Intermediate Information: June 2007 Archives

One of the concepts I keep seeing without a decent treatment is the concept of leveraging an investment. Real Estate has this like no other investment. You go talk to a bank about leveraging eighty to ninety or even one hundred percent of your investment in the stock market, or the same percentage of a speculative venture, and see what happens. Be prepared for laughter, and they're not laughing with you. But real estate they will do it. Why? Because it's land. It's not going anywhere, and they're not making any more.



The fact is that real estate has the potential for leverage like no other. This is due to the interplay of two factors. One is the fact that you can rent the property out to pay for the expenses of owning it, and even if you use it yourself, you're able to save the money you would be paying in rent. Everyone's got to live somewhere, and every business needs a place to put it. The other, more important factor is leverage, the fact that you're able to use the bank's money for such a large portion of your investment. The bank will loan you anywhere from fifty to one hundred per cent of the value of the property. Yes, you've got to pay interest on it, but you're paying that through the rent - either the rent you'd save or the rent you're getting - and there are tax deductions that make such costs less than they might appear.



Now here are some computations based upon the situation local to me. Suppose you have a choice as to whether to buy a three bedroom single family residence for $450,000 (to pick the figure for a starter home) or rent it for $1900. Let's even allow for the fact that the home may be overpriced by $100,000. You have $22500 - a five percent down payment. More than most folks, and you would invest that and the difference in monthly housing cost, and earn ten percent tax deferred if you didn't buy the house. Let's crank the numbers and see what they say.







Year

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

29

30

Value

$450,000.00

$374,500.00

$400,715.00

$428,765.05

$458,778.60

$490,893.11

$525,255.62

$562,023.52

$601,365.16

$643,460.72

$688,502.98

$736,698.18

$788,267.06

$843,445.75

$902,486.95

$965,661.04

$1,033,257.31

$1,105,585.32

$1,182,976.30

$1,265,784.64

$1,354,389.56

$1,449,196.83

$1,550,640.61

$1,659,185.45

$1,775,328.43

$1,899,601.42

$2,032,573.52

$2,174,853.67

$2,327,093.43

$2,489,989.97

Monthly Rent

$1,900.00

$1,976.00

$2,055.04

$2,137.24

$2,222.73

$2,311.64

$2,404.11

$2,500.27

$2,600.28

$2,704.29

$2,812.46

$2,924.96

$3,041.96

$3,163.64

$3,290.19

$3,421.79

$3,558.66

$3,701.01

$3,849.05

$4,003.01

$4,163.13

$4,329.66

$4,502.85

$4,682.96

$4,870.28

$5,065.09

$5,267.69

$5,478.40

$5,697.54

$5,925.44

Equity

22,500.00

-48,406.32

-17,287.01

15,999.55

51,604.93

89,691.37

130,432.52

174,014.27

220,635.59

270,509.51

323,864.05

380,943.34

442,008.77

507,340.18

577,237.20

652,020.69

732,034.20

817,645.65

909,249.05

1,007,266.37

1,112,149.54

1,224,382.64

1,344,484.16

1,473,009.54

1,610,553.79

1,757,754.34

1,915,294.15

2,083,904.97

2,264,370.91

2,457,532.19

Net Benefit

-31,500.00

-110,236.00

-94,761.88

-77,990.23

-59,828.07

-40,176.54

-18,930.59

-4,021.36

28,797.71

55,524.07

84,333.56

115,367.22

148,774.35

184,712.85

223,349.64

264,861.00

309,432.96

357,261.61

408,553.54

463,526.08

522,407.72

585,438.30

652,869.38

724,964.38

802,381.90

885,736.68

975,442.55

1,071,939.93

1,175,697.38

1,287,213.19



The Net Benefit Column is net of taxes, net of the value of the investment account. The cost of selling the property is also built in. Now most people won't really do this, invest every penny they'd save. I have intentionally created a scenario that contrasts a real world real estate investment where you bought in at a temporary top, with a hopelessly idealized other investment.



There is a potential downside, and it could be big. This is a real risk, and anyone who tells you otherwise is not your friend. Look at the beginning of years numbered 2 through 5 in the equity column. You haven't gotten your initial investment back until sometime in the fourth year. Look at years 1 through 7 in the net benefits column. You're immediately down $31,500, due to me assuming it would cost you seven percent to turn around and sell the property. A year later, due to me assuming the bubble has popped, you're down by over one hundred ten thousand dollars, as opposed to where you'd be in you put it in the idealized ten percent per year investment. There is no such thing, but for the purposes of this essay I'm assuming there is. This is the illustration of why you need to look ahead when you're playing with real estate - a long way ahead. A loan payment that makes you feel comfortable for a couple of years isn't going to cut it. You need something viable for a longer term. If you'll look at projected equity at the beginning of years five and six, it goes between fifty odd thousand and eighty some thousand, assuming you've been making a principal and interest payment. You have plenty of equity to refinance there if you need to. If you need to do something in year three, however, you're hosed. If you've been negatively amortizing, you're hosed. You owe more than the property is worth. The payment adjusts, you can't afford it, you can't refinance, and you have to sell at a loss, as well as getting that 1099 love note from the lender that says "You Owe Taxes!"



