How to Fix Housing, Unemployment and the Economy

As an active real estate investor who reads everything he can about the economy, finance and real estate it has become painfully clear that negativity sells.  I say this because all I keep hearing or reading about is negative information that does nothing more than cause a negative feedback loop.  I can’t recall the last time someone stepped up and proposed solutions that can fix Housing, Employment and the Economy.  The couple I have read essentially were hand outs to some constituent and not a balanced solution where all parties benefit.

I am sure someone out there smarter than I is talking about ways to fix the issues but to date I haven’t found them or read their proposed solutions.  As you will see I believe 4 parties working together can fix the problems. Please note I don’t believe in giving away free money (8K tax credit), I don’t believe in loose lending standards, I don’t believe in small down payments and I don’t believe you should build when you can buy used for less than 50% of replacement cost.

We will dive into the 4 critical teams/constituents that I believe need to work together in a single vision to address the challenges we face.  I believe if the four teams work together that we can be out of this mess in less than 3 years.

For the record if they don’t work together we will have 10-15 years of pain.  As an investor who likes cheap properties I hope they don’t figure it out as I can buy a lot more stuff in 10 years than I can buy in 3 years.  But as an American first and foremost I want to get this problem behind us so we can focus on being the best nation on the planet again.  I am an American first and an Investor second. Go America!!!

I strongly believe that this article will outline strategies that will put a floor under housing quickly, it will incentives investors and builders to buy distressed assets thus creating lots of jobs and finally with the rise in jobs and the rise in housing value the economy and the country will be back on solid footing.

The Four teams are: The Government, The Banks, The Builders and The Investors.  Each team will be discussed individually.

The Government:

It pains me to admit this as I am a capitalist which means I like it when the government is not involved and at best just plays traffic cop to insure everyone is playing by the rules and no one is gaming the system.

However, I believe the problem we face is so large that the government has to be involved and dare I say it may have to lead the charge as they are the only entity with the size to enact and enforce what is required.  Let me be very clear, the government will be part of the solution but if they do the wrong things they will get the blame if the pain is felt beyond 3 years.  I don’t envy their position but again we can fix this together.

First let’s start with a couple of things they should not do as I think the danger of politics points to short term and populist solutions that are totally wrong in the long term.  If they enact the wrong policies they will extend problems, timelines and severity.

The government should not give away free money.  No more $8,000 Credits, no more cash for clunkers/fixer houses, etc.  Just stop the madness on this front as these programs don’t help at the margin and invite fraud and are costly to manage and enforce.

Also the government has to stop all these programs that enable banks to play extend and pretend.  If a homeowner decides they can’t pay or better yet won’t pay they should be forced out quickly.  The homeowner should not be permitted to game the system and apply for various ill-defined programs in hopes of some magic ending.  Banks should be solely motivated by their bottom line and not some government incentive to review loan mod requests.  I don’t want to read about people not paying their mortgage for 12+ months.  This practice sends the wrong message and forces people to make decisions that invite more distressed inventories and foreclosures down the line.

Also don’t distinguish between owner occupants and investors with any program to purchase properties.  I understand the political logic behind giving the love to owner occupants but let me ask you a question. How many properties can an owner occupant buy in say a 2 year period?  One!!! While an Investor could buy 5, 10 or even 25 within 2 years.  We need to remember a sale is a sale no matter who the buyer is and we need to churn through the backlog of inventory.  You can’t turn around prices with just owner occupants there just aren’t enough of them.

I also understand that it is politically correct to blame the investors or speculators for this nasty mess we are in.  But instead of pointing fingers and looking backwards I think we need to look forward and figure out the best and fastest way to consume this inventory and again it is not with programs only for owner occupants.

Investors and the Government need to work hand in hand and we can’t do that by pointing fingers and talking about the past. So what can the government do to encourage investors to step up in a bigger way?

The very first thing the government HAS to do is stop punishing experienced real estate investors. I find it almost comical that someone would think a rookie investor would be a better risk that someone with 20 properties under their belt. 

Under this logic the government would rather go to a heart doctor that has never done a procedure (but read lots of books) instead of someone with 50 or 100 procedures under their belt.  If you had to go to a heart surgeon would you think the greatest risk is with someone who has only read books or someone that has done 100 procedures??? 

So what do I mean by punishing experienced investors?

I am referring to the ridiculous rule of limiting investor loans to 10.  I guess if I look at this really hard I can sort of see the political logic but we have to remember the market we are in now and we need more investor purchases. 

