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FHA Loan Changes, Sellers Disclosures, “Tax Free” Income, GSE Conservatorship with Guest Co-Host Robert Orfino
We’ve got four topics on this episode. FHA loan changes, we’ll talk about that. Seller’s disclosures, because a lot of folks don’t know the ins and outs of seller’s disclosures. Tax-free income and we’re going to talk about the conservatorship that is the GSEs right now. Fannie and Freddie and what is likely going to happen here in the next couple of years. We’ll break this down into four segments. Let’s talk about changes to FHA. A buddy of mine posted and he said, “There have been some changes to FHA’s underwriting guidelines.” “What does that mean exactly?” What it really means is that they are going to get more conservative. At least that’s what I could glean from the article. The question is why would Fannie Mae right now become more conservative with their underwriting guidelines?
There’s a thesis out there that says they changed their underwriting guidelines to get more people loans when interest rates are lower. I said, “That is actually not true.” What actually happens in the marketplace is that loans that have a higher interest rate, a higher rate of return typically have fewer underwriting guidelines. That’s what we’ve seen in the past. In a few months, rates have collapsed. The last time I looked, I knew we were at twelve-month lows. We might even be at 24-month lows at this point. Fannie Mae has come out and said, “Let’s tighten up lending standards because the rates are going down.” That’s what I’m seeing out there.
It was actually a yes and they did it through a technical reform. They no longer allow folks to go through automatic underwriting that is too close to the DTI and the credit score. What that means is 50,000 people who got loans last year will no longer qualify this year. Not that they’re going to take those mortgages back, but if you had a low DTI, which is Debt-To-Income ratio and if your credit score was 626 is now where they’re cruising at, there are 50,000 of those people across the country that would not qualify for a mortgage that was backed by FHA.
That makes total sense because at the end of the day, when rates are cheap, there’s not enough margin for investors to take on that risk. Right around the fourth quarter of 2018, it came out which was interesting. Experian, the FICO folks, the credit rating agencies made some changes to consumer credit in such a way that would increase their credit score. Some people would see as high as 50 to100 points in increase credit rating. It had to do with health care related expenses and some other things that show up on their credit report. There was this big outcry. If you want to stop torturing yourself or if you ever feel depressed, stop watching the news. Back away from the national news services because I remember all these articles coming out about how they were going to be these changes and people were going to get mortgages for free. It was going to be pure bedlam. It’s like, “Everybody calms down.” For some people, it’s a couple of point change and then FHA comes out and says, “We need to tighten these standards up a little bit because rates are lower again.”
It will make their product more value. There are stronger loans in there. I don’t know all the ins and outs of how the credit swaps are happening these days and the bonds backing the mortgages. For sure, when you have stronger lenders, you have a stronger product.
This goes to the common notion right now that there’s a real estate crash eminent. I keep asking people where is it coming from? Do you know how hard it is for Joe Sixpack to get a mortgage? It’s not easy. It’s not like it wasn’t ‘03 to about ‘07 where if you could fog a mirror and you had a pulse, you got a mortgage. My favorite scene in The Big Short is when they’re at the gentleman’s club and Michael Burry is there. There is this dancer and she’s dancing. She’s telling him how many houses she owns. She keeps doing her dance thing and he keeps turning around. At one point he says, “Just stop dancing.” “How many houses do you own?” “Five.” He looks at the other guys and he goes, “We got to go back to New York right now.” They get on the plane and they fly back to New York because they realized if the exotic dancer has five properties and she’s flipping in and doing all that other stuff, real estate has reached such a point that unsophisticated participants are now in the marketplace.
A good friend, Sean Terry in Arizona, tells a great story right before the crash. He’s getting his hair done. His stylist is talking to him and saying, “What do you do?” He says, “I’m in real estate and I do some development. I do some wholesaling and do some fix and flips.” She says, “So do I.” When the hairstylists are now into flipping, maybe it’s time to move on.
When the market gets to that point, that’s when you start looking for the exit.
When everyone thinks it’s viable, that’s when you got to run.