But now look ten years out. At the beginning of year 11, you have $323,000 in equity, and if you sell at that point, you are $84,000 ahead of where you would have been if you invested that money in the idealized investment I've posited. That's four times your original investment, and I only assumed real estate went up seven percent per year, whereas the alternative investment went up by ten percent per year. How could that possibly be right?



The answer is leverage. That $450,000 was almost entirely the bank's money. The appreciation applied to this entire amount. But you only invested $22,500. The bank isn't on the hook for the value; their upside is only the repayment of the loan. If the property goes to a value of $481,500 and then $515,205 (normal seven percent appreciation in two years), then that extra money is yours. Think Daffy Duck shouting "Mine! Mine! All Mine!". Daffy's got to pay some money to get the property sold, as real estate is not liquid. The bank gets all of it's money. The bank always gets all of its money first. After that, however, then the extra belongs only to the owner, not the lender.



The lender gets none of the appreciation. This is all fine and well with them, by the way. They've been well paid whether the property increased in value or not. This money from increased value is all yours. This applies even, as in our example, if the property lost value for a while. Yes, if you had had to sell in year two, you'd have been up the creek. But you didn't; you kept your head and waited until the property increased again. Given that you didn't, the only numbers that are important are the numbers when you bought it, and when you sold it. The rest of the time is completely irrelevant to the equation, a fact that is true for any investment, by the way. Doesn't matter if the value is ten times what it was when you bought on paper, it only matters that when you actually sold, it was for a loss. Doesn't matter if the value goes to zero the day after you buy, and stays there for thirty years. If in the thirty-first year it rebounds to fifty or a hundred times the original purchase price and that's when you sell, then you really were a genius. Get it? Got it? Good.



So when the property appreciated back to $688,000 and change at the beginning of year eleven, and you only owe $364,000 and change, that's $323,000 in equity. You're almost fifty percent owner. Even after you pay seven percent to sell the property, you come away with $275,000, as opposed to a little over $191,000 that you'd have in the idealized but unleveraged investment.



Keep in mind this whole scenario is a hypothetical. Every Real Estate transaction is different. Every property is different, every market is different, and the timing makes a critical difference. That's why you can't just call your broker to sell it and get a check within seven days, like you can with stocks and bonds. That's why a decent agent is worth every penny, and a good one is worth more than you will ever pay us. But properly executed, a leveraged investment pays off like nothing else can, and real estate is the easiest way to make a highly leveraged investment that is stable until such time as it is favorable to sell.



Caveat Emptor.

What is Real Estate Worth?

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One of the most common questions in real estate is "What is this property really worth?"



The easy answer is the same as the deepest, most profound one I can come up with, "Whatever you can get someone to pay for it." It's the answers in between that you've got to watch out for. The appraised value is simply a guesstimate based upon the sales of similar properties. But there is no such thing as an identical property. A Price Opinion is just a guesstimate based upon what an expert thinks might be an appropriate asking price. Even an accepted offer means nothing if the offerer backs out, changes their mind, or can't qualify.



Now it's no secret that some people can get folks to pay more for real estate than others, and others can bargain the price down better. But the bottom line is that if it's not worth what you paid, why did you buy it? If it's worth more than you sold it for, why did you sell it? There isn't a good answer to either one of these questions. It's worth what it sold for. Period. The only exceptions are when there's a distress sale, and even then, the answer reads, "Under the circumstances, that's what the property was worth," which is remarkably similar (like identical) to what the answer is in all other situations.



This goes for the other side of the coin, failed transactions, as well. Why didn't you sell to a good offer? Why didn't you offer more? Because it wasn't a good offer, or because it wasn't worth more, to that person.



If you walked up to the average person on the street and offered to sell them a parcel of land on which there's a home, anywhere in the US, for $5 or $10 or $100 or even $1000, most people would take you up on it sight unseen so long as you could deliver clear title. I can safely say that the average residential property in this country is worth at least $1000 to every legal adult in the country. Why then all of these elaborate rituals of listing contracts and MLS and inspections and offers and escrow and title insurance for the transfer of property?



