In Part One, Riding the “Paper” Tiger: The Subprime Disaster, I left off with a discussion of the current marketplace and the role subprime lending is playing. In Part Two, let’s explore how your knowledge of recent history–and what is going on right now can help you use time-tested techniques to profit in today’s marketplace.
Putting a tiger in the tank?
Realize that the private cash flow industry went through its own form of “subprime meltdown” back in 2000 and 2001.
As a result of the subprime lending industry establishing a foothold in the lending marketplace in the latter half of the 1990s, the creation of private seller-carryback purchase-money notes was drastically reduced in the most active private note sector–notes secured by single-family residences.
The private cash flow industry responded by aggressively purchasing more newly created notes “at the closing table” shortly after the sale of the real estate itself closed. Known as simultaneous closes, this method of note purchasing eventually came to include many land notes and notes secured by manufactured homes on land.
Though it is estimated that only about 20% of the total notes purchased annually in 1997 though 2000 were simultaneous closes, they had a dramatic negative impact on the private note market.
Institutional buyers jumped on the bandwagon
As it turns out, the rush to compete with subprime lenders led even some of the most prominent institutional note buyers to lower their standards in underwriting their note purchases.
The most prominent change was foregoing typical equity and seasoning requirements by purchasing green notes with as little as only 5% down payments.
Not surprisingly, a large number of notes became “non performing,” including an inordinately high number of “simultaneously closed” notes that also turned out to be fraudulent–most particularly those created by rehabbers and mobile home/land developers.
Another significant factor was that institutional note buyers did not have the luxury of charging the stiff “loan fees” enjoyed by subprime lenders; nor the ability to churn profits by “recycling” borrowers over and over again for additional fees.
Nor did they have the luxury of being paid back-end rebates loan investors; nor the benefit of PMI (mortgage insurance) that conventional lenders require when less than 20% down payments are made by the borrower.
A recipe for disaster
Consequently, note buyers did not have any cushion to help offset any “down drafts” caused by defaulting paper and insufficient collateral to protect their notes.
Between 2001 and 2003, the huge impact of fewer single-family residence notes to purchase, combined with the mounting impact of the increasing volume of non performing paper, caused several of the main institutional note buyers to close their doors, including two of the most prominent–The Associates and Metropolitan Mortgage.
Turning “trash & bury” into “cash & carry”
According to an article in the Denver Post on March 28, 2007, January 2007’s .7% (7/10 of one percent) real estate price drop price drop in S&P’s 10 city composite index was steepest year-over-year decline in 13 years.
A number of contributing factors are already apparent around the country to varying degrees and will cause some significant impact in the overall marketplace:
- Declining Affordability Index
- Rising interest rates and tricked out mortgages blowing up
- Collapse in subprime lending markets
- Foreclosures overloading housing inventories and pricing pressures
- World economic markets/speed and sensitivity
These will be offset in different regions due to the fact that an unusually large percentage of homeowners own their homes outright, free and clear of any debt (40% according to Realty Times editor, Blanche Evans in her recent book, Bubbles, Booms, and Busts).
Though different geographical areas will experience varying degrees affect from the downturn, understanding the events we’ve discussed, you can make several assumptions about how the current real estate downturn and the collapse in subprime financing will likely affect the private cash flow industry:
1) Investors will be purchasing an increasing percentage of real property sales, particularly in the residential housing sector. These buyers will have several objectives, including deal structures that allow them to meet target investment returns, risk management criteria, critical income tax, and working capital necessities.
2) Other buyers, in general, will have fewer lending options, less borrowing power, and affordability issues to work around. They’ll need sensible options that can assist them in purchasing properties at a price and/or terms they can afford
As part of this process?
3) More sellers will have to rely on creative deal making techniques and more focus on meeting the buyer’s objectives, in order to get their properties sold. This will include accepting Land Trust purchase structures, accommodating exchanges, agreeing to installment sales, “walking the mortgage,” trading paper and/or other property, and other deal structuring methods.
4) More property sellers will carry back all or part of the purchase price of their properties, particularly in the residential housing sector–whether they want to or not.
5) The private cash flow industry WILL NOT be rushing in to purchase newly created notes, and there will be fewer note buyers competing for those notes.
Consequently . . .
6) Though some new seller-carryback notes will be “simultaneously closed,” these note purchases will be facing tougher underwriting guidelines.
7) Times like these force dealmakers to return to “practical solutions” for real estate financing options–and not just for subprime borrowers.
8) Dealmakers (real estate agents, real estate investors, note brokers, note finders, and note investors) will need to be more familiar with a broader variety of legitimate and time-tested creative methods to make deals that offer “win-win-win” scenarios for all participants (seller, buyer, agent, note investor).
Since the 1950s, investors and progressive Realtor organizations (such as the Society of Exchange Counselors and the National Council of Exchangors) have recognized that fully understanding the underlying reasons an owner wants to sell and what the owner would do with the cash if it were obtainable were the keys to concluding more successful transactions.
Successful investors have learned that a professional approach incorporating the circumstances surrounding the ownership of property (and the understanding that cash by itself is not the answer for all satisfactory real estate conveyances) into the process is the most effective way to successfully deal with real estate–particularly in challenging times.