Friday, December 09, 2005

Surreal Estate

A reader brought my attention to this article in the SF Chronicle. Here is an otherwise unremarkable person who has no job, no steady income, and yet who chose to go $2.3 million into mortgage debt, with an average negative cash flow of $10,000 per month. On paper she and her partner are very wealthy. In truth, they are dependent on debt extraction. This degree of leverage reminds me of the Long Term Capitol Management business model and we all know (or should know) how that ended (and those guys were all Ph.D.s for crying out loud!). But the thing is, this is not an isolated case; it is going on all around us. It is vigorously encouraged by the RE industry, lenders, the Fed (remember Greenspan touting the goodness of ARMs at one time?), "the Jones", and others. Here in Marin real estate investing is of epidemic proportions as it is something of a hobby and really has become our only industry.

So what happens when the RE cycle changes as it seems to be doing now and as it has always done in the past? Should lenders be allowed to lend to people in this position? If their house of cards blows away, who should be held accountable? The borrower? The lender? Someone else? For my part, I don't begrudge anyone financial success in the real estate market; but irresponsible lending (and that is what I think is at the heart of it) needs to be significantly reigned in. And the only way to effectively reign it in is to make the lenders personally liable for the consequences of poor lending decisions -- use people's self-interest for positive social change.

What can YOU do? Share your thoughts.

Some choice quotes:
"In the three years since Sacco and McCook put their faith in real estate, the couple have embarked on what might conservatively be called an E-ticket ride, pulling equity from appreciating properties to provide down payments for the next investment. They have bought eight vacation properties - four homes in Florida, three in California and 100 raw acres on top of a mountain in Lake County."

"They don't have jobs, but their lives appear to be a whirlwind of work. They don't have incomes either, though they maintain middle-class lifestyles."

"Sacco estimates that along with McCook's mother, who has been a silent partner, they've made $1.3 million since they began their buying spree, but all of this is still in equity on their properties. Their monthly reality is more sobering. They have $2.3 million in mortgage debt and negative cash flow that ranges from $5,000 to $15,000 monthly depending on the season."

"So how do they pay the bills?"

""We sort of count our equity loans as our income," she says, with the slightest wince. "If we had real jobs, we'd be fine, but we just need to get some money in. Some people call it a pyramid, but I don't like to think about it that way.""

"Surreal financing? Bubble economics? Perhaps. But it's also the way people are increasingly approaching real estate: as a bet..."

"Whether it's first-time buyers who take out interest-only loans or investors who extract equity from one property to fund the next, real estate is an industry that is being buoyed by a belief in continued appreciation."


Anonymous Anonymous said...

I found a good article from the Financial Sense website. The author has the following comments:

"Now let's consider that there are regular mortgage fraud, regular appraisal fraud, predatory lending fraud, insider foreclosure fraud, and insider mortgage servicing fraud. This pickle barrel is quite interesting with Kosher Dills, Sweet Dills, Sweet Pickles, Sliced Pickles, Peppered Pickles, Sandwich Slices, and you name it. There's even some Bread and Butter Pickles in this barrel. Tennessee Legal Services has a great webpage with some nice links on subprimes and Mortgage Servicing and Foreclosure Fraud. They even name a few names. If the housing market goes belly up, let me tell you folks.... 800,000 Jobs is but the first plate the iceberg knocked off the hull of the RMS Titanic in 1912. I suspect there will be a lot more folks than that in the soup lines...? or finding themselves in some rather chilly water? Hypothermia, anyone?"

Dec 9, 2005, 1:14:00 PM  
Blogger Marinite said...

So, people are using names like "Sliced Dill Pickle" on their loan docs? Is that the point? Dang!

Dec 9, 2005, 1:28:00 PM  
Blogger marine_explorer said...

"they've made $1.3 million since they began their buying spree, but all of this is still in equity on their properties"

In other words, the're actually accumulating $5-15K/ debt mo. and not making anything yet! Pure genius. How long can this go on before break-even is a complete impossibility? How many investors in Marin have negative cash-flow? This will play out very badly for many people.

Dec 9, 2005, 2:33:00 PM  
Anonymous Anonymous said...