The answer lies in the fact that sellers want to get the highest price possible. Ideally, they want to find the one buyer who will bid more than anyone else on that particular property, because the property is worth more to them than anyone else.



To find that one perfect buyer is actually fairly rare, in my experience. But you can certainly find buyers willing to pay more than $1000, in most cases. How much more? Well, that depends upon the property and the buyer, how widely and effectively your net is cast and how long you are willing and able to wait. As with all investments, it's a trade off and sometimes the money you'll get from a better buyer isn't worth the money you spend finding them. Knowing stuff like that is part of what I get paid for.



It does you no good to accept the offer of someone who can't qualify for the loan they need in order to purchase the property. It does no good to make such an offer. How do you tell, as a seller? Make it a part of your counteroffer that the deposit revert to you the day after contingencies expire. That's not friendly, and it may lose you some potential buyers, particularly in a buyer's market, but it's the only way to be sure. Prequalification letters are basically used paper, for all they really mean.



There is nothing wrong with saying, "My property is worth $X" as long as you understand that it's shorthand for "Similar properties in my area are selling for about $X". Because your property is never worth $X. Nor are any of mine, Donald Trump's, or anyone else's. It's not worth that unless you sold it for that, and if you sold it, it's not yours anymore, is it?



People get caught up in the damnedest ego blocks on comparatively few dollars. You put the property up for sale because you wanted something other than that property, right? You're out there offering money for the property because you think you can make more money with the property than with the money, right? Trying to squeeze too many dollars out of the other side of the transaction can and often does leave you with no transaction. There is a thin line between hard bargaining that gets you a good bargain, and overplaying your hand that gets you left out in the cold.



Don't get left out in the cold.



Caveat Emptor.

There are all sorts of reasons why escrow falls through, but they fall into three main categories. They can best be described as failures of qualification, failures of the property itself, and failures of execution.



Before I get into the main subject matter of the article, I need to define a contingency period. This is a period built into the beginning of the escrow process when one party or the other can walk away without consequences or penalty, usually for a specific reason. For instance, the default on the standard forms here in California is that all offers to purchase are contingent upon the loan for seventeen calendar days after acceptance. If the loan is turned down on the sixteenth day and the buyer notifies the seller that they want out immediately, the seller should allow the deposit to be returned by escrow. If it happened on the nineteenth day, the buyer should be aware that their deposit is likely forfeit. A contingency, just like anything else, is something negotiated as part of the purchase contract. If it's in the contract, you have one. If it's not, you don't, although some states may give buyers certain contingency rights as a matter of law.



Failure to qualify means that something goes astray with the buyer's quest to acquire necessary financing. They cannot qualify for the loan, they do not qualify within the escrow period under the contract, they allow their loan officer to spin all kinds of fairy tales about what the market is doing or likely to be doing when the plain fact of the matter is that the loan officer just can't do the loan on the terms they indicated when the poor unsuspecting consumer signed up. Maybe it existed at one time, or maybe they just hoped it would. In any case, it wasn't locked in and it certainly doesn't exist now, so rather than pay the difference out of their commission, the loan officer delays and hopes for the market or a miracle to save them. Or they told the consumer about a loan they thought they might be able to qualify them for, only to find out they don't, and they're stalling, hoping a better alternative will open up. Fact is, that if a loan officer can't get the loan done in thirty days, I'll bet money they can't do it on the terms stated in the initial documents. Jokers like this are a large part of the reason you should have a back up loan if you can find someone willing. Chances are much better that both loans will be ready to go with a lot fewer games played.



Sometimes it does happen that consumers don't qualify for the loans due to real problems that just don't come up until the file is in underwriting. Since this can cause you to lose your deposit, it's a good idea to ask your loan officer about any potential problems before you make an offer. You know your personal financial situation but you probably don't know what all of the potential disqualifying issues for a lender. The loan officer should know what the issues are that may cause lenders to have difficulty approving your loan, but they don't know your history unless you tell them. Many things that underwriting will catch do not necessarily show up on a loan application or credit report, so if you have an unpaid collection, monthly expenses that might not show up, a lien, a dispute in progress, any issues with your source of income, or anything else in your background that you have any questions about whether it could impact your loan, it's a good idea to ask right upfront, before you get into the process. Sometimes these issues mean that you flat out do not qualify, sometimes they mean that instead of 100 percent financing, you only qualify for 70 percent. Unless you have that extra 30 percent of the purchase price lying around somewhere, the transaction isn't going to fly, and the sooner you find out, the better. A loan officer who can't show you a loan commitment with conditions you can meet before the end of the contingency period is not your friend.



