If you watch late-night infomercials, or attend the “free real estate investing” seminars, a popular element of the sales pitch is grinning people talking about buying property with “built-in equity”. They talk about getting a property, pulling $100K of equity out and going on a trip to Hawaii.
I’d like to get $100K and a trip to Hawaii!
The question rational people will ask is, why would properties with a bunch of money in them be sitting around for the taking like that? Why wouldn’t the gurus just hire a bunch of employees, buy up the properties themselves, and make lots of money instead of telling other people how to do it? These are great questions, but lets talk first about where the $100K is coming from.
Basically all the various techniques boil down to buying a property for more than its worth, paying what its actually worth, and getting the extra cash from the larger mortgage. Say you buy a $300K house, get a $400K mortgage, you give the seller his $300K, and pocket the other $100K. Yes, this probably involves fraud. Yes, this is “free money” in the same sense that a credit card with a $5000 limit is “free money”; i.e. its not free money, its debt. All you’ve managed to do is qualify for a loan you probably shouldn’t have qualified for.
So you go to Hawaii, spend the money, and expect to pay back the debt by selling the property after it appreciates or through income it produces. HOWEVER, in a normal markets, its going to take a long time for a property to appreciate 33% (and you’ll be paying high mortgage payments while it does). AND its very unlikely any income from the property will support such a high price (I recently did a post that (hopefully) showed how hard it can be making money from a property, even when its “reasonably” priced).
Alligators are properties where people have bought them for “investments” but they’re losing money on them every month. They need to sell at an inflated price to pay off the outrageous mortgage, but no buyer is going to overpay as much as is needed to dig the seller out of their hole. I think the joke is that they’re called alligators because they eat you rather than feed you.
Chain investing is something along the same lines. Instead of pulling the money out and going on vacation, you use it to buy another property (and you can pat yourself on the back for being *SO* “responsible”). Say you had 5% down for a property. You buy a property, and get a 7% cashback mortgage. 2% should cover the legal fees, and gives you back your 5%. You’re now in the “exact same place” (not quite, but we’ll get to that) where you started, except that you have a property in addition to your cash. Rinse and repeat until you have as large of a real estate empire as you want.
The problem with this is that each of your properties is leveraged to the hilt. Any downturn in the market is going to be magnified by the number of properties you own. If values go down, you won’t even have the option of selling some of them to raise quick cash if needed (they’ll all be alligators). With multiple properties, the chance of emergency repairs (like a furnace or roof replacement) obviously goes up.
Luckily lenders SHOULD stop you from doing this, but again the gurus will show you all sorts of techniques (some legal, most not) to get around them. Casey Serin basically tried this approach and put himself 2.2 million in debt before the foreclosures started.
If a property is “worth more” than you paid, pat yourself on the back and enjoy the extra income (or capture it by reselling the property). If there’s no extra income or if you can’t resell it, how can you fool yourself that its worth more? Borrowing against expected future earnings can be as irresponsible as buying consumer goods on credit. Either way, you’re paying a price (the interest rate) to have things in the present that you won’t earn until the future. If there’s any chance the future income won’t support the debt you’re incurring, you’ve gotten yourself into a very precarious position.