I have heard (and been envious) of people buying, preferably adding value, reinvesting their capital and making a fortune. I myself have done something similar (although more slowly, 3 properties in 8 years, and not really a fortune, since I still have to work). However, I have a day job to support my negative cash flow, I have a minimum 30% equity cushion to weather the downturns and although I take out IO loans, they are fixed rates for 30 years (and they are IO for the first 10 only, amortize for the next 20). So, I assess my appetite for risk, consider worse case scenarios and plan accordingly. That is what every good investor (RE or otherwise) shoud be doing. So far, I have not had to sell under duress, in fact I have not yet had to sell to "cash out", only to buy more properties. I am not speculating (I don't flip and my properties and I am not banking on future appreciation) and I can fund my neg cash flow indefinitely. I am executing on my plan to fund my retirement, not trying to get rich quickly. Some people choose IRA's, I choose real estate (although I am sitting pat in the current environment).

These people are speculators pure and simple. They are confusing income (positive cash flow that pays for living expenses) with capital appreciation (that can be used for a lot of things, but living expenses should not be one of them). She even mentioned pyramid scheme and that is more or less what it is. $10k/month negative with no other source of income to supplement it is a series of foreclosures waiting to happen. What is THEIR worst case scenario and plan for dealing with it, I wonder?

Dec 9, 2005, 2:34:00 PM  
Anonymous Anonymous said...


Negative cash flow, by itself, is not necessarily a bad thing. I run about $1000 negative a month on my two investment properties (combined) but I can afford it. Eventually, rents rise and you become cash flow positive. Any property bought in Marin in the last 25 years with only 20% down has started its life cash flow negative -- My parents have done this since 1971 and always said that you have to feed it the first 5 years. They now own 7 Marin properties free and clear with no mortgages on them generating $10k a month in free cash flow (after taxes, HOA dues, maintenance, insurance) etc., that all started life negative.

Dec 9, 2005, 2:39:00 PM  
Anonymous Anonymous said...


I should add you are right on the money in this case, though. Break even will never occur if the loan keep swelling to pay the negative. Not unless rents rise very quickly, and building that assumption into your model is, once again, speculation.

Dec 9, 2005, 2:45:00 PM  
Blogger marine_explorer said...

Eventually, rents rise and you become cash flow positive

No, I suppose it's not always a bad thing, but my comments were specific to that particular case (as you noted later).

Personally, I decided to pass on being a landlord now after looking into what the future might bring in terms of appreciation. It's not just whether you'll eventually get that property to pay out, but it's also all the hits you take along the way, to be simplistic about it. If you can afford the hits long-term, then it may simply be a hobby. If the return far outweighs the hassle in 10 or 20, then it might be worth it for me.

Dec 9, 2005, 2:51:00 PM  
Blogger Downturn said...

Eventually, rents rise and you become cash flow positive

Except, of course, in San Francisco where rents dropped, 13.1% in the last 12 months!


Dec 10, 2005, 9:03:00 AM  
Blogger mover said...

When one deals with a person they don't believe, don't listen to what they say. Listen to what they don't say. Here is what I think is happening to the couple in Surreal Estate. The woman is using the man for his mother's equity. If the whole thing collapses, she dumps him and his mom like a bad investment. If it comes out a winner, she splits with as much as she can squeeze out of the both of them, using the skills she aquirred dumping her last partner. In the end, Mom is just an equity source and the boyfreind a sucker. She has no intention of working. She's using him and the system. The loans on this adventure are like kiting credit cards to play the margins market, only it sounds much cooler to the uneducated.

Dec 12, 2005, 8:35:00 PM  
Blogger mover said...

This is an easy one to spot. Listen not to what is being said, but to what is not being said. This woman is using the guy and his mother's equity to play the margin market in real estate. It's the same as using someone elses credit card to buy stocks on margin. If you win, you bail out on the suckers with as much as you can get(having learned from your last bail-out from your husband). If you lose, you just walk and let Mom deal with her new mortgage payments on the blown investments.

Dec 12, 2005, 8:49:00 PM  
Anonymous Anonymous said...


Your link did not work. Can you repost?

Dec 14, 2005, 7:35:00 PM  

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