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Trust Deed Investment

Arixa Capital 2012 Spring Newsletter

First Quarter 2012 Newsletter
First Quarter 2012 Newsletter

This edition of Arixa's newsletter includes:

  • The growth of our investment programs and the launch of our second fund
  • Our annual panel discussion at UCLA in conjunction with the Ziman Center and the Anderson School
  • An update on Arixa's first assignment as a court-appointed receiver; and
  • Information on a new white paper by Jan Brzeski
 

The Case for Single Family Homes (Part 2)

Jan Brzeski is a contributor to Seeking Alpha. The article below is a copy of what he posted on August 30, 2011. To access his article on Seeking Alpha, please click here. In the first article in this series, we explored how "replacement cost" analysis suggests that single family homes in Phoenix are undervalued, and why they are much more likley to go up in value in coming years, rather than moving down.

In this article, we explore a second, independent, strong signal that single family housing in some areas is undervalued. For this article, we will switch to inland Southern California rather than Phoenix, since I know the rental economics better in this area.

Single Family Rental Economics Below is a home about an hour from Los Angeles that was purchased for a little over $100,000 in early 2010.

The buyers of this home are a father and son team who have purchased about 100 homes in the same area in the past two years. They have sold about sixty homes after rehabilitating them, and they have held onto the other 40 homes to create rental income.

They spent about $13,000 rehabilitating this property, so their total cost basis is about $115,000. Today, the house is rented for $1,450 per month. Assuming one month of vacancy each year, rental income is about $16,000 per year. Operating expenses are about $5,000 per year. Net income is about $11,000 per year. On their cost basis, the owners are getting about a 9.6% cash-on-cash return ($11,000/$115,000).

If they bought a similar home today, in need of repairs, direct from a bank, the market is more competitive and they would pay more--probably $130,000 instead of $100,000. Even so, they would still have well over a 7% cash on cash return. Once rehabbed, the property would be worth in the high $100s. This property is appraised at a retail value of $195,000 today.

A Quick Look At Multifamily Rental Economics Let's compare the single family home "fix-and-rent" strategy with buying apartments.

If one were to buy a 100 unit "Class B" apartment building in the same area as this home, it would trade at a capitalization rate of about 6.5%. That is, the income before debt service would represent a yield of about 6.5% as compared to the purchase price.

Given today's low interest rates on multifamily properties courtesy of Fannie Mae (currently under 5% for a 10-year maturity), the cash-on-cash return would be okay from the apartment property--probably about 5% after accounting for principal payments required by the mortgage, reserves and other factors.

However, if interest rates go up, or Fannie Mae stops subsidizing the apartment market by providing such low rates for apartment owners, the value of such assets could easily drop. Investors look at their cash-on-cash returns after debt service, and apartment values have been driven up by very low interest rates for apartment loans. If these rates were to go higher, apartment values would drop, just like bond values.

The Risk Of Buying Apartments Today The bottom line for apartment investors is, they can enjoy low single digit cash-on-cash returns. However, in my view, there is a substantial chance of capital loss, even if rents keep going up, because higher interest rates will lead to higher capitalization rates which means lower values.

For example, suppose we have a change in cap rates from 6.5% to 7.5% (which is historically a more typical cap rate for Class B apartments in secondary markets). A property with annual cash flow before debt service of $300,000 drops in value from $4.6 million to $4.0 million--a 13% drop in value. Now suppose that the property has a loan of $2.3 million. The $600,000 drop in value now equates to a reduction in equity from $2.3 million to $1.7 million, or a 26% drop in equity.

Apartments are currently a favorite asset class for real estate investors, but as the numbers show, there is real risk for apartment buyers when cap rates are at historic lows, as they are now.

Apartments vs. Single Family Home Rentals If, instead of buying a 100 unit apartment building, one were to purchase, say, 60 homes in the same area, there would be certain advantages and disadvantages.

The apartments would be much easier to manage, since they are all grouped together and there are economies of scale. Also, it is easy to get financing to buy apartments, while financing to buy single family homes as an investment is difficult to find and expensive.

The single family homes have the advantage that the current yield (cap rate) is a little higher than the current yield on apartments. Say, 8% vs. 6.5%. They also have one other important advantage. The homes can be sold individually, and if they are purchased from a bank by an experienced operator, they can be bought at "wholesale" prices.

