Today’s blog post is the result of a conversation I was having with a gentleman this morning, who was exploring real estate investing opportunities.  After we exchanged pleasantry’s and caught up about people we knew in common, I was asked:

“What is the impact on my portfolios of mortgage note investments if the real estate market changes?”

This is a question that I get asked quite frequently from people who are trying to make sense of understanding what SCL Capital does everyday for our business.  The concept of buying assets undervalued, adding value through one or more various strategies, then exiting the asset or keeping the cash flow can sometimes be a challenging idea to grasp as I explain to people unfamiliar with our business model.

Typically, prospective investors or people just looking to make polite conversation from a frame of reference they have already assume that SCL Capital buys mortgage notes that are bought at deep discounts because the real estate attached to the mortgage has dropped significantly in value due to real estate price declines post 2008.

I think it was Warren Buffett who said “price is what you pay, value is what you get.”  Said another way, the price of the assets determine if I choose to purchase a pool of mortgage notes or not, but current price DOES NOT impact the value of the assets while me and my team are performing our due diligence. In the context of the stock market, Mr. Buffett would not care one bit if the stock market were to close for a decade.  Berkshire Hathaway makes investments based on the value, not what the current market says the asset is worth.

SCL Capital targets mortgage notes secured by real estate in the United States that is presently in a state of distress.  Our management team categorizes opportunities from troubled real estate into three classifications: market distress, owner distress, and building distress.  So that I can describe our approach and how we capitalize on today’s market conditions, let’s consider these three types of distress.

1) Market Distress

The laws of economics have created the market distress covered by the media.  Turn on CNBC, check CNN.com or listen to NPR and you can get all types of data about what is happening in the real estate market.  Economic woes are on everyone’s lips and easy money in the last decade has been identified as the culprit.  Predominantly, economic factors fueled speculative buying creating excessive demand running up prices but not necessarily actual values of real estate.

Buyers jumped in with a “gold rush” mentality acquiring multiple properties in heavily promoted regions such as California, Nevada, Florida and Arizona using credit backed only by “stated income” and a signature.  If we stop to think how crazy this is, no wonder there was a “real estate bubble” that burst around 2008.  Please note I am not placing blame on any one group, not homeowners, investors, real estate agents, mortgage brokers, Wall Street financial firms….people got greedy and common sense went out the window.

Buyers thought they could get out before the day of reckoning, but this “false demand” resulted in excessive supply.  When the day of reckoning finally did come, speculators could not unload before the massive market corrections – creating massive portfolios of non-performing loans and homes for sale with few buyers.

While the states listed above exhibited the most dramatic price jumps, prices escalated across the United States (just less dramatically) for two more reasons: 1) non-speculators – homeowners – were using “paper gains” from new valuations of their homes to borrow 100% or more of the newly inflated values, and no one complained because the economy benefitted from lots of consumer spending; and 2) easy money policies allowed many people to qualify for loans to buy homes (and to borrow against them) who would never have qualified under normal circumstances.

Not only were home buyers granted access to take out these paper gains from their houses in the form of HELOC’s (Home Equity Line of Credit), but 100% financing was pretty easy to obtain.  100% financing means that home buyers were using a combination of 1st and 2nd mortgages to buy their house, no matter if it was for their family to live or a fix and flip they thought they could make a quick buck.  The days of people putting down a downpayment of 20% were long gone.

Regardless of the cause, many people received loans without having the means to service them.  This led to a market free-fall and the large volume of non-performing loans being bailed-out today.

2) Owner Distress

Owner distress exists when the owner has problems that need to be solved independently of the marketplace.  This might include financial circumstances such as when a lender calls a loan; alternatively, the property owner could face business failure, personal trauma like divorce, or pressure from the IRS.  Medical bills or illness are also a major cause of personal bankruptcies.  In the link to the CNBC article below entitled  “Medical Bills Are the Biggest Cause of US Bankruptcies.” The study finds:

“Bankruptcies resulting from unpaid medical bills will affect nearly 2 million people this year—making health care the No. 1 cause of such filings, and outpacing bankruptcies due to credit-card bills or unpaid mortgages, according to new data. And even having health insurance doesn’t buffer consumers against financial hardship.”

http://www.cnbc.com/id/100840148

Yahoo published an article in 2010 highlighting the top 5 reasons why people go bankrupt:

1. Medical Expenses
2. Job Loss
3. Poor/Excess Use of Credit
4. Divorce/Separation
5. Unexpected Expenses

http://finance.yahoo.com/news/pf_article_109143.html

When you start to understand the situation of the average American, it becomes quite clear whey owner distress causes people to miss mortgage payments. An article by CNN below, reports that 76% of Americans are living paycheck to paycheck.  Some circumstance is going to happen at some point in our lives, it happens to all of us.  We may not know when, but not putting money away for a rainy day will cause owner distress.

http://money.cnn.com/2013/06/24/pf/emergency-savings/

A buyer with ready cash is usually the best solution for this problem.  The key distinction to understand with owner distress is that the underlying real estate or mortgage attached to the real estate may have nothing distressed about it, just the homeowner is not in a financial position to hold that asset at more.

 

3) Building Distress

Building distress occurs when tenants have taken advantage of the property through irresponsible behavior that management has tolerated and not remedied.  It may be correlated to owner distress.  The owner may have siphoned cash that is flowing well from a particular property to prop up sagging performance on other properties for lifestyle issues.  Neglecting routine maintenance and deferring capital projects creates a cycle of deteriorating real estate, decreasing rents, and decreasing value, all of which further deter the owner from contributing capital to address the problems.  It is completely unrealistic to think that real estate will not need any upkeep.  Some real estate investors have a line item expense called “deferred maintenance” to put away money every year to ensure the long term health of the asset.  A buyer with ready cash works well to solve this problem as well.

 

Are there any other types of distress that I missed?

Jeffrey Greco