The market we are in now is producing great returns and actual cash flow so I suggest investor loans are less risky than owner occupant loans, especially investors with lots of property as they have a bigger base to spread the cost of remodels against.

If the government did nothing else than remove this limit we would shave years off this painful recovery.  Again remove this limit ASAP and the market will change quickly almost over night!!!

Another thing the government should consider instituting is a 5 year rule that reduces the taxes burden on house flipping.  We want to encourage people to buy distressed assets, add value and ideally make a profit.  Instead of treating this profit as ordinary income lets agree for the next 5 years any real estate flipping profits is considered long term capital gains. 

We want to incentives the natural animal spirits of capitalism and the best way to do that is by lowering the tax burden on the item or section of the economy you want to improve.

If we incentives people to profit from fixing distressed assets we will put a floor under real estate and help turn this cycle around.  I believe this tax rule change would incentives both individual investors as well as home builders to take a larger role of purchasing and fixing distressed inventory. 

This activity would consume inventory and it would raise prices as new repaired units sell for a lot more than distressed inventory.  This practice would also help the current homeowner as prices would stabilize and likely rise in many markets.  Everyone would feel richer if the government pushed this 5 year tax program. In addition to more tax revenue we would see a lot more people put back to work!!!  Appraisers, Inspectors, Painters, Carpet, etc would all be in high demand.  Unemployment goes down, tax revenue goes up and the economy will be stronger!!!

I understand why the government creates programs with low down payments.  However, I think if we don’t fix the housing problem we are discussing now that at least 20-25% of these 3 ½% down loans will go into default.  So instead of incenting buyers with loan down payment let’s go the other way!!!

Let’s create incentives for larger down payments. For example save ½ a percent with 20% Down Payment.  People with significant skin in the game are less likely to walk and thus deserve a reduced interest rate. 

I would go as far as to recommend that the person with a 3% or 5% down payment on the same house with the same credit should pay 1.5% higher interest rate over someone who puts down 20%.  It is simple if we want to reduce future risks we need to be smart and encourage people to be fiscally responsible and have strong balance sheets. 

Note I am not saying we should kill the 3% down program but what I am saying is it should be a lot more expensive than it is now and we should take that extra cost and shave it off the interest rate of 20%+ down payment programs.  If we do this we reduce future risks and produce stronger balance sheets across America.

In conclusion I believe the government needs to be a partner and a leader in this battle to turn housing, jobs and the economy around.  They need to be smart and ignore some of the cat calls that investors are evil and bad and realize investors are the only ones that can chew through the mountain of inventory quickly.

 

I feel very strongly about these suggestions and will boil each of them down to simple terms.

First increase investor loan limit from 10 to 100.  This means more sales or transactions. This means more work for repair teams, painters, appraiser, inspectors, agents, etc. This means less unemployment, more tax revenue for local governments and a stronger economy.  It is just that simple!!!

Second if we tweak the tax code to encourage flipping for a short period of time we will create more competition which will lead to higher prices and more tax revenue.  If we do this correctly it will bring more investors and possibly home builders into the mix.

Third we need to encourage strong balance sheets in America and reward folks for putting down 20%+ of capital.  Owners equity is a very good thing and means the neighborhood will be a lot stronger and less likely to become a ghost town because everyone is upside down.

The Banks

So if the Government is the only organization large enough to lead and create the incentives that drive housing forward, the banks must become the oil that keeps the system humming. 

I freely admit that the banks are in a very tight spot as many of them are in real trouble and if we truly had to value assets at today’s prices many of them would be insolvent. 

We can’t have that and thus we need to be conscious of past mistakes while implementing new programs that foster sales and price stabilization.  Remember if we can first put a floor under housing and then turn housing prices around all of our balance sheets will be stronger (especially banks).  Okay so let’s discuss a couple of items that banks could or should do.

The first and most important yet painful thing the banks need to do is focus on clearing the system.  People that decide not to pay their mortgage because of life events or strategic default need to lose their house and lose it fast!!!

We need to stop seeing articles where people are bragging about not paying their mortgage for 18 Months, 24 Months, 5 years, etc.  That just sends the wrong message and drags prices lower and lower as more people decide lets test the system and see how long we can go without paying our mortgage. 

