Friday, December 7, 2007

My Life In and Out of Real Estate Markets, continued

Part II: Getting Out


In the first post in this series, I told the story of how my wife and I came to own a rental property at the start of 2004. In this post, I will tell you about the problems that I had with tenants, how I was tempted by mortgage brokers who prey on landlords with vacant properties, and why I concluded that owning a rental property was more trouble than I needed.

This reminiscence is especially timely given what is happening in the real estate and mortgage markets currently. As I look around at the wave of foreclosures and at all of the borrowers who are facing increased mortgage payments as their exotic mortgage products reset to higher interest rates, I am reminded of how fortunate I am to have been born with a cautious streak. So many real estate investors lost thousands of dollars because they were tempted by mortgages offering lower monthly payments.

But I am getting ahead of myself, again. My last post ended with telling the story of how I became a landlord. This post gets into the reasons that I decided to quit my second job as a landlord.

Did I mention that being a landlord is a second job?

The Honeymoon Ends

As the person who had come up with the idea of buying a rental property, my wife rightly pointed out, it was my job to find and manage the tenants. She was glad to co-sign the mortgage and help with cleanup and repairs (bless her heart for her patience), but the day-to-day finding and management of tenants would be my job.

An important factor that I failed to consider, as it turned out, was that a lot of people who had good credit and were in the habit of paying rent on time were becoming homeowners at the same time that we were becoming landlords. So, the initial plan of only renting to people with good credit quickly went by the wayside. Landlords who had such tenants were eager to keep them, and there were fewer such tenants by the day as people with good credit and a few thousand dollars to their names purchased their own homes.

As competition between landlords intensified, long-standing practices such as collecting the first and last month’s rent during the move-in inspection also went by the wayside. I quickly discovered that the descriptions of “ideal tenants” in my real estate books, like so much of the other information in those books, no longer corresponded with reality.

So, I settled for tenants who simply met some basic employment and income guidelines, such as having a job for more than a year and having gross income in excess of three times rent. And I only collected the first month’s rent and a small deposit. I figured: they had the money to pay rent and would make it a top priority, just like I make paying the mortgage on time a top priority.

I was wrong. They often had other priorities. It seemed like every time that tenants left town before the end of their lease, or left without paying the last month’s rent, they left behind a child’s fantasyland of high-priced toys or a well-stocked home bar.

Part of the problem was that the tenants were not good with money, but part of the problem was that I was not firm enough. When I was told a sufficiently harrowing sob-story, I would volunteer to waive late fees and accept rent a few days (or even a few weeks) late. As soon as they sensed that they were dealing with someone who would cut them some slack, they started taking advantage.

Eventually I felt so taken advantage of that I began enforcing the late fees no matter what the story. Then they would often cut and run, leaving my wife and I to shampoo the rug, spackle the walls and seek out another tenant, usually in the depth of winter when few people move. The low point of my life as a landlord was when my wife and I spent New Year’s Eve, 2005, cleaning the house late into the night so that we could rent it out again.

Happy New Year, indeed.

It is when your spirits are low, when you are eating that mortgage payment by burning up your savings, when the metaphorical blood is in the water, that the sharks begin to circle.

Fending off the Exotic Mortgage Sharks

“We have a great mortgage product for you” said the chipper-sounding young woman on the other end of the phone. She had apparently pulled my business number from the advertisement that I had placed in the Seattle Times. “It is designed for landlords just like you.”

Like me? The hair on the back of my neck started to stand up and I furrowed by brow. I don’t like being pitched to, and something seemed really wrong already, just five seconds into this call.

“You get to decide what payment you want to make” she continued. ”You can make a full payment with principal and interest, a payment on just the interest for the month, or nothing at all. Skipping a payment really takes the heat off when you have a vacancy.”

This piqued my interest. I certainly loathed taking the mortgage for the rental out of savings when the property was vacant. She was reading my mind.

“So,” I replied, “If I skip a payment, what happens to the interest? Is it a fixed-rate mortgage?”

“If you skip a payment, the interest is added to your principal. But at current rates, that doesn’t add up to much. And it is tied to the London Interbank Overnight Rate, or LIBOR, so you don’t have to worry about the Federal Reserve hiking rates – they don’t set this rate!”