The second category of reasons escrow fails are failures of the property. Some defect is disclosed by the inspection process that the owner does not want to correct or is unable to correct, and the buyer decides that the property is not for them under the circumstances. Mold, termite damage, seepage, damage to the foundation, and all of the other usual suspects fall into this category. Title issues are here also, although they usually become unsolvable when they impact the loan. If the seller can't deliver clear title, the title company won't insure it, the lender won't lend the money, and any rational buyer should want to walk away. Why do you want to give someone money when they are likely not legally entitled to sell you the property?



For defects, both structural and title, providing it was discovered within the contingency period, it's up to the seller to convince the buyer they should still be interested. After the contingency period is over, things are more complicated as there is the possible forfeiture of the deposit to weigh. Good agents that you want to recommend to your friends get out and get the inspections done right away to avoid this issue. Agents that are looking to line their own pocket wait until the contingency period is over before doing so, as this gives the buyer more incentive to stay in the transaction. Let's say you've got a $5000 deposit on the line and seventeen days to remove contingencies, as is the default here in California. Would you rather your agent got an inspector out within a couple of days, or waited three weeks? Keep in mind that you're going to pay the inspector, but that's money you're going to spend regardless. The first possibility means that you find out about potential defects while you can still recover your deposit, while the second possibility means the seller can likely keep that deposit. I know which situation I'd rather be in.



Failures of execution are likely to be because someone messed up. The seller didn't do this. The buyer didn't do that. One agent or the other dropped the ball. The escrow officer didn't do their job. Loan officer failures would be here if loans weren't a whole category on their own. This category covers all the little details in the purchase contract, each of which has to be met before the escrow officer can close the transaction. These failures may or may not be actionable, in the sense of you being able to hold them responsible for their failure. Many times, the escrow officer is used as a whipping post for the failures of other parties, but some escrow officers do screw up big time. Sometimes it takes an outside expert to dissect things dispassionately in order to figure out what went wrong where and whose fault it was, but outside experts cost money, so most of the time everybody just fades into the sunset pointing fingers at each other, unless there's some pretty significant cash involved. The transaction is dead and it's not coming back. Unless there's a good possibility of recovering enough money to make it worthwhile, let it go.



Caveat Emptor.

Over the last few years, a lot of folks have gotten used to zero real scrutiny of transactions. With values increasing rapidly, it was hard to lose money on real estate, whether you were purchaser or lender. One of the most common abuses has been Straw Buyer Fraud. Well, with local prices having receded roughly 25% and no rapid increases on the horizon right at this instant, a lot of lenders are getting burned on loans, losing money, and going back after those who aided and abetted and made those transactions appear more solid than they were.



Against that backdrop I got this email, with the subject, "I am a straw buyer":



I thought I was helping out a friend and HONESTLY did not think and/or realize I was doing anything wrong.



The friend has been making the payments for 10 months and is due to buy the property back from me at the 1 year anniversary (DELETED).



If he can't buy the property back (which I don't think he can), I want to approach the Lender. I can't afford the payments of DELETED and I don't want the property which is worth DELETED.



What kind of trouble could I be in?



Also there is an agent, a broker and an attorney involved in this scenario as well.



Well, California is an escrow state, so this isn't anywhere I can get involved, and the rules are different in every single state. As I've said before, the best thing to do if you find you may have violated the law is consult a licensed attorney in your area, and if it relates to real estate, make it an attorney who's a real estate specialist.



There are some generally applicable principles, but keep in mind that I'm not an attorney, so if there's any conflict between this and what your attorney says, believe your attorney.



The situation is this: You signed a Note, and in most cases, a Trust Deed or the equivalent. The Note says you owe the money. The Trust Deed pledges the property as security for that money.



Now in many states, California among them, purchase money loans are not subject to recourse generally. Unfortunately, you have committed fraud, which is one of the exceptions and therefore subject to full recourse in every state I'm aware of. Furthermore, loan fraud itself is usually a matter that causes the federal government to get involved, as most lenders are federally chartered. So you have a criminal fraud case, most likely at the federal level, quite likely conspiracy added to that charge, and on the civil side, you are going to be at least one target of a civil suit if the lender loses any money. You can also expect to hold a share of liability for the lender's attorney fees. That's the bad news.



The good news is there's quite likely evidence that you were led down the primrose path by those alleged professionals who should have kept you from breaking the law. This won't get you released from your basic responsibility for what you did, but if the feds and the lender bother with you, you're not likely to be their primary focus, and on the civil side, you're not likely to be the deep pockets they are really interested in. While neither the feds nor the lender is going to want to let you off the hook, you shouldn't be their primary target if you can show that you were advised to do this. Ignorance of the law is no excuse, but when comparing the level and degree of culpability, I'd expect that a non-professional led afoul of the law by allegedly professional advice you should have been able to trust is a fraction the culpability of those professionals who willfully advised you to commit an illegal action.