I guarantee you if we start getting people out in less than 6 months, fear will come back into play and people will once again strive to pay the mortgage first.  Today many people pay it last after car payments and after credit cards.  People used to pay the mortgage first and we need to get back to that if we are going to turn this puppy around.

It sounds terrible but both parties agreed to a contract and if you don’t pay the bank gets the asset and they should take it quickly so we can shake out all the weak hands and start healing the system. 

If we keep on the same path we are on today we will see no noticeable improvements for at least a decade which is just too long for this great country.

Something else the banks really should consider is financing some of their own REO inventory.  I can tell you as a cash buyer I would gladly pay more for a property if I could get a 30 year loan with 25% down.  I haven’t run specific numbers but I can tell you this much.  I just bought a property last week for 38K cash that I would have easily paid 60K for if the bank had agreed to finance the purchase with 30 year fixed money!!!

Think about that for a minute.  I would have paid almost 40% MORE for the property if the bank agreed to finance the deal with 25% down and 30 year fixed at say 5.5%.  The property was fairly clean and needed about 4K in make ready costs so not a total trash job.  I would have even agreed to put the 4K in escrow if the bank asked.  I will say it again the banks NEED to start financing some of their inventory to maximize prices paid!!!!  Else properties go to cheap cash buyers like me which is not good for the system but very good for investors like me.

As an investor I need to manage my yield and thus under the current cash only world I have to pay ridiculously low prices to insure a return on my private investors capital.  But again if the banks reviewed their inventory and selected say 30% of the clean properties I guarantee you they would get better prices.  As you know better prices puts a floor under housing and may even increase the value of housing thus reducing future risks of default.

This simple act could be the catalyst for a positive feedback cycle instead of the current negative feedback cycle.

Something else banks need to consider is identifying programs that would enable them to extend credit profitably on cheap rental properties.  I understand that a 30K loan on a cheap rental house is not very exciting especially with 30 year money.  But maybe banks can get a little creative and dare I say it create a special program for rental housing under 50K.  Maybe they demand 25% down, escrow repair money, charge 7.5% and do a fully amortized 10 year loan.

The key for good real estate investors is leverage and bank lending is the key to cheap fix rate lending.   The banks that understand the power they have and the flexibility they have to demand darn near anything to finance cheap rentals will again increase demand, prices and make everyone more profitable. 

The first banks that figure this out will be way ahead of the competition as they will see a large spike in demand which will require more hiring and allow them to earn nice rates of return on their deposits.  I am just an investor and I know I would gladly line up for lending on cheap rentals. 

Today all I hear is no thanks you have too many properties or the loan amount is too small which means I have to pay less for properties and drive down the value with my cheap comps which cause more people to give up and stop paying their mortgage.  Banks have the power to stop this negative feedback loop.

In the end banks can fix this negative feedback loop by designing highly profitable program aimed at cheap rental housing.

Another program banks should look to create are blanket loans across a set of properties.  Investors are buying distressed assets and they should be able to leverage their capital by going to a bank with repaired and leased inventory.  The ability to create a blanket loan across a set of properties will give the bank greater security and enable the investor the chance to recycle their capital.  The recycling of capital means more distressed assets get turned into performing rentals increasing the value of all properties.

In the end the banks need to become the oil for this four team effort to succeed.  Again the first thing they must do is enforce past contracts and kick people out of houses quickly that don’t want to or can’t pay their mortgage. 

Second the banks need to design lending programs that fit the market.  Currently there is a great need for cheap rental property loans.  It really is pretty simple; if investors can get leverage on rental properties they will pay more and increase the general value of properties than if they have to pay cash.  If cash is the only way deals get done then prices will continue to fall. 

The final thing banks could do is look to establish blanket loans for investors with several rental properties so they can recycle capital and continue buying distressed assets.  I am hearing about blanket loans but I haven’t seen any proof of them in my market.

The Builders:

The Builders need to become change agents in the short term. I call them change agents as most builders should change their traditional business model for the next 2-4 years. Builders need to stop building new properties if we are to turn housing around, lower unemployment and produce a stronger economy.

I have no idea how new construction can pencil in our current market with relatively new REO’s going for 30%-40% the cost of new construction.  How can builders compete against these prices???  The short answer is they can’t and they should stop trying or they will burn through capital quickly and be in a world of hurt eventually. 

