusted sales price. Then add $720.44/month x 60 months = $43,226.40 less net monthly income of $9,009. The question would be “If I could show you a way to take $131,300 and get back the original investment plus $94,277 after taxes over 5 years, would that be a good deal?” Roughly, it will be 12.27% per annum after tax return based on internal rate of return. An advantage agreement with the mortgage will be more.

The whole key to Bob, or any other opposition, is to offer plenty based on valuable analysis. If you don’t get a deal, let someone else take the hit. There is frustration in the market and it is a buyer’s market. Professionals tune out the bad financial news and leave the living room and put some serious cash to work. A year ago sellers would laugh at bottom feeder buyers out of town. No one laughs anymore. A constant thought of desperate sellers is “Where have all the buyers gone?” Here they are, babies! Contrasts are on the beach and going in. The maddened crowd is on the sidelines wondering if it’s time to dip their toe in the water. By the time the water temperature is just right, it will be too late. The deals are here and now. All things being equal, value investing outperformed every time.

Dale Rogers

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