Now before you breathe a sigh of relief, let's consider the following: What if those alleged professionals aren't there any more? What if they're already out of business, broke, and in jail? Now you're the only target left. Ouch. Now you know how the last of Custer's men felt.



Here's another not so comforting thought: What if that property isn't really worth what was paid for it? From what I understand, a large proportion of felons like to combine their scams. For instance, adding appraisal fraud usually doesn't add appreciably to the risk, while adding greatly to the reward. They pay an appraiser to come up with an inflated value, get someone to pay it, and voila! Extra profit! The games that can be played are legion. Usually, the sucker or mark is just so pleased to be getting "such a great property" that they don't really examine what's going on. Sometimes, they're so happy to be qualifying for anything at all that they won't examine the situation at all, for fear that they will won't qualify and it will all somehow melt away. It's been said before, but you're never so vulnerable as when you're trying to get away with something. If something seems to good to be true, it probably is, especially where hundreds of thousands of dollars are involved. Look the metaphorical gift horse in the mouth. If it's real, it will stand up to the examination. If it's not, you might just avoid paying three times what the property is worth, not to mention criminal prosecution.



Read those contracts. Really read them. Pay attention to paragraphs that say stuff like, "It is a felony to misrepresent information on this application." Trust me: With hundreds of thousands of dollars on the line, they mean it.



If anybody claims to be helping you break the law or circumvent safeguards, run away! If they're willing to break one law, or one of their ethical responsibilities, ask yourself what reason there is to believe they won't break others? To be precise, their duties to you? If you're trusting them for advice, it seems likely they know the system a lot better than you ever will. There is a reason for every single law and procedure in real estate. The vast majority of the time, it's to protect consumers. If an alleged professional is willing to admit to doing one thing illegal or unethical, what evidence do you have that you're not going to end up one of the victims?



If there are legal ways around legal requirements and procedures that have been put in place, it almost always involves full disclosure to all parties. There some stuff that's none of the business of some parties, but that's because they have no reason to be interested. For instance, the listing agent in a recent transaction asked me for some financial history on the buyers that they had no need to know - they were just trolling for data which might lead to future clients, i.e. trying to get my clients future business. For that sort of stuff, it's good to tell them something vulgar and report them to the state. But if you know or have been led to believe that the other side of the transaction is being deceived or intentionally kept in the dark, you should be hearing more warning sirens than a ten alarm fire during an air raid. Do all the agents know everything they need to? Does Escrow know? Does Title know? Does the other side of the buyer/seller transaction know? Most importantly, does the lender know? Are you sure? Did you tell them? If not, what evidence do you have that they know?



Nobody should ever rush you into signing anything. Take your time. If you're not certain you understand it, don't sign, no matter who's hopping with impatience. Even me, although I don't recall ever committing that particular sin. Taking your time and consulting disinterested parties may cost you some money, although your agent or loan officer is doing their job if they inform you of what consequences there may be. Not doing so can cost you a lot more money, plus your freedom for years and your credit rating for the rest of your life. Worst comes to absolute worst and you lose the transaction and your deposit, that's better than getting convicted of fraud and owing half a million dollars that the property isn't worth.



Caveat Emptor


What can a seller do to get the deposit when the buyer backed out after the time limit and just won't sign off on the money? My real estate agent is not helping at all. The real estate office was representing both the seller and buyer and I believe they don't want to upset the buyer and that is why they aren't pushing her to do the right thing. Thanks for any help,.

They're not representing your interests in a fiduciary manner as demanded by the listing contract.

Real Estate is not sugar and spice and everything nice. Sometimes doing your job as an agent means that you have to do something unpleasant by taking your client's side. If your agent isn't willing to be a complete jerk on your behalf if they have to, they're not worth a talking to, much less signing a contract with.

This is another reason why Dual Agency is a bad idea from the consumer's point of view. Most of the reasons are from the buyer's side, but here's a concrete example why you do not want to permit your listing agent to also represent the buyer. Since about thirty percent of all purchase contracts fall out of escrow for some reason or another, ask yourself how you'd feel about your listing agent trying to preserve the buyer's deposit even though you, the seller, may be entitled to it. You gave them thirty or sixty days exclusive shot at that property, paid the mortgage and all the other bills for that time period, and could not sell it to anyone else while they were wasting all of that time and money of yours. This is a very common phenomenon when one agent tries to represent the interests of both sides. But your interests call for the buyer to forfeit the deposit, and if they want to continue to represent you, they need to act in your best interests. They haven't done that.

