The Right Property and Seller Make for a Profitable Deal
Yellow Court did not look like the kind of property you see on the late-night cable TV show How to Get Rich Without Cash or Credit. There were no Rolls-Royces, no testimonials from slick pitchmen, and certainly no bikini-clad women frolicking on the deck of an expensive yacht.
Yellow Court was five ugly houses repossessed by an out-of-town bank for nonpayment of the mortgages. When a bank forecloses on real estate, as you recall from Chapter 4, it’s called an “REO” (or “real estate owned”). Banks don’t like REOs because they’re in the business of lending out money for interest, not managing houses. When you learn how much money they lose on them, you’ll clearly understand why REOs are poison to the banker’s balance sheet and profitability.
In the case of Yellow Court, the bank had foreclosed on five junky houses that had been completely trashed by wave after wave of deadbeat tenants. The city had formally advised the bank that the houses had become a public nuisance. Finally, after continuous nonpayment of utilities, the city shut off all services and “red-tagged” the houses, deeming them unsafe for human occupancy. The tenants moved out, taking everything they could tear loose—medicine cabinets, plumbing fixtures, carpets, interior doors, and even the kitchen sinks and toilets.
When I first heard about Yellow Court, the tenants had been gone for nearly 18 months. All the houses had long since been boarded up. The windows and doors were covered over with plywood that was bolted in place. There were nearly enough boards and bolts to build another house. It’s like you see on those “trashed-out” HUD-foreclosed houses—they look like forts under enemy attack.
Why Banks Want to Unload REOs
Banks not only despise REO properties because the mortgages are non-performing, but also because they now own a liability, rather than an asset. To cover their loss, they must set aside funds that they could otherwise be lending. Also, they must now shoulder the liability costs involved when they become the owner. That means fire insurance and management fees. It costs them even more when no one is living there. After an extended period of ownership with continuous cash losses, even the richest banks will become extremely motivated to dump a property.
Timing Is Everything, from Wine-Making to Real Estate
Winemaker Paul Masson claims to sell no wine before its time. That claim is based on simple economics. Obviously, they can’t sell unfermented grape juice or they would, believe me.
Life is full of events that require perfect timing. With real estate investing, you must have proper timing if you expect to make serious money. For example, if you decide to purchase a property simply because “you want to own it right now,” you might be doing exactly the wrong thing unless, of course, you have a special plan worked out in advance. Buying right requires a good plan. Buying property and having a good plan go together like a pair of purple socks.
By the way, I make exactly this same argument when I discuss selling properties. You simply cannot make maximum profits unless you time your sales properly. Buying low and selling high will happen only when you learn how to properly time both events.
Determining How Much to Pay
I cannot overemphasize the importance of knowing your particular marketplace. You must know what properties are worth, either to sell or to rent. You will also need special knowledge about repairs and fix-ups. This may sound a bit more difficult than it really is. However, estimating fix-up work on a house is really no more difficult than learning grocery prices at your local supermarket. Once you’ve done the first one and compared the actual expenses with your initial estimate, you’ll catch on very quickly.
I always submit my bid for REO properties written on plain paper or on the bank’s forms. Verbal communications back and forth by telephone are often misunderstood, sometimes on purpose. They are also not binding. If a bank accepts my bid, I want to see a piece of paper with a bank officer’s signature on it. That way all my time and hard work won’t be lost in the event a higher bidder shows up and the bank suddenly forgets all its verbal promises to me. With fax machines, signatures are just as easy to get as verbal commitments—and much safer for investors.
Making an Offer
I first learned about the five houses on Yellow Court when I saw the “Do Not Enter” notices posted on the buildings. The bank ran several classified ads in my local paper. No price was listed, so I immediately called the bank’s REO department and asked how much they wanted. No prices had been set yet; however, they sent me their forms to submit a bid.
The five Yellow Court houses were three-bedroom, two-bath properties with approximately 1,350 square feet of living space. They each had double-car garages and large backyards. That’s the good news.
The bad news was everything inside the houses was totally trashed. There were giant holes in the plasterboard walls and holes in the floors, doors were ripped off cabinets, windows and sliding glass doors were broken, the roofs were leaking, and every hot water heater had been stolen.
