Re Academic Press Private Real Estate Investment_9 docx

File: {Elsevier}Brown/Revises-II/3d/Brown-ch010.3d Creator: iruchan/cipl-un1-3b2-1.unit1.cepha.net Date/Time: 22.12.2004/3:27pm Page: 237/258 CHAPTER 10 The Private Lender The contemplation of difficult mathematics, Wolfskehl realized, was far more rewarding than the love of a difficult woman. Paul Hoffman, The Man Who Loved Only Numbers, p. 209 INTRODUCTION The two most common ways the private real estate investor becomes a lender are: 1. Originate or purchase a loan for cash. 2. As the seller of investment property, provide a buyer with financing for a portion of the purchase price by taking a note rather than cash in partial payment. There are ramifications associated with either strategy. Combinations are also possible, an example being a loan made as part of a sale that is then purchased by another private investor. Like many real estate opportunities, the permutations are numerous. In this chapter we will:  Examine motives of private investors who choose to become lenders.  Discuss the difference between aggressive and conservative lending policies.  Measure some of the true economic costs of private funds.  Describe specific loan provisions that accomplish tax objectives.  Warn against a few of the ‘‘traps for the unwary’’ that exist in the tax code. Lending requires a host of special skills. Local laws govern many of the conditions under which loans are made. This chapter is not about those legal details. Rather, it is about the economic, financial, and tax ramifications of these activities. 237 File: {Elsevier}Brown/Revises-II/3d/Brown-ch010.3d Creator: iruchan/cipl-un1-3b2-1.unit1.cepha.net Date/Ti me: 22.12.2004/3:27pm Page: 238/ 258 THE ‘‘HARD MONEY’’ LOAN VERSUS THE ‘‘PURCHASE MONEY’’ LOAN A loan secured by real property made directly to a borrower via a cash advance from the lender is known as a hard money loan. Loans granted to buyers by the seller as part of a sale are referred to as purchase money loans. While this is our convention, the language is imprecise. Some states consider cash loans from third parties purchase money simply because the proceeds of the loan constitute part of the purchase price. A common misconception is that because cash was paid for a hard money loan it should be held to some sort of higher underwriting standard. This is not true. A loan is a loan. Lenders, regardless of how they came by the instrument, usually want to be paid and want good security that will redeem the debt in the event of borrower default. Nonetheless, sellers sometimes make desirable loans to induce buyers to purchase, perhaps at a higher price. This will be taken up in detail later. As hard money lenders, institutions put borrowers and their property through a rigorous and time-consuming examination prior to granting the loan. Borrowers and properties that do not meet their standards are declined. Borrowers often seek out private parties because the loan can be made faster with fewer formalities. This is not to say that private loans are or should be poorly thought out or that private lending is a casual matter. A few simple rules can successfully guide the real estate investor who wishes to make loans. The fact that these rules are simple does not make them any less effective. THE DIVERSIFICATION PROBLEM Although it is possible for a private investor to own a portfolio of loans, real estate lending involves an entry cost close to that of the purchase of a parcel of real property. Because most private investors have relatively small amounts to invest, they cannot achieve the same diversification benefits a large lending institution can. For this reason, the first rule of private real estate lending must always be observed: Rule 1: Never make a loan on a property you are unwilling or unable to own. This rule opens the discussion on just what it is that a private lender obtains when he makes a real estate loan. Of course, the textbook legal answer is that he gets a security interest in the property. Perhaps. A financial or risk 238 Private Real Estate Investment File: {Elsevier}Brown/Revises-II/3d/Brown-ch010.3d Creator: iruchan/cipl-un1-3b2-1.unit1.cepha.net Date/Ti me: 22.12.2004/3:27pm Page: 239/ 258 management view is that he faces some probability that he will own the property sometime in the future. The most common remedy for a lender who does not receive payment is foreclosure. Thus, from an economic and risk perspective, the lender must view his situation as having made a loan to the property. For it is the property, not the borrower, that is expected to repay the loan. Many states do not permit a lender to collect funds from the borrower in excess of the amount realized from the sale of the property in foreclosure. 