There is a 2020 episode out there somewhere where it’s Chris Hansen or one of these guys is interviewing a nurse on the balcony of those condos. If you guys remember back to ’06 to ’07, the peak of the condo days in Miami, you could put a property under contract. Typically, the way development works are once the actual building is up, they start selling condos. They have to sell about 50% before they start occupying those condos. That’s the big breakeven if you will. The funding, a lot of construction and escrow gets paid. There are all kinds of stuff that happens on the backside for developers. It’s a big deal. They would pre sell at least 50% of these condos.
What a lot of speculators were doing like this poor nurse, she bought five or six of these things. She said, for a couple of years she would buy four, five, six of them, turn around and resell them as the building was becoming occupied and make $50,000, $60,0000 to $100,000 on each. She got to the point where I think she had fifteen or twenty of these things when the whole market collapsed. He’s sitting across from her, they’re sitting down, legs crossed. It’s one of those interviews on the balcony of these gorgeous condos and he said, “Did you have any real estate training, any real estate experience?” All she says is, “No.” Completely dead pan then goes into the next screen, the next shot in that documentary. You are just like, “That’s what was going on.”
Everybody blames the banks and all of these unsophisticated people were jumping in. I see a lot of similarities to what’s going on in the stock market on the tech side. I’m talking about the Lyft IPO on Facebook. I’m like, “This thing’s going to be a dumpster fire and a half.” I called it on Snapchat. I’m going to call it on Lyft. I’m calling it here. It’s going to be awful. It will be a $20 maybe $15, give it eighteen months. They’re talking $70 a pop when it comes out of the IPO, which I don’t know when. It’s insane. All these people are going to go invest. It makes no sense. You guys that are reading this blog, you’re like, “I’ll never invest in something like that.” I’ll give you a great example. NBC Universal bought a whole bunch of Snapchat.
Are you invested in NBC Universal? Their mutual fund did, their pension. Most people don’t know what their investing in. I don’t have this conversation much anymore. When someone wants to debate stocks versus real estate, I’m like, “At the end of the day, I know what I’m invested in. I own that apartment. I own that one. I know that we turned into an Airbnb.” I’d rather walk out and say, “I own that than this bunch of mangled garbage that I don’t know what’s what.” Warren Buffett said it best, “Diversification is for the ignorant.” He comes out and says that about once every eighteen months. He’ll be on MSNBC. He’ll be on Squawk Box. When somebody says diversification around him and he looks around and goes, “That’s for ignorant people.” He’s talking of his book.
I’ll call them out to people that say, “You got to diversify. I want to sell you.”If you want to stop torturing yourself, stop watching the news. Click To Tweet
When he says that, the financial media goes into a tailspin. They go, “He didn’t really mean,” that because all of them sell this idea. You need to be diversified. Every single one of them. There’s a great video on YouTube where they have all these guys, Mark Cuban, Warren Buffett and all these guys that talk about how diversification is so terrible. In any case guys, what we’re seeing is the change in the FHA loan standards are such that mortgages are becoming harder to get. I anticipate this being an issue for real estate investors as well.
Which means when we flip houses, it’s going to be on the market a little longer. The pool of people that could possibly buy your property is shrinking. 50,000 people who got mortgages last year would not qualify this year and that that affects days on the market. It affects your cost and it affects your profit. When you start working in that jumbo space, $700 million, $800 million properties, there’s a handful of people that are ever going to get those deals. If we’re flipping, I want to keep it into $339,000 even though as I said, I have an $800,000 house in the market. I want to keep those properties at $339,000. We’re going to look at one now.
We’ve talked about FHA loan standards and some of the changes there. Let’s switch gears here, I want to talk about seller’s disclosures. We’re going to get really nerdy for a minute here. I know this is not taught in real estate education surface.
Let’s talk to the neophyte. The first person has no idea what’s going on. We are actually going to talk about off market properties and how people find them, which is called wholesaling in the marketing for wholesaling. People go out there and they find properties that are not on the MLS, not on Zillow. For those of you that are pretty much looking only on Zillow and they talk directly with the homeowner and they get the homeowner to sell them their property. Then what they do is they take that contract and they assign that contract to another buyer, preferably me.
This is one misconception if we’re talking to the newbie. One misconception I see a lot of is that you can’t sell a house without a realtor. I hear that all the time and that’s not the case. You, Robert Orfino, who is not a realtor can sell me your house, Jason Bible, not a realtor. You don’t have to have a license to sell real estate.