From where I sit builders either need to take the next 2-4 years off completely or change their business model. It is that simple.  I propose that builders should actively look into purchasing distressed properties in communities they once built.  Think about it.  Who could remodel a unit quicker and more cost effectively than the one who built it the first time???  If this proves to be too small a market for a builder they should look to pick up other distressed assets and create value by turning ugly ducklings into beautiful swans. 

I have seen homes go for land value and a builder with their skill and experience could create a nice business model buying at 30 cents on the dollar and creating a new and finished product sold at 80 cents on the dollar.

If Builders stopped building and instead focused on the distressed inventory we currently have what would happen? Well first competition would go up slowly, which would raise prices and most importantly we would burn through our shadow inventory.  The sooner we reduce supply the quicker we get back to replacement cost where builders can start to pencil new construction.

Think about all the new jobs, tax revenue, etc that would be created by turning builders into remodelers for the next 2-4 years!!!  Things could get real interesting really quickly.

So why won’t builders do this?  Well I hope some do but the chances are not many as they are wired to do one thing and what I propose is just too outside the box for them.  That is unfortunate as they would earn more money for their shareholders by buying distressed assets and turning them into functioning properties.

So if builders became change agents with the tax benefits offered in Part One and the Financing offered in Part Two we would turn prices around quickly, we would add a lot more jobs and the economy would be a lot stronger!!!

The Investors:

It probably comes as no surprise to you that I feel Investors will play a critical role in turning this situation around.  However, before we review the investors role let’s review the environment we have established with the first three teams.

First thing we discussed is stopping artificial programs that extend, delay or paper over the problem.  We won’t be giving any free money or creating accounting gimmicks that reward slow foreclosure processing.  Instead the government will be partnering with Investors and no longer treating the Investor as the enemy but instead as part of the solution. The government will remove the ridiculous limit of 10 houses that actually punishes experienced investors while rewarding the new investors who are more likely to make mistakes. 

We also discussed creating tax incentives for a short period, possibly 5 years to reward investors or builders to flip (read improve distressed assets).  The final area we discussed was rewarding buyers who put 20% down or more with a reduction in interest rate. 

If we do all these things buyers will have stronger balance sheets, we will increase competition, increase prices and we will insure experienced investors are not left with few options.

Once these programs are in place we discussed how banks need to be the oil that keeps the system going.  The first thing we did was talk about needing to take the pain quickly and foreclose on people who can’t or won’t pay their mortgage.  We have to stop the craziness about people bragging about not paying a mortgage for 1+ year.  Then we talked about banks financing some of their own REO’s to get better prices.  As a cash buyer myself I know I would pay 50% more in many cases to get better leverage. 

We also talked about small banks creating investor specific loan programs that fit their market.  For example if their area has 50K rental units they could create a 10 Year loan program.  We need banks to create programs that are profitable to process even if the loan balances are small.

Next we discussed builders and their need to tweak their business model for a few years.  Many should become remodelers in the short term instead of builders.  This would reduce new inventory, create more competition and allow the builders to take advantage of the tax savings created by the government in the first part. 

It should also be noted that with builders bidding on distressed assets we will create a positive feedback loop as more competition sparks higher prices and pretty soon we have housing being sold at or near replacement cost.  Don’t forget all of this remodeling will also mean more jobs and a stronger economy.

Now we are going to talk about investors and I am going to break them into two distinct parts.  First we will look at Active Investors who Buy, Fix and Hold or Buy, Fix and Sell.  Then we will discuss Passive Investors who are looking for significant returns on secure investments.  Each group deserves their own discussion as both groups can benefit by being a part of the process. 

I will start with Active investors as this is the segment of the business I am a part of and close with Passive investors as I work with them on occasion and I talk to them frequently. 

Active Investors

If we are working under the premise of the first three parts being put into practice the first thing active investors have to do is bring equity to table.  Just to be clear I mean cash.  If we are offered tax incentives, lending programs and all the other goodies then we need to bring some cash to the table to offer security and continue to deleverage the system.  By having skin in the game of 20%+ we can insure investors will not just give up at the first sign of failure.

Active investors will need to understand that competition should increase given the first three parts but because we have leverage in the system returns could actually go up. Another thing the active investor should realize is that the window for aggressive acquisition will be short should the first three parts of this series be implemented. 

The next area active real estate investors should realize is that they will need to run a tight business to insure long term success in what should be a rapidly changing environment.  At the beginning of the cycle it should be easy to find, secure and turn or rent a property.  But as the cycle turns and the press and the mass market pick up the new momentum we will see a lot of new or dumb money chase deals.  Only the active investors with tight criteria will succeed in the long term.  Don’t be fooled by momentum it will come in waves as we recycle the system. 