There was great potential for overpaying, because every system needed major repairs or replacement. I knew full well that if I paid too much I would end up working my tail off several months for no profits. I had estimated it would take my crew and me the full summer (approximately three months) to rehab all five houses. That’s a ton of labor, not including the licensed contractors I would need to reroof the houses, install new gas lines, and rebuild the electrical services. It was also necessary to install brand-new fuse boxes, because former occupants had completely stripped them.
Overpaying can destroy dreams for wide-eyed, inexperienced investors. Take my advice seriously here: work the numbers, backwards and forwards, then over and over. Always use Murphy’s Law of Estimating—“If something else can go wrong, it will.” If it can possibly cost more than you thought, it always will. If there’s the slightest chance you missed something in your cost estimate, you did.”
My Bid and the Reaction
I called in my numbers first, then I mailed the written offer. The REO manager did not like my numbers: I could hear it in his voice.
Before I could even speak a word, he advised me that the bank would need $42,000 per house just to come out even. “However,” he said, “any offer you make will receive our serious consideration.” I’ve always been fond of those words—serious consideration—so I told him my offer and terms:
Offer: $100,000 full purchase price for the five houses. $20,000 cash down payment to be paid to seller upon acceptance of offer.
Terms:
Buyer to purchase property in “as is” condition with no contingencies.
Seller to finance balance of purchase price ($80,000 mortgage), for 10 years, 10% interest-only payments.
Seller to provide a six-month moratorium on the mortgage payments to allow buyer time to repair houses and begin generating income.
Buyer will provide required financial statements necessary for seller to approve carryback mortgage ($80,000) for buyer.
I recall that telephone conversation vividly. There was a rather long pause at the other end of the line. I had to ask, “Are you still there?”
Then came sort of a muffled whisper: “But that’s only $20,000 per house!”
“That’s correct,” I agreed.
Just before he hung up, the REO manager said, “Jay, I’ll need to get back to you on this. There could be some problems, but I will tell you right now, our bank never allows moratoriums. Also, if we provide carryback loans, they are always written at 12% interest for five years maximum.”
Unknown to me, at the time, several local building contractors had also submitted bids to purchase Yellow Court. The bank knows that competition makes for a better horse race. Looking back now, I imagine they probably mailed out information packages to everyone they knew.
The REO manager finally called me back. He sounded a bit too gleeful. He told me that the bank had not accepted my offer. It had accepted a higher purchase price. He thanked me for my participation, made some joke about “maybe next time,” and said, “Goodbye.” And that was it. I never expected to hear about Yellow Court again.
Keep Records
Here’s a tip for all investors: never throw away your notes or cost estimates. I’ve learned this lesson the hard way—several times. Keep files on every property you have an interest in. If it’s worth your efforts the first time, chances are it will be the second or third time, too. Good notes last forever. Besides that, you will develop a good history about the property that allows you to act quickly if there should be another round of bidding. Dedicate a special file for this purpose, “Pending Property Deals.” It will pay big dividends over time, believe me. Now back to our exciting Yellow Court episode.
The REO Man Rings Twice Sometimes
Three weeks later, the phone rang. When I answered, I recognized the
REO manager’s voice immediately. This time the gleefulness was missing.“Jay,” he began, “would you reconsider your Yellow Court offer?”
“I most certainly would,” I told him, “with the same terms as I submitted before.”
He once again explained how the bank had this policy about no moratoriums and no carryback loans for more than five years.
“The deal can’t work that way,” I said. “I need more time.”
He said, “Let me check with the loan committee and get right back to you on this.”
It wasn’t even two hours before my phone rang again.
“We’ve just had a new policy revision for REOs,” the manager said. “We can allow up to a six months moratorium for mortgage payments and we’ll extend our financing for up to 10 years.”
“Gee, that’s wonderful.” I said “That’s exactly how my offer is written; therefore, I accept. We’ve got ourselves a deal.”
About a year later, I learned that the contractor who had bid higher than me lost out because he had lousy credit. The bank would not approve financing for him. My persistence had finally won out.