I will tell you that the license is good but the E&O insurance is even better.
You want to have errors and omissions insurance. There are a group of real estate professionals that go out into the world here and they contract apartments and single-family homes and warehouses. They represent their equitable interest in the contract, which is some nonsense workaround. They will get this property under contract and then they will sell their rights to that contract to a real estate investor. That’s typically who buys these things. Actually, they own it. A deal down in Bay town, you got a call from a wholesaler, a friend of ours. He said, “We got this deal. My wholesale buddy has it under contract. We want to sell it to you.” He’s going to add $6,000.” He’s added a fee and he is going to sell that property to you, no real estate involved at all. Here’s the challenge. If you understand real estate law in Texas, the first question you ask is does it have a seller’s disclosure? Let’s talk about what a seller’s disclosure is. A seller’s disclosure is exactly what it sounds like. It’s a three-page form that a seller of a piece of real estate must fill out that discloses the condition of the asset. Has it had any foundation issues? Has it flooded? Does it have carbon monoxide detectors and peepholes? It is a three-page form. Most of them are check boxes.
You can basically go through it in about five or fifteen minutes. That’s the most it’s going to take for you. You don’t need to walk around the property and inspect it.
This is not a property assessment.
It’s disclosure, “I had a roof leak and I got it fixed.”
My engineer brethren out there, you go a little overboard. I bought a house one time that when they sent the seller’s disclosure, we had to go pick it up. I remember them saying, “I’m filling out the seller’s disclosure. You guys need to come to pick it up?” I’m like, “Bob, you can’t email it.” “No, you got to come and pick it up.” We went over there and it was three, three-inch ring binders. He owned the house for twenty years. He had every receipt for everything he had ever done to the house. You engineers out there, I know you love this kind of stuff. That was his addendum.
However, in most cases it’s just a three-page form. It’s no big deal. It’s super easy. Here’s the problem. The seller in a lot of these wholesale deals does not furnish a seller’s disclosure and they are required to. Now, when you talk to a real estate wholesaler, they say, “No, they’re not.” I’ll say, “Yes, they are right. You don’t know Texas Property Law.” Most of these folks don’t. I know that all the real estate educators out there that are flying to town and tell you can be a wholesaler and make $5,000 a deal with no money and no credit. They don’t teach this either.
This never comes up. I am absolutely certain the people that have little real estate classes that teach wholesaling do not teach the finer points like this. Let’s talk about what could happen. You have a property and let’s say you’re selling it and don’t provide a seller’s disclosure. You don’t disclose to the buyer certain conditions that you are aware of. You can become liable for those things post sale. Let’s say you’ve had foundation work, you didn’t disclose it had foundation work. You know it has foundation work because you paid for it as the owner and you don’t disclose that to the seller.
We have a situation right now. We have a friend of ours from California who’s investing here in Houston and they bought in a pretty good deal. They took over with the tenant still in place. They thought everything was going to be good. The tenant emails them and says, “Do you know about this plumbing issue?” The new owners say, “No. I have no idea.” “Let me show you the bid I got from a plumber to fix this issue that I had sent to the previous owner of the property.” She sends it over and looks at it and says, “There’s a $3,800 work order that needs to get done.”Most people don't know what they’re investing now. Click To Tweet
This is not we’re fixing a clogged drain. This is sub-slab plumbing. There were new drain lines or something that.
That was easy. It was going to be about six feet out to the side, but it wasn’t on the seller’s disclosure. Clearly, he was aware of it because now we’re in an email thread with the old owner that says, “You have a problem. I went ahead and got the plumber like you asked to come out and give us a bid.” Now, you have an issue because either the person forgot or chose not to disclose that.
I’m fairly certain they didn’t forget, allegedly. I have a feeling someone is going to get slapped with a $3,800 little email. Has he already emailed the owner?
They have and our buddy, Ashley, is on that.