This isn't to say they have to start with scorched earth. A simple request to sign the cancellation and release of deposit is very reasonable - and precisely what they agreed to when they wanted to represent both sides, if the transaction fell apart. When there's no other agent, there isn't anyone else to do the job. They're it, because they tagged themselves by requesting dual agency.

Agents, however, are not lawyers, arbitrators, legal mediators, or judges. They have zero authority to force their other client to sign the cancellation and release of deposit. Some people won't do the reasonable and intelligent thing, whether it's because they're hoping to get away with it, or because they don't think it's the reasonable and intelligent thing, or for some other reason. But a failure to ask, and a failure to do their utmost in persuading the other side is a failure of their contracted fiduciary duty to you.

This means that you quite likely have a valid reason to cancel your listing. Consult with your attorney, but from the information presented, they have clearly failed to represent your best interests in accordance with that listing contract. As far as calls upon agent loyalty go, listing contracts conquer everything but the law, or at least they should. That's why I give each and every one of my buyer clients an explicit written release of any obligation if they should choose buy a property I'm listing. They can always find another buyer's agent to represent them, but the sellers are contractually committed to staying with me for the contracted period. I also tend not to show my few listings to my contracted buyer clients, for reasons I've gone into elsewhere.

One hopes you see why I make such a big deal about putting in the work to find a good agent. Here you are with months and multiple thousands of dollars gone, and you have absolutely nothing to show for it because your agent is a self-serving bozo. You don't need to fret about finding absolutely the best agent there is, but you do need to find one who knows what they're doing and will do what is necessary to represent your interests. I wrote a two part article How to Effectively Shop For A Listing Agent (Part I) and How to Effectively Shop For A Listing Agent (Part II) on this very subject. Chances are, there is more than one good agent in your area, but the good ones are usually outnumbered by the bozos, so just using your relative or friend is like playing Financial Russian Roulette with four of six chambers loaded. Nor is "top producer" any kind of sobriquet I'd want for my listing agent, because they're talking about overall volume of sales, and that's not likely to be present in the agent who can actually get top dollar for your property. All of the agency mechanics that favor mass production of sales work against them getting the best price possible for any particular property. To be fair, this works in the other direction as well, but it's not your problem. You want someone who's going to get the best possible price for your property, not someone who mass produces transactions. If they've chosen the other path, you don't need to feel guilty about passing them up in favor of the boutique agency that busts their backside to satisfy you. That high producing chain is making plenty of money off the suckers who don't know any better.

Caveat Emptor

Builder Upgrades

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What I still am unclear on is the pool and how (in my opinion) it's crazy to finance $40,000 into a mortgage when you *plan* on refinancing in a few years. By *plan* I mean you take out a mortgage that you know isn't what you want but you took it because the builder forced you into it with "incentives" or they just plain wouldn't build a house for you if you don't use their lender and the builders lender is looking out for the builder, not you. I guess you can't *know* that the pool won't add value . . . especially in a new area where there are no comps . . . but am I crazy here?

Another situation I don't get is with all the "upgrades" they try to get you to buy with a new house. Blinds, paint, water softener, ro water filter, counter tops, cabinet upgrades. I wonder if you would be better off just getting the cheapest options and then upgrading later when you can afford to pay cash. I can guess that's the case but people figure life is too short to live in a a despicable house that has a kitchen with laminate counter tops instead of granite!! (I have laminate and somehow my wife and I manage.)

And that leads me to the pricing on new homes and how the builder sets the price and somehow the lender will lend you money on a house that may or may not be worth what you end up paying (granite counter tops may add value to the house but probably not $10,000). The more I learn the more I realize how much I still have to learn.


Builder upgrades are an almost entirely different set of rules and calculations than after-market upgrades. There are reasons for this that mostly reduce to "The lender can do a lot of things if they really want to, but most lenders don't have a reason to want to." For all of this, keep in mind that my normal stomping grounds just don't have a whole lot of new developments any more, so I don't deal with developer issues a lot, and it's very possible for the rules to change while I'm not doing any developer deals. I'm working with one set of clients right now who might end up buying in a new development, but it's been over a year since my last set of clients who bought just one (although if there's any developers reading this, I do have one investment firm client who wants to buy out the last of any new development that isn't moving quick enough).

The normal after-market upgrade, if you want a normal mortgage loan for it, has to be justified in terms of the property's current numbers. In other words, if you want to take $50,000 cash out to put in a pool, you must already have $50,000 equity available to you. You have to qualify for that loan debt to income ratio and loan to value ratio exactly as if you were going to take that money and buy lottery tickets with it. In other words, without the value of the proposed pool or other improvement added to your property, but solely based upon the situation as it sits now.