1 The private investor should make the loan as if he were buying the property at some unspecified time in the future under economic and physical conditions that are less rosy than the day the loan was made. After all, why does a buyer default? Why is no one else willing to rescue the buyer and obtain the property? If these questions cast a chill on the reader’s enthusiasm to be a real estate lender, that is understandable. If lending is a deferred ownership opportunity, to deal with the ‘‘opportunity’’ portion one need only follow the acquisition analysis standards set forth in Chapters 3 and 4. To deal with the ‘‘deferred’’ portion one need only choose the loan-to-value or debt coverage ratios carefully. Underwriting ratios are meant to prevent the lender from ever becoming the owner. The second rule of private real estate lending is: Rule 2: Never make a loan at a loan-to-value ratio that will permit you to become the owner of the property. Following those two simple rules (and some other technical rules of documentation) should prevent most real estate lending problems and result in timely payments. On the few occasions when borrowers get in trouble, someone else will enter the picture to cure the problem in return for the opportunity to obtain the property, perhaps at a discounted value, but one that is still greater than the loan balances. OTHER POSSIBILITIES Good rules are boring (and make short chapters). There are some interesting quirks of real estate lending that can take us in a very different, but still useful direction. Suppose the investor sees the market in a bubble condition as discussed in Chapter 9. He can wait until those buyers stumble and have to sell or he can loan to those buyers with the knowledge that they might stumble into foreclosure. This is a case where only the first rule of private lending is being observed. Such an investor views the possibility of obtaining 1 These laws are complex and many exceptions apply. The Private Lender 239 File: {Elsevier}Brown/Revises-II/3d/Brown-ch010.3d Creator: iruchan/cipl-un1-3b2-1.unit1.cepha.net Date/Ti me: 22.12.2004/3:27pm Page: 240/ 258 the property in foreclosure as a valuable option to acquire a property at a price below the last round of appreciation (or the last puff of inflation into the bubble). This strategy has its own difficulties. One never knows what the borrower may do when trouble calls.  He may gather his resources and see the problem through. In this case the lender should receive a high return, presuming that the loan was made at a higher interest rate than other alternatives, at least in part because the loan-to-value ratio was higher.  He may file bankruptcy, delaying the foreclosure process and increasing its cost.  He may find a financially stronger third party to purchase his interest at a discount, but at a price that is still greater than the loan balance.  He may neglect the property through a long period of decline before and during the foreclosure process, reducing its value below the loan balance. DID WE MAKE A LOAN OR DID WE BUY THE PROPERTY? The line between lending and owning blurs as the interest rate charged on the loan rises. Let’s examine this statement closely and see why it may be true. Imagine a lender who is indifferent about whether the loan obligations are met. Such a lender might even welcome the opportunity to own the property. The lender’s ultimate source of repayment is always the property. As the loan is presumably for a term of years, it is important to know the property’s value at various times, such as the loan funding date, the maturity date, the date the buyer defaults, and the date the lender takes possession in a foreclosure. Let’s begin by defining a simple future value function that will govern the property’s value over time. fv ¼ pv 1 þ g ÀÁ t ð10-1Þ This function anticipates a simple monotonic increase of a certain percent per year (g > 0) and is compared in Figure 10-1 with a flat value over time (g ¼ 0). High interest rates should accompany high loan-to-value ratios. Figure 10-2 shows the loan balance over time, assuming that interest is accrued and added to principal at a relatively high interest rate. This is a simplifying, but 240 Private Real Estate Investment File: {Elsevier}Brown/Revises-II/3d/Brown-ch010.3d Creator: iruchan/cipl-un1-3b2-1.unit1.cepha.net Date/Time:22.12.2004/3:27pm Page:241/258 realistic assumption. A borrower may take out a loan on vacant land calling for annual payments and then, unable to make even the first payment, default. The result is a foreclosure that may take a year or more, at which point the lender then has invested his original principal plus interest accrued up until he is able to take title and sell the property. The borrower’s equity in the property is the difference between the property’s value at any given time and the loan balance at that same time. At the point the loan balance is equal to the value, the borrower has no equity 0246810 Time 1000000 2000000 3000000 Value Flat Value Value Growth FIGURE 10-1 Value over time with and without growth. 0246810 Time 1000000 2000000 3000000 Value Aggressive Loan Flat Value Value Growth • • • • ••• • • • • • • • • • • • • • FIGURE 10-2 An aggressive loan with and without growth in property value. The Private Lender 241 File: {Elsevier}Brown/Revises-II/3d/Brown-ch010.3d Creator: iruchan/cipl-un1-3b2-1.unit1.cepha.net Date/Time: 22.12.2004/3:27pm Page: 242/ 258 and is only nominally the owner. That is, he may be in title, but he has no economic interest in the property. From an economic standpoint, the lender is the de facto owner of the property. Thus, we are interested in when the two plots meet. Given a fixed set of loan terms but two different possible property values (one flat, one increasing), we have two possible break even points. Note for Figure 10-2 that the first of these is a little more than two years after the loan is made and the second is a longer time, slightly less than three years following the funding of the loan. The reason for this, of course, is that the increase in property value in the second instance delays the time when the borrower’s equity is exhausted. Imagine what happens to the break even point if the value of the property falls (g < 0) after the loan is made. This carries an additional lesson in property rights. A well-established legal concept warns: ‘‘The Law abhors a forfeiture.’’ Courts frown on pre- determined penalties in contracts. Most states provide for minimum periods of reinstatement or redemption during a foreclosure or after a borrower loses his property in foreclosure. This gives the borrower an opportunity to avoid having his equity unceremoniously ‘‘captured’’ by a lender who may have had a hidden agenda or superior bargaining position when the loan was made. High loan-to-value loans combined with restrictions on lenders’ foreclosure rights mean the borrower can at least ‘‘live out’’ some or all of his remaining equity during the time (including redemption time) it takes the lender to foreclose and obtain clear title. By changing the variables in our example, one concludes that whatever ‘‘blurring’’ there is of the line between lending and owning, it is dependent on the loan-to-value ratio, the interest rate on the loan, the change in property value during the period of any default, and the time involved in foreclosure. Now let’s change the situation to reflect the more conservative loan made by a lender whose only motive is lending. In Figure 10-3 the lender observes both fundamental rules of private lending. Rather than loaning 75%, he only loans 60%. With this improved security the borrower is entitled to a lower rate, say 10% per annum. Note the change in the break even points to more than five years if the property does not increase in value and nearly eight years if it goes up slightly. We now turn to an example of a purchase money loan. In keeping with our wish to consider the twists and turns in the process that make life interesting, we will examine a private loan with tax deferral benefits for the lender. THE INSTALLMENT SALE While every sale transaction requires at least a buyer and a seller, for most transactions a third party lender is also required. We have noted that 242 Private Real Estate Investment File: {Elsevier}Brown/Revises-II/3d/Brown-ch010.3d Creator: iruchan/cipl-un1-3b2-1.unit1.cepha.net Date/Ti me: 22.12.2004/3:27pm Page: 243/ 258 institutional lenders impose expensive and burdensome requirements in connection with making loans. Many of these requirements are appro- priate for any lender, but some are peculiar to how a lending institution does business. A private lender may elect to suspend or waive certain requirements, making the financing process easier and less expensive for the borrower. Separate from underwriting standards, a third party lender introduces its own profit motive. When the seller agrees to be the lender, profits from the transaction that would have gone to a third party lender remain to be shared by the buyer and seller. This section is about that allocation. Chapter 7 showed that tax deferral is a good thing and that timing the exchange closing is critical. Private lending can materially assist this process. What will unfold in this section is an intricate weaving of economic interests and property rights in a transaction involving only two parties. As in Chapter 7, we will plumb the murky depths of the U.S. tax system to discover how parties modify their behavior to accomplish after-tax investment objectives. We will examine alternatives from the standpoint of each party. Conflicting interests abound in this area. Reconciling these is the art of real estate brokerage. Placing numerical values on the tradeoffs is the science. We will continue the example begun in Chapter 4 and further devel- oped in Chapter 7. For reference, our exchange–buyer client in Chapter 7 expected or had achieved (depending on whether one is projecting 0246810 Time 1000000 2000000 3000000 Value Conservative Loan Flat Value Value Growth • • ••• • • • • • • • • • • • • • • • • FIGURE 10-3 A conservative loan. The Private Lender 243 File: {Elsevier}Brown/Revises-II/3d/Brown-ch010.3d Creator: iruchan/cipl-un1-3b2-1.unit1.cepha.net Date/Time: 22.12.2004/3:27pm Page: 244/ 258 forward or looking back at the exchange acquisition) the results shown in Table 10-1. THE MOTIVATION OF THE PARTIES To maximize investments of any kind, one must control costs. The cost of financing is an important buyer concern. The seller keeps a watchful eye on taxes. For each party there are both long- and short-term considerations. THE BUYER Until now we have been silent on the source of financing, merely assuming that buyers obtain loans from conventional lenders. These lenders offer financing at market rates and terms that include origination costs. We ignored these costs for simplicity thus far, but now wish to look at them closely. Suffice it to say that if the exchange–buyer in Chapter 7 can avoid