We got to get the attorney involved. That’s why the seller’s disclosures are important. It protects the seller too. When we would flip houses, we would get a seller’s disclosure from the seller and we’re buying it as is. I am like, “Seller, tell me everything that’s wrong with it.” Then we would do rehab and then we would fill out our seller’s disclosure. Ten we would attach the old seller’s disclosure, our disclosure and our scope of work and hand that to the new buyer and say, “Here’s all the stuff.” A lot of times they’d hand that to the inspector. We don’t want any surprises here. We want to show you everything that’s going on here. There are some people, amateurs in this business that want to hide stuff. I am like, “Let it out. This is what it was before and this is what we did. It’s beautiful now.” People appreciate that. We have never scared off a buyer with that when we disclose everything.
I want to tackle the myth of tax-free real estate investing. It’s the way it’s explained and there are two myths I want to talk about. One is refinancing properties instead of selling them and you don’t have to pay any taxes, which is true. The other thing I want to talk about is depreciation because there are some real big misnomers there between those two. I want to start this segment out with, we’re not attorneys, we’re not CPAS, we’re not doctors, we’re not auto mechanics and we’re not IT professionals. Please don’t consider this legal tax advice and all that other stuff. You will hear in real estate circles on radio shows and podcasts and on blogs and all the other stuff that you could do real estate and its tax-free. Here’s why it’s tax free. I heard this last night. We did a real estate podcast last night.
We’re going to announce what the name of it is and all that other stuff here in the next couple of days. It’s a happy hour kind of thing. It’s four or five hours, a couple of people hanging out. It’s chaotic to be honest with you. It’s a little bit different in this format, but it’s a lot of fun. One of the guys there said, “I like to refi my properties, so I don’t have to pay taxes on the income.” I said, “That’s technically true, but what happens when you sell it?” He got quiet. He goes, “What do you mean?” I’m like, “You claim you’ve done hundreds and hundreds of properties. You’ve sold some of those since then. Did you not notice? You’ve got to pay that back.” You buy a property for $50,000. It’s worth $100,000. Let’s say you get a loan for $100,000. You put $50,000 in your pocket.
When you go to sell that property, your tax basis doesn’t step up to $100,000. It’s back to the $50,000. You still pay taxes on that difference. I always think it’s funny when I hear that, “I just refinanced my properties and I don’t pay taxes.” I’m like, “That’s technically true in that one instance, but when you sell that property, you are absolutely going to pay taxes on that gain.” This was the discussion we had. It’s one of my pet peeves. It’s called equity stripping. This is what these guys were doing. I said, “I’ll buy a house at 60% ARV. ARV is After Repair Value. A bank will lend me up to 75% ARV. I will take the difference and put that in my pocket. Here’s the problem with that, “You’re going to be paying a much higher tax rate for that difference and you’re paying interest on that money.” It doesn’t make sense.
It’s probably 12% interest on that money.
Even if it’s 5%, it goes into a 30-year fixed rate mortgage.
I’ve done equity stripping and for us, it’s a stop gap. I don’t do it anymore, but there’s a point in your real estate investing career where your cashflow sucks. It’s terrible and everyone around you is freaking out and “We’re not going to be able to afford this and get that and the insurance payments coming up.” I talked about it this year. This was the first January in the last seven years where I wasn’t broke, because taxes are due, charges due, all this stuff is due in January. I’m like, “I’m not broke,” but I had to in 2014, 2013. I would equity strip that for sure. I would get a deal really deep and wholesale it to myself and pull out $10,000 to keep the house going.
The challenge here is we were sitting at a table with experienced real estate investors. You’ve got to stop at some point. There was me, George, Curtis and couple other guys that were there. We were telling this guy, “You’ve got to stop that. If your portfolio is as big as you claim on Facebook, you need to stop that immediately.”
I did go through a period where I was a landlord. I own the property, but I was paying an extra $150 out of my pocket every month just to keep the property. Sometimes we go through that stage where we’re the landlord and we’re just losing it and somehow, we convinced ourselves that there’s a lot of equity in that property. I don’t want to let it go. You come across that sometimes.
That’s equity stripping, pulling equity out of the deal because we’re “not going to pay taxes.” That’s not true. Let’s talk about the second thing. The second one is the depreciation. I was at one of these big apartment seminars and here’s a guy who is allegedly doing this for twenty plus years and he gets on stage and he said, “Let me tell you about accelerated depreciation and apartment complexes.” I’m going to save a million plus dollars this year because of depreciation. This is a quote, “Something I just learned.” You’ve been in apartments for twenty plus years and you didn’t know this. This is Real Estate 101. Fire your CPA and sue them for incompetence. This is the best definition of depreciation I’ve ever heard and I got it from Jeff Watson. Depreciation is a loan from the government. That’s what depreciation is. Depreciation is not a write off against earned income that I’d never have to pay back. That’s not how depreciation works. Depreciation is a loan from the government that when you sell, you have to pay that back.Depreciation is an expense. Click To Tweet
In 27.5 years, you owe 100% of that value.