With builder upgrades, however, there's a little more latitude built in - especially where the builder controls the lender outright. Sure, the property is really only worth maybe five thousand more with that fifty thousand dollar pool installed, but because the basic number equates to money in their pocket directly, as well as money that they're going to earn interest on, they have a motivation to be more forgiving than in the case of the lender who is not getting $50,000 placed into their left hand while they loan it out - at interest - with their right. In many cases, even if they don't control the lender directly because they're not that big yet, they've made an agreement to indemnify the lender for any losses they take as a result of lending that money. The builder is secure in the knowledge that they'll make a lot more from the increased number of upgrades than they'll lose from the small proportion of defaulters. However, this should explain to consumers why sometimes builder's preferred lenders can do things nobody else can - because they're getting paid to do it. Furthermore, because they can do something nobody else will, they can charge a premium, either in rate, points, or both, over general market rates. Because the consumer wants the home with these upgrades, and because this is the only way anyone will lend on it, there's money to be made! Usually, there's plenty of money to go around - the consumers are, in aggregate, paying for it. Surcharges and premiums on the secondary mortgage market can go anywhere from two and a half percent up to six percent, perhaps more. On a hundred $500,000 homes, four and a half percent is over two million dollars additional clear profit. Even if three of those homes default, losing roughly fifty thousand in each case, they've still cleared more than two million extra profit for having done this.

(This is not to say that many after-market contractors don't have their own finance department cranking out trust deed financing even if the equity may not be there to pay it right now. But this way they get the job, which means they make the money for that job, and most of these contractor loans carry rates well above regular current market, so they can make more on the job as well as on the loan. How remarkably analogous!)

As for whether it's smarter to upgrade with the builder or wait and pay cash, there's an argument for each side. On one hand, the argument for waiting is that you are a lot less likely to owe more than the property is worth if you need to sell. Furthermore, you're not paying interest on depreciating fixtures, a classic double whammy anyone who's even bought a car on credit can relate to. Because you're not asking for anything special or difficult in the way of financing, you can at least theoretically go anywhere for your financing. Builders in California cannot legally require you to use their lender, which is not to say it doesn't happen - sometimes very blatantly in violation of the law - but that's the theory, anyway, that you should be able to shop the market. Finally, the cost of most upgrades is rarely recovered in increased sales price when the current owner sells. Spending a dollar, and paying interest on it, to make back twenty cents in eventual increased sales price strikes me as shooting yourself in the foot. It is to be admitted, however, if it was worth a dollar to you to have the upgrade, the twenty cents is icing on the cake.

Against this, however, is the cold hard reality of labor costs. If you build granite counter-tops in the first place, the only increase in costs is the comparatively small increase for more expensive materials. If you wait until after it's done, you've got to tear all the old work you've already paid for out, then pay the labor costs to put the new counter-tops in, as well as new materials, the cost of haul away, etcetera - not to mention the restaurant meals you'll be eating while it gets done. At anywhere from $15 per hour up, plus benefits plus markup, that labor isn't cheap, and it's usually at least a couple of workers for several days.

Builders know all of this, and that it's very attractive to roll the upgrades into the cost like this. When they build a property "on spec" (meaning it hasn't sold before the framing is done at the very latest), they typically build in all of the upgrades they can, and if you went to them to take a completed property off their hands, but wanted something not upgraded, it's likely they will be unable to accommodate you (This is a negotiating opportunity on the rare occasions it happens!). They don't tend to build very many "on spec" around here, or anywhere else if they can avoid it without worse consequences, but that's what they do when they do it.

There's also one more argument in favor of builder upgrades: You won't get your extra money out of them, but in slow markets like right now, it's more likely the property will sell if you do need to sell it. There are always suckers out there who will zero in on the upgraded property because "it's soooo beautiful!" even though there are better bargains nearby. Real estate fixers and flippers worldwide make their fortunes on the backs of these people, but they're legal adults deciding this stuff is worth their hard-earned money. Who am I to say it isn't?

Builders set their prices on the same motto as Poul Anderson's Polesotechnic League: "All the traffic will bear!" Profit isn't evil, it's what motivates developers to build places for people to live. But there's nothing that says you have to cater to it by forking over excessive numbers of your hard earned dollars, either.

Caveat Emptor

This woman made herself a victim



stayed in a hotel for 7 weeks looking for my "Dream Home." And, when I found it, even though it wasn't in my price range, I knew I would do anything I could to get it. I was vulnerable, emotional and became a victim.



Actually, that is not quite accurate - I made myself a victim.