Another standard I want to hold all active investors to should the first three sections be adopted is we can’t “Cheat the System”.  Let’s have the capitalist system work and we create value as we help turn housing, employment and the economy around.  If someone tries to game the system and somehow cheat, steal, lie or perform other dishonest things to turn a profit they should go to jail or lose 3X what they gained.  The system should offer lots of deals if you’re willing to work for it.  Don’t be lazy and look for the cheap and only dishonest routes.  Do be confused even if it is on slightly dishonest or a gray area it should be passed on and we should look for a different deal.

Now for the Passive Investors who will have an equally vital role to play as we turn the system around.  Just to be clear I refer to a Passive Investor as someone who invests capital in a deal for defined return over a defined period.  They will have lots of options and they will need to do just as much work to validate an investor, their strategy, and the investment.

A Passive Investor might be someone who has Money but no Time.  I talk to lots of people who have nest eggs that are earning almost zero in the bank and actually losing money when they calculate Inflation.  That is crazy and very sad!!!  But most people don’t know they have options outside of Banks, CD’s and Money Market accounts. 

Others know they have options and they want a better return but they just don’t have the time between work, family and everyday living to master the skills necessary to become active investors.  Let’s face it, it takes work, a system and a fair amount of experience to get dependable returns in any investment area, and a lot of people don’t have the time or desire to tackle yet another area as they already have a very full life!!!

 

Another frequent Passive Investor is someone who has money but afraid of making mistakes as they have read or heard about all the negative stories.  Fear is holding a lot of people back and that is okay as people shouldn’t feel stressed with their investments.  If their investments keep them awake at night they need a new investment.  Not to state the obvious but some folks are not wired to invest directly in real estate as we have lots of ups and downs and active real estate investing would be too stressful.

The final Passive Investor I run into frequently are the investors that have money but can’t find a decent return or deal in their home market.  Let’s face it not all real estate markets are created equal and if you happen to live in a high priced or low return market it is tough to make something work.  In this case investors can pick up stakes and move or they can look into long distance land lording or they can be passive investors that deliver better returns than their home market.

As we round out the discussion on investors and how both Active and Passive investors can complement the other 3 parties involved in turning around housing, unemployment and the economy I feel compelled to offer just a few suggestions to those contemplating becoming a passive investor.

First you need to do your homework and check out at least the following three things at a minimum.  Don’t fall for promises of riches, possible returns, and bloated appraisals.  Also I recommend not lending on distressed assets unless you are compensated for the extra risk.  In short make sure you do the following.

It should be obvious but first you need to review the Investor and insure you understand how both of you are going to make money.  You should never invest in skinny deals where the investor is only making upside on appreciation.  Remember negative cash flow kills most investors and if your loan helps the investor produce negative cash flow you need to avoid the deal because at some point both of you will lose. 

The Investor needs to be able to show you in black and white how they have such a wide margin of safety that your loan will not impact the security of the property.  Remember if they lose the property you lose the cash flow which is what you are likely investing for.

I have heard it said many times that an effective investment strategy needs to be simple, clear and repeatable.  If the investor can not clearly show you how the strategy works, how you both make money and they hide behind fancy vocabulary then run away.  The investment might be great but if I can’t understand it I won’t invest in it.  Equally important is the idea of repeatability.  Is this the investor’s first deal or do they have documented success that you can review to insure they are not one hit wonders hoping to score a homerun with your money.  You should invest in a proven investor and their strategy.

The final area is likely obvious as you should obviously review the deal being offered.  Does the deal meet your long term goals? Do you want a certain return for only 6 months but the deal is for 10 years.  Does the deal offer the margin of safety you’re looking for?  Do you understand the worst case scenario? 

I believe in the statement that an Active Investor should offer his Private Investors a deal so good that the Private investors hope they don’t get paid.  This type of arrangement insures that all parties get paid and everyone stays in the game and gets what they are promised in the original agreement.

In the end with Active and Passive investors complementing The Government, The Banks and The Builders we can turn housing, unemployment and the economy around. 

We are a great country and we will be back.  If we adopt this framework we will be back in as little as three years, if not it could take 10 years.  As an investor I hope for 10 Years but as an American I hope for three years!!!

Good Investing

Website Designed at Homestead™ Create a Website for Your Business