Every investment vehicle and financial program under the sun has some sort of risk attached to it. Whether it is stocks, bonds, stock options (deep in the money/out of the money) puts, arbitrage, stock shorting, derivatives, mergers, Real Estate investment Trusts, etc. The key is managing the risks within convenient parameters while superimposing an investment template and guidelines over the investment.
Many have used the option Adjustable Rate Mortgage for consumer home purchases and some are in deep do-do for never insight exactly what the downside held for them. Many wealthy people have used the option Arm in mixture with financial planning, as they knew exactly what to do with the payment dissimilarity between the fully indexed payment and the option payment. They put it to work to more than offset any negative amortization and have benefited. A familiar lender proponent of this vehicle structures the deal with an 80% or lower Ltv (Loan To Value) and offers a biweekly payment schedule. This allows the borrower to pay the loan off in 21 to 22 years by making one extra payment per year thereby shortening the term and recovery 8 to 9 years of payments. This can make for mammoth savings while working within the program guidelines. The problems started when the option Arm became morphed by new players in the game by allowing Piggy-Back Second mortgages behind the potentially negative Arm thereby putting more pressure on the borrower to keep up with the adjustments while the current mortgage upswing. Typically the monthly payment has a 7.5% built in escalator per year for the first five years with an further limitation of the whole of negative amortization (original mortgage whole goes up) 115% of the customary loan amount. while an accelerating real estate store the appreciation has kept ahead of the negative amortization. For example: If a borrower had an customary 80% Ltv loan of 0,000.00 and the dissimilarity between the fully indexed rate (fixed margin percentage and the changeable index used) and the minimum payment whole was say 6% less and neighborhood prices per appreciating say 11% per year fine. Even with say 3.5% inflation a borrower would be ahead of the game in this scenario. Keep in mind, the 11% appreciation is taking place on the total value where the negative amortization is effecting the mortgage whole only. As long as this scenario carried send for say five years the borrower could be still be ok. However, when the store turns suddenly, the borrower could be upside down (owe more than the asset is worth) in short order.
The best evidence of the sudden turn of events is in monitoring the foreclosure rates of Arms versus Fixed rate mortgages. In many areas, there are steep rises in these programs. To complicate things, hybrid option Arms have found there way into Alt A store with borrowers demonstrating less than stellar credit, employment, assets, etc. Or a mixture of all the aforementioned. With this mixture and possibly a Piggy Back Second Mortgage making for an introductory 95% to 100% Combined Loan To Value the handwriting has been on the wall for major problems when a downturn occurred in asset values. There will be foreclosures, short sales (lenders settling for less than what is owed) and much agony experienced by borrowers, but at last it will work itself out. Regulators are already touting closer regulation of option Arm and other mortgage hybrid products that may pose a danger to the consumer.
So do we straight through the baby out with the bath water, or is there a way to make this program work?
Let's then look at a four-unit residential investor asset acquisition using an option Arm mortgage vehicle. This is a scenario and argument of buying asset in a softer store as is found in many areas of the country. If the goal in any investments is to make something in the range of 10% plus or minus in other investments then how would this four unit stack up. First of all if you are a professional asset manager, great. If not, spend a lot of time to uncover and interview a licensed professional asset boss possibly with a Certified asset boss Realtor designation. Allowable administration is a must. A road smart Realtor who is not afraid to make lots of low offers is another. Like stocks, a margin inventory can get you about 50% leverage. Likewise real estate has that and more. Our goal then would be to buy an undervalued asset with distributor help on costs. The asset will be structurally sound with a good roof but may be tired looking and dated with tenants paying less rent than the market. After negotiating a stellar price and term deal the financing will need to allow us Cash Flow while we tune up the face and interior including updated baths and kitchens, floor covering and new decorating. The existing tenants will be given the opportunity to stay and pay the higher rents or move and bring in new rental customers who can appreciate the amenities of the new digs. The key to this deal is the option Arm mortgage, which will allow for a low starter payment while the asset is being rehabbed. When rents stabilize-full payments can be made at the indexed rate. This will be on a 75% Loan To Value basis to make the numbers work. On a 0,000 asset a mortgage of 5,000 at a start rate of say 2.75% or a payment of ,530.90/month. Rents would be ,400 per month with a vacancy factor. Taxes are ,200 or 3.33/month and hazard insurance is 1.66/month. The units have separate meters for water, galvanic and gas. The owner pays the garbage and lawn maintenance and snow removal. The asset was the dog on the block so there is exquisite appreciation opportunities over time. Rents will move up annually. In this instance, the asset has a Net Operating income of ,000 before debt service giving a Cap Rate of ,000/5,000(including costs) = 6.4%. With the 2.75% payment rate on the option Arm the cash flow would be ,000-,000=,000 in Cash Flow. The introductory investment is 5,000 down + ,000 cost + ,000 fix up totaling 8,000. So with ,000 in cash flow the return on equity is ,000/8,000 = 8.33%. Now with the interest and depreciation factored in of some ,636 plus an interest deduction of ,250 totals (fully loaded) = ,886 giving a tax loss of ,886-,000=,886 but with a before tax cash flow of ,000. The Federal Tax savings would be some ,065 for a 30% tax bracket. The total return on equity would ,065 + ,000=,065/8,000= 9.56% in After Tax Return. To compare to fully taxed investments we would then allow for the 30% tax bracket or 9.56%/. 70 = 13.66% before tax rate for investment comparison purposes.
Option Arms can make sense for a discounted value asset at a value below store that will appreciate with upgrades and improvements to make for a more desirable rental space. In this niche with 80% Ltv or lower using this program can make a lot of sense. A borrower does not Have to go negative; it just cuts down on the inescapable cash flow. The option Arm gives lots of flexibility to an investor where cash flow is king. It's not for everyone. The asset has to be acquired at the right price and there must be the possible for a greater value with improvements and higher rents. If that is not the case, pass; bring on the next property. Make lots of offers and bargain for your terms. The blush on this rose (current market) will be returning sooner than not. store opportunities do not last in this dynamically changing climate. option Arms can be used as a useful cash flow tool. Compared to other investments, the depreciation and interest deductions are huge for sheltering investment dollars with the opportunity for appreciation and expanding rents to keep up with rising operational costs. Take a closer look. This can work for good or bad credit. Give it a shot and complete your due diligence.
Dale Rogers
http://www.brokencredit.com
