Thursday, November 02, 2006

The Reverse-Millionaire

It's been over two years since I bought my first building, and since the very beginning my goal has been to accumulate as much real estate as possible. The phrase I've been using to describe this aspiration is to become a Reverse-Millionaire: to owe as much money to the banks, in the form of secured real-estate mortgages, as possible. The thought is, that the more money I owe the bank, the more properties I'll own and the more money I'll make, not necessarily in the short term, but by holding for the long term. If I can become a reverse millionaire while I'm young, in 15-20 years I'll most likely have "boatloads of money". There are lots of other advantages, for example, any rent inflation, becomes more money that I can pocket each month.


In order for this tactic make sense, I have a few important rules.



  1. Only buy a place when you definitely have the monthly cashflow to support it. I only want to buy a place if I know that I have the money to pay for it. I assume a 33% vacancy rate, meaning that if I receives $1,000 a month rent, count it as only +$666.67 toward cashflow to cover maintenance and vacancy costs (banks conservatively use 25% when calculating your income before giving you a mortgage).

  2. Only use 30-year fixed mortgages. Although you will have to pay a higher interest rate, this will keep the mortgage costs from spiraling out of control. After I buy a place, I know that my principle and interest payments will stay the same for the next 30 years, which is very comforting (although insurance and taxes go up).

  3. Do not lie on the applications. This should be obvious, but it isn't always as you'll see shortly. When a bank gives you a mortgage, they're betting based on the information that you gave them that you are going to pay the loan back. They use the information on the application to determine how likely it is that you will default. If they are willing to give you a loan based on an honest application, then they believe that they won't, within a tolerable level of risk, lose money. There are reasons for the checks and balances that the bank uses, when you lie you're much more likely to get yourself in over your head.


Now, using this method I've purchased four properties in the last two years. I am not quite the reverse millionaire that I want to be, but I'm about two-thirds of the way there. Because I followed the rules listed above, I am in fine financial shape. If interest rates go to 500% tomorrow, that's fine for me because I will be paying the same amount for the next 30 years. If a tenant doesn't pay rent for a few months (as regular Landlord Shmandlord readers are aware does occasionally happen), then I can handle it.


The key point that I want to make is that, if I didn't follow something similar to the above guidelines, it would have been very easy for me to achieve my goal of becoming a reverse millionaire by now. For example, I could have selected much riskier loans, like the infamous interest-only ones. Or I could buy more places from sellers that are in kahoots with shady mortgage brokers, which appear to be able to offer loans regardless of credit scores. The problem is, if I did these things the entire house of cards would be much more unstable than it is now.


Not everybody has been as careful. Case in point: Casey at I am Facing Forclosure dot com. This guy racked up 2.2 mil in debt (including 140k in unsecured credit card debt). Now, as you'll see very quickly on his blog, he's in trouble. I stumbled upon his blog on I Will Teach You To Be Rich, where oddly enough Ramit knew Casey from high school and gives some insight into Casey's character:



Casey had tried to sucker people into a scam real-estate deal less than a week before he admitted he was going through foreclosure. I was fortunate enough to recognize his pitch as bulls**t, but what if someone had gotten conned into it? Financial scams on unsuspecting people make me furious. So I read through his site. It turns out that he had bought multiple houses in different states (hoping to flip them quickly), lied on his applications to get his loans approved, and had grossly miscalculated how much it would cost to renovate and flip them. Bad move. His debt is now over $2 million.

Now I don't feel quite as bad about not being a Reverse Millionaire yet. However, I'm still confident that if I continue the course that I'm on, I'll eventually get there in a reasonably safe way.

5 comments:

traineeinvestor said...

A nice conservative strategy which is more or less what I am trying to do in real estate as well. I only buy where estimated yield (net of outgoings and vacancies) will cover a P+I mortgage. This means that I am forced to put a lot more equity into my properties than more aggressive investors but I also get to sleep an night.