You will absolutely have to pay that back. I hear this, “I’m just going to depreciate it. I’m not going to pay any taxes.” You will pay that back. It’s coming to you. Back to your point when you said, “There’s a lot of landlords out there who are not negative cashflow, maybe positive cashflow but negative profit. Most single-family houses are not as profitable as rental properties. I’m going to say that again because I hear a lot of people pitch in single-family real estate as a way for financial freedom and there’s some truth in that. The vast majority of your leveraged single-family real estate is not profitable as a rental property. We were hanging out with our property Tax Pros test guy, David. He’s been a broker for twenty years, right out of high school. He actually said, “I remember when TREC forms were on carbon copy in triplicate.” I’m like, “That is so awesome.” Let’s talk about why a tax-free investing is a little bit of a myth. For those of you who buy single-family real estate, if you’re a single-family real estate investor, one of the dirty little secrets in a single-family is that there’s no expense ratio.
Let’s talk about what an expense ratio is. If you’re buying a multifamily apartment complex, typically the industry ad for average is somewhere between 30% and 50%. It’s one of these numbers you use when you’re doing a quick valuation. I’m looking at an apartment complex that brings in $1 million a month. We assume that the expense ratio is 50%, $500,000 a month and that’s before debt service. When you look at your single-family house, here’s how I know that the vast majority of them are not profitable on a rental basis. Look at your tax returns. Depending on where your rentals are in your portfolio, take a look at your Schedule E and what does it say? All of those numbers are negative.
That’s why you’ve got losses from depreciation. Depreciation is an expense. What is that expense in the real world? Depreciation is an expense that some would call CapEx, future capital expenditures. The roof is degrading. The carpet is degrading over time. You’re going to have to replace the carpet and the HVAC and all that other stuff. The IRS in their wisdom has said, “This asset is deteriorating every single day. We are going to allow you to write off a certain percentage of the property every year and you can deduct that from your earned income from that asset.
You can go deeper because some parts of the building are basically degrading quicker than other parts of the building. That is called cost segregation.
The HVAC has a different cost seg schedule than the roof does. You’ll see this typically on big single-family portfolios and apartment complex. Everybody does an apartment complex. It makes total sense to an apartment complex. If you look at your taxes, you will notice that a single-family is not profitable as a rental property, but for one thing, appreciation. That’s where you make your money in single-family real estate. It produces a little cash and you can use that cash to keep the property up and that sort of thing. At the end of the day, where it makes money is when you sell that property.
For us, we teach this. We have our big game hunting. We’ve got a lot of folks in California and New York, New Jersey coming down in Texas to buy properties. We want them buying a property that’s distressed because we want to hit the roof. We want to do the HVAC and the hot water heater and put all new lighting fixtures. Everything in my life right now is a five to the seven-year horizon. I want to fix everything that would typically break in the next five to seven years during that flip part of it. I flipped to hold at this point in my life. I don’t have CapEx. It is very rare that it’s going to be a manufacturer problem or an install problem. It’s not going to be wear and tear.
The duplex that fast tracks are rehabbing for me, “I put those numbers up on one of the groups I’m in. They said, “Where’s your CapEx number in there?” I’m like, “We’re doing everything. It’s a down to the sticks rehab so our capital expenditures on something like that is going to be virtually zero for five to seven years.” Probably at about seven, you will maybe get a new water heater.
You have to change out a rug or two or tenants come and go, but it won’t be a lot. It’s not going to be $6,500 for an HVAC system or $10,000 for the roof because you’re doing it now.
In that instance, you’re not going to have a real high CapEx. Let’s say I bought house retail and this is where investors mess up. They’ll say, “It needs a little paint and carpet rehab.” “A little paint carpet but what about all those other major systems because you’re not upgrading any of that stuff at the time.”