As a result, a home bought for $130,000 and rehabbed for $15,000, for a total cost basis of $145,000, might be worth $185,000 once it is fixed up, because it can then be purchased by a family and once fixed up, the home will qualify for Fannie Mae or HUD financing (which increases the affordability for families substantially). After accounting for broker fees, there is still maybe $25,000 or $30,000 of equity created in the home, by virtue of a favorable purchase and an efficient rehabilitation, both of which create real value.

By contrast, there is almost no way to purchase apartments at "wholesale cost", at least not within an hour's drive of Los Angeles. Anything worth owning will become a competitive auction led by the large number of opportunistic investors who have been trying to buy apartments since the downturn began. The most common complaint from these savvy investors is that there is too much competition, and not enough product available to buy.

Conclusion Most members of the Seeking Alpha community have no interest in being landlords, let alone being landlords for a portfolio of single family homes. The point of this article is two-fold:

The attractive economics of the "fix-and-rent" market today, as compared with the apartment investment market, suggests that home values are near a floor in the most beaten down areas of the Southwestern U.S. It is hard to see values falling much further when already the numbers are compelling for investors to purchase these properties at current prices, given current rents; and The "fix-and-rent" strategy outlined in this article can be accessed by passive investors as well, but only if they know the right people. The key is to find trustworthy operators with a demonstrated track record, and to be able to structure a mutually favorable program to deliver cash flow and a portion of any equity created to the investors. And to insist that the operators have real "skin in the game" in the form of capital alongside the non-operator investors. The Best Of Times For Single Family Home Investors Who Can Execute

For those seeking to gain exposure to real estate intelligently, "small is beatiful." In other words, unglamorous investments like a portfolio of single family homes in a blue collar neighborhood trumps "trophy properties" like pricy Manhattan office buildings--if one is looking for current cash flow and solid risk-adjusted returns.

Several years from now, many investors will look back at the investments that are being made today by obscure but hard-working teams like the father and son team that bought the property pictured above, and they might ask themselves, "why didn't I put some money into that?"

The answer is, this is a truly contrarian strategy and it is non-scalable, so you won't hear about it from any mainstream firms who need to invest on a large scale.

Assessing the Risk: Is a particular SFR Trust Deed Safe?

This podcast explains the pricing and terms private lenders can expect when lending to established, high volume single family residential rehabilitation specialists. It also explains the loan-to-cost and loan-to-value underwriting criteria that are typical in our market as of mid-2011. The current market is profitable for both lender and borrower, and provides an appealing opportunity for real estate investors looking for high current yields with a solid margin of safety.

The Three Sub-Markets of Trust Deed Investing

This podcast examines three different sub-markets within the trust deed investing universe: (1) single family residential "fix and flip" six-month loans; (2) single family investor loans of up to 24 months; and (3) commercial real estate bridge loans of 12-24 months. The podcast compares and contrasts these three areas from the investor's perspective. Please watch our blog as we will be posting one new podcast roughly every week. There will be about 30 podcasts total in the series, and this is the seventh. If you are interested in learning more about what we do, please sign up for our newsletter at www.arixacpital.com or give us a call at 310-846-1754.

Our February 2 Event is only three weeks away!

Please join us for an evening of networking and stimulating discussion among noted real estate investment experts in our region. Our latest co-sponsor is GlobeSt.com, a leading web-based publication serving the real estate investment industry. Both GlobeSt.com and the Daily Journal currently have senior editorial staff on our registration list in anticipation of a newsworthy back-and-forth dialogue among our panelists. The event starts at 6:30 p.m. with an hour of networking, wine, beer and hors d'oeuvres, with the panel discussion going from 7:30 p.m. to 8:30 p.m. Questions and answers and the event will conclude at 9 p.m. Pre-registration is just $15 with a major credit card.

What makes our event different and why did we attract almost 200 people last year?

I think our event has three special qualities that set it apart: (1) great panelists who are unusually candid about what is happening behind the scenes in the real estate investment market; (2) a low price and excellent value, thanks to our generous sponsors; and (3) a collegial atmosphere in which the speakers are more accessible than usual. Our event is not set up to earn a profit…it is designed to build community and provide a venue for all of us to become better investors by tracking a group of experienced real estate pros through the ups and downs of the real estate market cycle.

Please feel free to call me directly if you have any questions about the event, or need help registering, or if you have any special requests or ideas to make our event better. I look forward to seeing you on February 2.