“That sounds a bit risky,” I said, realizing that that my first instincts had been correct. I had no interest in playing interest-rate roulette.

“Well, I would love to meet you at Starbucks to walk you through our program,” she said, “Let me give you my number.”

“No, thanks.” - I hung up.

This was the first of many, many attempts by mortgage brokers to lure me away from the straight and narrow path of the 30-year mortgage with exotic mortgage products; but after fending off a cheerful voice on the phone promising to dispel my worries over vacancies, I had no problem throwing the mailed solicitations from the other mortgage brokers straight into the recycle bin. Even the ones offering cash-out refinancing, formatted as fake checks. So, I managed to avoid the mortgage sharks that preyed upon many other homeowners. I stuck with conventional 30-year fixed rate financing. Here, again, The Expert (the realtor who I mentioned in my last post) played a key role, telling me “30-year mortgages are simple and predictable. I have always left the exotic mortgages alone.”

A Little Help from USA Today

USA Today publishes a feature called Close to Home each Tuesday that takes an up-close look at house prices in cities scattered around the country. For each city, they provide three arrows to show the gains (or losses) in the last 12 months for the city, the state and the nation. At first, all of the arrows were pointed up. Boston was featured several times, and in 2003 and 2004, it had some of the strongest gains in the nation. But early 2005, it started to slow down, and by the end of 2005 Boston housing markets were down from the previous year.

I read this feature each week because I had learned about how housing markets in one part of the country can sometimes help to predict the course of housing markets in other parts of the country. And after my first tenant, I was thinking about shorter and shorter timeframes for holding this rental property. Over the course of 2006 more and more cities profiled in USA Today began turning down: Miami. Denver. By the end of 2006, only a few markets such as Seattle and Austin were still up over the last 12 months.

I had had enough with problem tenants by this point (I was starting to lose my longstanding faith in the goodness of humanity), and it looked like the appreciation was about to end for a while. I was ready to get out, and my wife agreed. We were convinced. If the rental had been a stock, I would have fired up my Web browser and sold in January, and been out at the end of that same day.

But a house is not a stock. It must be vacant and ready to sell. Then you must find a buyer, and that buyer will need to find a willing lender.

Slippage, part II: Waiting out the Lease

Thus began my second lesson in “slippage”, that great gulf between the transaction that we want and the transaction that we get. We had to wait until July for the end of the lease.

At the top of the market in April, we could have sold the property for $290,000. It took a few weeks to fix up the property after it became vacant in July – which would have been months if The Expert had not found the right people to do the repairs. We listed the property at $280,000 and waited for the buyers to arrive.

No dice. The pool of buyers was starting to dry up in response to tighter lending standards, spurred by the beginning of the subprime mortgage crisis. Also, caution was starting to reign in the real estate mania that was still alive and well in the greater Seattle area.

So, we lowered the price to $272,000. We found a buyer and haggled our way to $265,000. Between the date that the offer was accepted and the date that it closed in September, a larger house across the street went on the market for $275,000. If we were still holding that house today, we would be lucky to get $250,000.

We were very fortunate to have The Expert on our side, and to have the good sense to trust him and make use of his knowledge. I told him when discussing the sale of the house, “Please do exactly what you would do if it were your house and you were trying to sell it in this market – in terms of repairs, and in terms of the listing price”.

Considering the commissions that you pay when buying and selling real estate, it is foolish not to make full use of the specialized knowledge that your realtor has to offer.

Salvation from the Storm

My life as a landlord ended on Sept. 18, 2007, when the sale closed and I picked up the check from the escrow company. I was rewarded for doing my homework, resisting mortgage offers, being patient, and suffering through weekends and holidays cleaning up the house and making repairs - but I was also lucky. If my wife and I had lived in a part of the country that was hit by sudden job losses, as was much of Michigan, we would not have escaped with our principal, or our credit, intact.

In the next and final post in this series, I will discuss the lessons that I learned from my life as a landlord, and provide you with a list of issues that you should carefully consider before taking the plunge and becoming a landlord, yourself.

1 comment:

Payam Ahdout said...

This is an amazing post. Great story, great rhetoric. Top notch.