these costs, he is better off. Also, if he can obtain a below-market interest rate, that is in his best interests. Suppose an institutional lender charges 2.5% of the initial loan for origination. If the seller is willing to provide the financing, these costs are reduced considerably. They are not reduced to zero because there are always some costs in documenting a real estate loan. We will assume the seller could TABLE 10-1 Client Status Terminal year cash flow data ($) Equity reversion data ($) Sale price 5,196,898. Beginning loan balance 2,321,146. Ending loan balance 2,273,804. Net operating income 504,646. Original cost 2,604,683. Debt service 234,209. Sale costs 389,767. Depreciation 66,301. Accumulated depreciation 293,212. Income tax 77,501. Capital gain 2,401,351. After-tax cash flow 192,936. Capital gain tax 389,524. Pre-tax net equity 2,533,327. After-tax net equity 2,143,803. Net present value ¼ 1,039,896 IRR ¼ 0.46205 244 Private Real Estate Investment File: {Elsevier}Brown/Revises-II/3d/Brown-ch010.3d Creator: iruchan/cipl-un1-3b2-1.unit1.cepha.net Date/Ti me: 22.12.2004/3:27pm Page: 245/ 258 provide financing at .5% of the initial loan, a savings of 2 ‘‘points’’ on the Beginning Loan Balance in Table 10-1, or approximately $46,000. This has four major ramifications: 1. The buyer and seller would both like to capture these savings. The seller’s position to the buyer is, ‘‘You were going to pay it anyway.’’ The buyer replies, ‘‘But, you were not going to get it if I did pay it.’’ 2. Should the buyer and seller agree on how to divide the loan cost savings, the natural way for the seller to receive his share is in the form of a price increase. This has tax ramifications for both parties. The seller has a higher capital gain, but under the doctrine that after-tax money is better than no money, he does not complain. The buyer has a higher basis resulting in a higher depreciation deduction and lower future capital gain. But as it is cheaper to pay taxes than lose money, deduc- tions are a small consolation. 3. As part of reaching agreement on the division of the financing cost savings, the question arises as to the form of payment. The buyer can (a) increase his down payment, effectively paying the seller in cash; (b) increase the amount of the loan the seller will carry, effectively financing the cost; or (c) pay the amount in any combination of cash and higher loan balance. 4. The decision required in item 3 introduces secondary considerations having to do with underwriting risk, interest deductions, amortization period, etc. Using the tools provided in prior chapters, we can calculate the effect of many of the above decisions, or a combination of them, on either party. The advanced mathematics of game theory and matrices in multiple dimensions of Euclidian space might suggest a global optimum for both parties. Such an effort, while interesting, is beyond the scope of this book. In practice, the parties depend on the bargaining and negotiating abilities of their respective agents to reach an acceptable agreement. It is easier for us. We make assumptions. THE SELLER Before looking at the seller’s position we will make some assumptions about his circumstances. We will assume he is a mature investor whose property represents the latest in a series of exchanges. Along the way he has added labor, but now has reached the point where his effective return on his real estate has dropped due to his lack of time, interest, or ability to continue to actively manage his property. The combination of long holding periods, a set The Private Lender 245 File: {Elsevier}Brown/Revises-II/3d/Brown-ch010.3d Creator: iruchan/cipl-un1-3b2-1.unit1.cepha.net Date/Ti me: 22.12.2004/3:27pm Page: 246/ 258 of sequential exchanges, and the addition of costless (from a tax standpoint) labor means that he faces a large capital gain tax upon sale. Although he may be able to retire on the after-tax cash proceeds, he is intrigued at the opportunity to continue in a real estate lending capacity that is passive—or relatively so—and that offers continued tax deferral. The foregoing qualitative assumptions lead to the requirement of specific information about the seller’s tax basis, cost of sale, and loan balance. Table 10-2 provides this information followed by calculations for two capital gain reporting methods. Without the installment sale the seller of the second property in Example 2 of Chapter 7 (dataEG2b) must take $24,806 from other sources in order to close the sale and pay his taxes. This is clearly an unappetizing result. Fortunately, Section 453 of the U.S. tax code provides for the reporting of a capital gain under the Installment Sale method. By this rule the gain is divided into two parts, the recognized (cash) portion and the non-recognized (promissory note) portion. The result, in the right column of Table 10-2, is to tax only the cash received at the time of sale and defer remaining taxes until the seller receives cash payment of any principal due under the terms of the note. Using the Installment Sale method of reporting the capital gain, we overcome the negative net proceeds problem. But several other repercussions TABLE 10-2 Seller Results with and without Installment Sale Reporting Without installment sale ($) With installment sale ($) Seller adjusted basis 300,000 300,000 Seller sales costs 156,908 156,908 Seller loan balance 300,000 300,000 Capital gain tax rate 0.15 0.15 Recapture rate 0.25 0.25 Seller accrued depreciation 250,000 250,000 Sale price 3,276,132 3,276,132 Downpayment 954,986 954,986 Loan from seller 2,321,146 2,321,146 Seller capital gain 2,819,224 2,819,224 Seller recognized gain 2,819,224 954,986 Sale year capital gain tax 522,884 168,248 Seller net proceeds (24,806) 329,830 246 Private Real Estate Investment [...]