First mistake: shopping outside your price range. Assuming that you get it, the bottom line is that you are going to have to make the payments, every month, from here on out. I can get you the loan, any competent loan officer can get you the loan, but I would not even look at any home not in my price range. First, it's a useless exercse. Second, the reason it's outside your price range is because it has something extra. So it's going to be more attractive to the average buyer than the ones you are looking at. Many agents will capitalize on this by showing you such a property, knowing that a large percentage will fall in love with the property right there, and bingo, they've got a higher commission for an easy sale. Despite their highly touted "code of ethics" the proportion of Realtors® who do this is every bit as high as regular agents. "Well, it's just a little bit. I can handle the extra." Demand to know the asking price before you agree to view the property, and if it is outside your range, refuse to go. Fire any agent who suggests this to you more than once. I'd fire them the first time, myself.





Being self-employed, (actually at the time, I was on disability from hand surgery), the only loan I could qualify for was a Stated Income Loan. That's where you just tell them what you make, and it is not verified except through two years od tax records and your FICO score





This is not correct. You do sign a 4506 form, but the whole idea behind a stated income loan is that the bank agrees not to verify your income. They verify only that you have a source of income, and the amount you claim you make must be reasonable for someone in your profession. If you can show income via two years of tax returns, that is a full documentation loan, and you get better rates (See this for information on documenting income). However, documenting income via tax returns is tougher because whereas the bank loves doing it, the number they will accept is the number that is after all the write-offs, often a significantly lower number. This is the reason for the stated income loan in the first place. Many business people, particularly small business people, are earning a heck of a good living but they find legal ways to pay for most of it with before tax dollars that they then are actually able to deduct. So they're living as if they make $10,000 per month, which they do, but the tax return only shows $3000 per month. Stated Income is intended to serve this niche, not the niche of people on weekly paychecks who don't really make enough money to justify this loan.





six months later, when the interest rate changed, my payment went up. But I still had some disability money, so I didn't think about it - I just knew work would come.





What she is saying here is that she had to accept a short-term adjustable rate mortgage in order to get a rate low enough to qualify. Or that she was sold one on the basis of "low payment" and she didn't bother to check the fine print.



There are loan officers and real estate agents and realtors out there who make one heck of a living off the fact that people buy loans (and homes) on the basis of payment. They have "interest only" and even negative amortization loans out there. I'm not going to say you should never buy a home with a negative amortization loan, but it's a good way to get yourself in serious trouble. Let's just say that of all the home loans I've done (and I've done a lot of loans) I've never seen a situation where I would recommend it.



Look for terms that are going to be stable for at least a couple of years, particularly if this is your first time in a home or the payments are going to be near the upper edge of what you're comfortable with.





I:



• Did not shop lenders (I felt I wasn't in a position to).



• Did not tell the truth about my income.



• Took the first loan they offered me.



• Didn't read the fine print.



• Did not fix a budget and stick to it.



• Bought way too much house.



Fact: If anybody tells you not to shop lenders, what they are really telling you is that their loans are not competitive and that they are afraid of the competition. The National Association of Mortgage Brokers got a law through congress a couple of years ago that all the mortgage inquiries within a thirty day period count as one inquiry, so it no longer hurts your credit score to shop around. I tell everybody who comes to this site to apply for a back-up loan if they can find somebody willing to do it.



There are issues out there with loan providers who will tell you with a Mortgage Loan Disclosure Statement, that they can do the loan on a given set of terms when they have no intention of and no ability to actually deliver those terms. Certainly the HUD 1 form at the end of the loan process is nothing like the earlier form. Furthermore, many loan providers cannot or will not deliver within a stated time frame, which is critical when you're buying, and still important when you are refinancing. So look for someone who's going to stand behind their quote with something that says they mean it.



(It's hard for anyone you'll actually be able to talk to to use the word "guarantee" with regards to a loan. It's not just loan providers who pull unethical tricks. People attempt fraud regularly. Furthermore, there are "nobody's fault" impediments that happen regularly, and they always change the transaction. That property doesn't appraise for enough value is probably the most common. Only an underwriter can give a loan commitment, you as a loan applicant will never talk to your underwriter, and until you've got that commitment, there is no guarantee it can be done at all. So the real guarantees are always conditional).



Here is a List of Red Flags, real estate and loan practices that should have you running away, and here is a list of Questions to You Should Ask Prospective Loan Providers. Those who are doing business honestly should be happy to answer these sorts of questions - it gives us assurance that we're not going to be competing with somebody blowing sunshine and wet sloppy kisses at you. Because the fact that you're asking the questions means you're not going to do business with those who give you unsatisfactory answers. Finally, here is an article on What to look for at Closing, to make certain all of your due diligence paid off and determine if you should go with your backup loan provider.



Caveat Emptor



(and I'm always happy to get suggestions for additions to either of the lists)

 



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