All of those have a lifespan. They have a cycle of life and you have to figure that out. For us, for sure every time we look at a hot water heater, if it’s past its half-life, we replace it. It’s the same thing with HVAC, if it’s past the half-life, replace it. The roof is the same thing. If it’s one-third of its life because a 30-year roof is good for twenty around here. If it’s one-third in the 30-year roof, we replaced. Most times insurance companies are going to ask us to replace it if it’s anything past ten or twelve years. We look at that stuff and there’s nothing rent ready for us. Brand new construction, that’s it.
As we go through it, we’re like, “No, we’re not because this water heater’s going to rust out on the bottom and one day we’re going to wake up and there’s going to be a leak in the garage and no hot water. People are going to be freaking out and it’s going to happen on a Sunday. You’re going to get that phone call and he’s going to fix it.” We replace that stuff and we avoid our CapEx. For us, we are trying to be very profitable, not just the loss. We’ll certainly take the depreciation because it’s a loan. It’s a gift. We like that. For us, we want to be profitable on our properties and we Airbnb them.
It’s the classic 25-year-old HVAC, “It still works,” and the condenser is out there shaking. It still works just fine. This thing’s going to go out the day after I buy it. I am always impressed with an HVAC when a condenser can make it to twenty years. You look at that and you go, “That’s a solid piece of engineering to put up with the Texas heat.” It’s pretty impressive when you think about it. You want to go in and replace all that. Here’s the problem. In single-family real estate, you run into an issue where you’ve got a house that’s a $1,200 a month rent and your expenses are not $600 a month. They’re not. When you include CapEx and all that other stuff, they’re probably 30%. A lot of times if you look at a deal like that, it kills all the cashflow. Which is why when you look at your Schedule E, if those properties are not profitable, you can carry the losses in some cases against your earned income if that’s available to you. That’s why we say in single-family where you really make your money is on the appreciation side. Obviously, they cashflow a little bit but the appreciation is really where you make it.
We’re going to talk about Fannie and Freddie.
Let’s go back in time. In 2008 the world was ending. Barack Obama gets elected president. George Bush calls him up. He says, “You need to get up here. We got a real big financial problem. We need to have a chat about. I think they met with him and McCain. I think they did both go up there. They flew up there. I will never forget the look on McCain and Obama’s face. It was like, “Holy smokes.” When you become president, they have that meet and greet, the transition team and all that. I’ll never forget the look on Trump’s face where the, when he met with Obama after he got elected. They had that little press conference in the Oval Office and Trump has that look on his face like, “I just found out about the Star Gate. Aliens are real and all that.” It was that look. I remember Obama had this and McCain too had this look on their face because now we’re about finance and they were both, “Whoa.” They did a joint press conference if I remember. The federal government steps in and says we’re going to take over control of Fannie Mae and Freddie Mac.
As a side note, in April of 2008, I decided to be an entrepreneur. It’s perfect timing, four months before the world collapses.
They said, “We’re going to go in and we’re going to take over Fannie Mae and Freddie Mac to shore up the housing market.” At the same time, they bailed out to a certain extent AIG. They let Lehman collapse. The whole world was in peril. It was crazy. The auto industry, they went in and backstopped that. Trump has come out and said, “We need to let FHA and Freddie Mac go. We got to get him out of conservatorship.” The little secret out there is the federal government has made a lot of money. They made $100 billion. Out of everything they shored up, everybody they backstopped with taxpayer dollars, the only thing they lost money on was the auto bailout. They lost $10 billion on that. They made a $100 billion on the mortgage side. They made $25 billion on AIG. In hindsight, it was pretty smart. They made a lot of money. The question is, “The federal government’s now making money on this thing, are they really going to let it go?” That is the question. I don’t know what the legal precedent is but at some point, they’ve got to let them go back to the “private sector.”
I agree with Libertarians. We’ve got to get up. Back then, the world is on fire. Now, we’ve got to let it go.
You’re going to see some changes over at a Fannie and Freddie here probably over the next two years.
Six regions are what they are talking about.
They’re talking about a couple of different plants, break it up into a couple of different companies with obviously some government oversight for the insurance and all that other stuff. What that really means is the mortgage market is going to change again, be ready for that. Thank you for tuning in. We will see you all on our next episode.