... etc.) for the remainder of his life He can even sell his interest, but he only sells the life estate Any buyer then has the same rights in the property, but subject to a time limit measured by the retiree’s life For this reason life estates are rarely sold and are not very liquid Upon the death of the holder of the life estate, the life estate ‘‘falls’’ to the Remainderman who owns the remainder in... advisors, obtaining different and sometimes conflicting advice Such an experience is a byproduct of our complex society The Private Lender 257 Careful, well-intentioned advisors are invaluable The best approach may be to collect them all into one conference room and require them to coordinate their agreements and sort out their differences REFERENCE 1 Sirmans, C F (1989) Real Estate Finance, New York:...  Examine the retiree’s housing dilemma from two standpoints: discretionary income or house size  Compute investment returns for the Remainderman who provides financing for the retiree’s living arrangements RETIREMENT AND CREATIVE FINANCING One broad definition of creative financing is merely financing provided by individuals Oddly, this was the only kind of financing in earlier times before the establishment... direction of interest rates In this section we will assume that the buyer feels the option to prepay is worth more than $47,000 If the seller is unwilling to further reduce the price or interest rate, we would appear to have no deal But there is yet another alternative The seller may permit early repayment if prepayment is accompanied by a bonus in the form of a prepayment penalty or fee There are... periods, a Life Estate and a Remainder A Life Estate is a specific form of ownership of real property It is different in that the rights Creative Financing 261 to the property are limited in time by a human life It can be any life, but for simplicity we will assume it is the life of the party who occupies the house, in this case our retiree Thus, if our senior family member owns a life estate in a house,... sunbelt, often motivated by health reasons, by personal lifestyle, or to be closer to grown children We will assume our retiree owns a debt free home of modest value in a Midwestern state Suppose further that a younger family member, perhaps living in a warmer climate to which the retiree would like to move, is interested in an investment that supports both the retirement and estate planning goals of his... the retiree will occupy the house represented by his life expectancy ¼ value at purchase of the house to be occupied, a proxy for size ¼ occupancy cost of the property (taxes, insurance, maintenance), a function of the size of the property 276 262 Private Real Estate Investment b ¼ bequest at death g ¼ growth in value over time inc ¼ income of the retiree, a constraint on the size of the loan and therefore... good use of these tools It is common for a parent to sell to his child, reporting the gain as an installment sale However, the IRS has ‘‘related party’’ rules that must be carefully followed The issues touched on briefly in this chapter each may be interpreted differently in different fact situations It is for this reason that readers of material such as this are always urged to consult with competent... to structure a prepayment penalty We shall consider just two of these The first is a rather standard provision used in residential lending; the second is more common to commercial lending 1 Any prepayment in any loan year in excess of 20% of the remaining outstanding balance must be accompanied by an additional payment equal to six months interest on the excess amount prepaid 2 Any prepayment received... in present value 258 255 The Private Lender PV of Tax Deferral 35000 30000 25000 20000 15000 10000 1 2 3 4 5 6 7 Year FIGURE 10-9 Decline over time in present value of income from tax deferral As the years progress, the seller realizes the extra income year by year Each year the present value of the remaining income to be earned on the tax deferred gain drops as in Figure 10-9, assuming that full payment . 3,276,132 3,276,132 Downpayment 95 4 ,98 6 95 4 ,98 6 Loan from seller 2,321,146 2,321,146 Seller capital gain 2,8 19, 224 2,8 19, 224 Seller recognized gain 2,8 19, 224 95 4 ,98 6 Sale year capital gain tax. greater than the loan balances. OTHER POSSIBILITIES Good rules are boring (and make short chapters). There are some interesting quirks of real estate lending that can take us in a very different,. and added to principal at a relatively high interest rate. This is a simplifying, but 240 Private Real Estate Investment File: {Elsevier}Brown/Revises-II/3d/Brown-ch010.3d Creator: iruchan/cipl-un1-3b2-1.unit1.cepha.net