My cost estimate to fix Yellow Court was $12,500 for each house. Since there were five houses, the total estimated cost was $62,500. Fix-up expenses quickly add up for trashed-out properties.
Affording the Fix-Up
In this case, I was financially able to pay the bills as I did the work. This is not a job you should attempt without money. You must purchase these properties and fix them up within your own financial limitations. Obviously, this was not my first fix-up experience. My first fix-ups were much smaller and took a whole lot less cash, believe me. By the time Yellow Court came along in my career, I was doing pretty well with my other properties.
Everybody starts with small steps. If you don’t trip, you’ll soon have the money to be doing five-house jobs like Yellow Court.
Success!
The Yellow Court job took all summer, like I’d thought. It was, indeed, a lot of work, but the houses turned out simply beautiful, I’m proud to say.
I often take my “Fixer Camp” seminar students over to see them. I like to brag about the way the houses look today. The students are always interested to hear about the financial rewards at Yellow Court.
Was it worth all that effort? I’ll let you judge for yourself.
Do you remember the mortgage payment moratorium I worked so hard to get? Well, I never needed the full six months they gave me. Instead, I completed all the work in half that time and refinanced the entire property (all five houses) with a local savings bank. My new appraisals averaged $62,500 per house. I placed new $40,000 mortgages on each house. That was enough to pay off the existing mortgage debt and pay back all my fix-up money. There were even a few bucks left over for me. By the way, my actual expenses to fix each house were $15,000—not $12,500 as I had estimated. That’s how Murphy’s Law works.
Here’s a quick view of the financial picture at Yellow Court. You’ll recall that I paid $100,000 total cost ($20,000 per house), with $20,000 cash down payment. My new financing paid off the $80,000 loan carried back by the REO seller.
Purchase and Fix-Up—Five Houses: Purchase price for each house: $20,000 Cash down payment by Jay: $4,000 Mortgage carried back by seller: $16,000 Fix-up costs, paid out over three months by Jay, out-of-pocket: $15,000
Completion—Six Months Later:
New appraisal value of each house: $62,500
Income from rents: $550 per month
New 30-year mortgage on each house: $40,000
Mortgage payment: $305 per month
Pay off REO loan: $16,000
Pay back Jay for fix-up costs: $15,000
Return of down payment to Jay: $4,000
Cost of loan—escrow expenses: $1,250
Balance of loan proceeds from escrow: $3,750
Leftover funds, returned to Jay’s pocket
The bottom line: I have all my money back, plus I get to keep $3,750 for each house (leftover loan proceeds), for a total of $18,750. My equity after the refinance was $22,500 per house, for a total of $112,500. The monthly rental income, less mortgage payment, was $245 per house, for a total of $1,225.
You won’t need a computer to figure out the return on this investment. I’ve got all my money back—my fix-up money, my down payment, and all financing costs—plus I put $18,750 in my pocket. I no longer have one thin dime invested, yet I end up with $112,500 equity and $1,225 per month cash flow. When you own properties like this, all you need to do is hang onto them and start looking for more.
The Goal Is Finding Profitable Deals
Good properties are always available, but it takes a little creative effort to find them. Finding the right properties—the kind that will produce monthly cash flow and long-term profits—is one of the most important skills you must develop to enjoy any success in this business. Remember: if this was too easy, everybody would be doing it and all would be getting rich. Finding properties that will earn reasonable profits is one of the biggest challenges for every investor, regardless of how many properties are for sale in the buying area.
You must always keep in mind that the goal is finding profitable deals, not finding lots of deals. You should pattern your buying strategy somewhat like the old Hills Brothers TV commercial. The buyer in the ad says, “90% of all the world’s coffee beans are rejected by Hills Brothers. They’re simply not good enough for Hills Brothers, so they’re sold to the other guys.” I would guess about the same percentage should apply to investors looking for the right properties—unless, of course, they’re buying property as a hobby. Quality deals are the ones that make money. Don’t substitute your profits for volume. It makes little sense to hurry up and buy a loser.
To Be Continued . . .
Tags: Fixer-Uppers, real estate, real estate book
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