The only difference is that I have opted for floating mortgage rates because (i) long term fixed rates are not generally available in Hong Kong and (ii) the medium term (1-5 year) fixed rates are hugely more expensive than the floating rates. So far it has been the right strategy.

Steven James said...

Even i would like to do something of that sort. Is Reverse Mortgage a possible solution ?

Jim Day said...

Glad to hear things are working out well for you Rick.

In your last tip you write about being honest on the loan applications at the bank. I'm curious, do you do all of your financing through your local lender? If so, what kind of rate are they do they generally offer?

I'm just getting my feet wet with landlording and from what I've read so far, it seems that it's just too difficult to make a profit after the banks gouge you with ridiculous interest rates.

I'd really appreciate any insight.

Christina said...

Rick, I like your conservative approach to investing. So I'd like to run my scenerio by you and get your feedback. I live in CA but purchased a 2/1 condo in Honolulu, HI (where I grew up) late June 2006. Purchased price was $305K, 20%down, 30-yr fixed at 6.625%. Total monthly payment is approx. $2000 ($1633 for PITII, $285 for HOA dues, $75 for prop. mgmt fee). In August I it rented out for $1500/mo. So each month, I am $500 out of pocket. This is do-able for me but leaves me with a tight budget to live by (since I am also paying mortgage for the my home in San Jose, CA).
I am not sure if you're even familiar with the market in HI, but I wanted to get your opinion. If you held this piece of property given this financial situation, what would your next move be?

Rick said...

Thank you all for the comments.

TraineeInvestor:
Sounds like a very good strategy if you can do it.

Jim Day:
I have used a few different lenders. My first loans were with a large mortgage broker through offices in my home town. Through them the rates weren't great but they definitely got the job done. Recently, I used a national bank who I've had checking and savings accounts with for several years. For future loans I will try them all again and go with the best. I would recommend that you shop around as soon as you have the first bank run a credit check. You have roughly 2 weeks from the first check to do all your shopping without an additional tick on future credit reports. Have 5-10 places run your credit and tell you what they can offer. The interest rates are higher for investment properties, but it can be done.

Also, it is important to find a market where home prices are reasonable compared to rent, which certainly isn't everywhere. You want to make sure that if you buy a place and put down 10%-20%, your mortgage payments will be covered by the rental income. If your expected cashflow is very negative, then you should probably look elsewhere. You could also try putting more money down if possible (like TraineeInvestor), because this will lower your mortgage payments. If you would like to discuss more specific numbers, email me at landlordshmandlord AT gmail DOT com.

Christina:
I can't tell you exactly what to do, but I can offer a few thoughts.

Pros: 1) I am typically a fan of buying and holding if you can, but it does have to make economic sense. 2) For the most part, I do believe that rents are going to go up as the real estate market continues to soften, it is a matter of how quickly. This will close your gap over time (hopefully in the next few years). 3) If property rates go up on average 3% over the next few years, you'll make pretty good money. If they go up 5%, you'll make very good money. What do you think is going to happen? 4) Will you ever move back? If yes, then that could be an added incentive to hold it so that you'll have a place and won't pay the closing costs twice (first to sell this, then to buy later). 5) How much of your mortgage payments are going toward principle? Whatever that amount (probably around $200 now) is basically money that you're putting in the bank each month (from the $500).

Cons: 1) You are only getting 75% of your cost (not counting vacancy and maintenance), which is low. 2) Assumptions about rent increases or property value increases could be wrong. 3) You could find a better use for this money, either in real estate elsewhere or in a different investment. To figure out how much you'll have to invest, you must remember to include closing/transfer costs (like any local transfer taxes).

I don't know what the market is like in Honolulu, how much is the place worth today? Let me know if this helps or if you have any additional questions. I would also recommend making a spreadsheet to project where you'll stand economically if you hold it through next 30 years. Make each row a year, and make sure to include property value at a certain appreciation (try 1%, then 3%, 5%, or whatever else), mortgage that reflects payments made each year, your current equity, estimated yearly income, estimated yearly expenses (including vacancies), and your net (equity - money spent). I have one made, email me and I'll send it to you.