From Property to Liens and Back

In light of my previous post on timing the market, I thought that I would follow up with a post on one type of investment strategy that takes advantage of the cyclical nature of real estate.

There are a number of ways to invest in real estate. From property acquisition to shorting housing starts to buying equity in a REIT, each type of investment in the real estate market comes with its own idiosyncrasies, which must be understood in order to ensure maximum profitability. Specialization in one category or subcategory is often expected and praised among real estate practitioners and investors. The various entry points into real estate, however, allow for diversification. Purchasing property, notes or securitized bonds provide direct access to the real estate market, while liens, nonperforming notes and real estate derivatives can serve to counteract real estate defaults, if properly purchased. Although, given the change in the regulatory climate for derivatives, real estate derivatives have become more theoretical than piratical.

Since the real estate market has some many points of entry, one can balance a real estate portfolio by investing in different asset classes, depending on the performance of the market at any given time. In this way, an investor can capitalize on the cyclical nature of real estate. One such way to diversify is to purchase property for appreciation and purchase liens and nonperforming notes as the market declines.

Buy Low, Sell High

I am always amazed at how the real estate market seems to demonstrate a certain level of fervor during the upswings and panic during the downturns. Although the magnitude and length of each particular cycle may vary, the cyclical nature of real estate is one of its fundamental traits.  Given the illiquidity of property, however, real estate cycles typically take place over a number of years. It has been my experience that an entire real estate cycle can last 5-10 years. Given this timeframe, there is usually sufficient opportunity to prepare to take advantage of the idiosyncrasies of each section of the real estate curve.

 The old stock market adage: "buy low, sell high" can serve as a strong guiding principal when creating a real estate strategy that will yield success throughout the real estate cycle. Almost contrite in its simplicity as it applies to equities, "buy low, sell high" is a great way to describe the recommended counter-cyclical behavior of a real estate investor. Buying low essentially means that purchases should be made in a down market and sales should be made in an up market. The challenge with counter-cyclical investment however, is that it goes against market conditions. Buying in a down market can be challenging, as that is when lenders tend to be wary of additional exposure to declining price and credit becomes scarce. It is, therefore, important to have capital available for purchases in down markets. Solid valuation is also key in a down market, as purchasing too early can result in acquiring an asset at a price point at which the asset will take a substantial amount of time to recover through appreciation. The fear of overpaying, however, should not paralyze investors into inaction, but should be seen as requiring a higher level of diligence and discipline. Opportunities are generally present in the down market, but must be scrutinized.

Same Mechanism, Different Crisis

I recently read William Seidman's book Full Faith and Credit, which contains a detailed explanation of the S&L crash of the early 1990's that was spurred on by a crash of the US commercial real estate market. William Seidman was head of the FDIC at the time of the crash. A day after I finished the book, I walked by my bookshelf and noticed the book Bull By Its Horns, by Shelia Bair, the chairman of the FDIC during the 2007/2008 financial crisis, when it hit me--both publications are the same book written nearly 20 years apart. Although each of the authors have their individual differences, they are both similar in that they were Republican chairmen (or is the term chairpeople?), serving during Republican presidencies, who presided over the fallout of a banking crisis that resulted in the largescale nationalization of private assets and companies.

The political affiliation of both former heads of the FDIC is tangential to my point, however, I mention it to make two observations. The first observation is that both Mr. Seidman and Ms. Bair are linked by political party. The second is that the economic climate forced them to participate in the goverment takeover of private companies and their assets, an idea that is antithetical to most Republican ideology.

Although one of the chief duties of the FDIC is to close failing institutions and liquidate their assets, under most normal economic circumstances, this duty of the FDIC is either carried out infrequently or confined to a certain sector of the market. Both the S&L crisis of early 1990's and the Great Recession of the late first decade 2000's, however, forced the FDIC and other government agencies to either take ownership an stake or fully national financial institutions in a large, systemic manner.

My Take On Tax Liens

Tax liens have always been of interest to me. As a teen, I would remember the infomercials advertising tax lien investments as the way to own tons of property for pennies on the dollar. Since my father was a contractor and property manager, I was introduced to real estate ownership at a young age and read my first book on tax liens in my late teens. At the time, I could not figure out why more people were not investing in tax liens. As an adult, real estate professional and attorney, I can now appreciate the risks/reward trade off that comes with this asset class. So, here is my take on tax liens.

Tax liens are a low cost way to obtain exposure to the real estate market. Although the supply and demand of tax liens is very much influenced by local events, tax liens will be around as long as there are municipalities in need of money and property owners who do not pay their taxes. Although cheap and available, investments in tax liens propose some unique risks and benefits.

One of the unique benefits of tax liens is that they initially offer passive income at high rates of return. Most tax liens are purchased via auction and most auctions employ one of two bidding methods--bidding up price or bidding down interest. Whether the price of the lien is bid up or the interest rate is bid down, the amount of back taxes owed does not increase and statutory penalty rates of interest typically offer an attractive return to purchasers that do not overbid. Moreover, upon the purchase of a tax lien, the municipality continues to serve as the collection agency for a statutorily mandated length of time, in most cases. This allows investors to collect on the purchased lien with minimal effort, for a period of time.

Taxes, Taxes, Taxes

This may be stating the obvious, but the tax consequences of a real estate transaction are one of the most important aspects of the deal. Although most generic measures of property value, such as cap rate and NOI seek to exclude taxation in order to generate values that can be comparable across investors, an individualized tax assessment of any real estate acquisition is essential to determining its true rate of return of and its opportunity costs.

Although I am not a tax professional, tax expert or tax adviser, I would like to briefly discuss various real estate investment tax considerations. I will attempt to address a few of the more popular tax considerations at the property, entity and security level:

Mortgage Backed Securities and Personal Bankruptcy

At long last, the end of the series!

Personal bankruptcy is usually filed by an individual for very different reasons than corporate bankruptcies. Whereas the primary motivation behind filing a business bankruptcy may be protection of the business or satisfaction of debts, personal bankruptcies are frequently filed for asset protection, in addition to satisfaction of debts.

The two sections of the bankruptcy code that apply to personal bankruptcies are chapter 7 and chapter 13. As with business bankruptcies, chapter 7 for personal bankruptcies is a process of liquidation and seeks include all non-exempt assets of the petitioner in the bankruptcy estate in order to liquidate them to pay off debts. Chapter 13, on the other hand, seeks to reorganize the debt of a petitioner pursuant to a payment plan, which typically last from 3 to 5 years.

Special Purpose Entity Bankruptcy Concerns for Mortgage-Backed Securities

Let us continue the bankruptcy theme begun in my last post and discuss the effects of Special Purpose Entity (SPE) bankruptcies and their effect on mortgage-backed securities. Obviously, most bond covenants designate the bankruptcy of a SPE an event of default and restrict the likelihood of its happening. In the unlikely event that such a bankruptcy does happen however, here is an overview of the process.

As a quick review, I would like to restate that mortgage-backed securities are the result of a process of securitization that takes place when a real estate lender sells a package of its loans to an entity, called and SPE. The SPE receives the money to purchase the loans from the sale of either securities, beneficial interests in the entity or trust certificates from a trust set-up to hold the loans. If securities or trust certificates are sold, they are called mortgage-backed securities (MBS). Through the securitization process, real estate lenders are provided with cash to originate more loans and investors are able to purchase MBS and invest in the real estate market without having to hold real property. If you question why one would want to invest in the real estate market at all, please see my earlier post, “Why I Choose Real Estate.”