Hedge funds have been buying thousands of cash flow houses for over a year and it has impacted the market in the USA.

This is creating opportunities for property managers, property inspectors, realtors, and bird dogs. I know, I have sold to “The Funds” and they are chasing “would be” investors and home buyers out of the market. They will pay more then the average investor and they are leaving only crumbs left over for  families looking for homes.

The Real Estate market has rebound in some areas and there is always opportunity to buy cash flow houses; however you may have to re-think your game plan and modify your strategy.

My friend John Schaub writes a terrific newsletter called Strategies and Solutions. The following insights are from his March/April 2013 Newsletter

Lots of Wall Street Money Chasing Property

Last year, former Morgan Stanley chief housing analyst Oliver Chang declared it was “The Year of the Landlord.” In August 2012 he resigned and started a hedge fund to buy houses. Mr. Chang worked for Morgan Stanley for 4 years, is well educated with an MBA from Columbia, and is now seeking his fortune as a hedge fund landlord. I recommend that you watch the CNBC interview with Mr. Chang at: http://video.cnbc.com/gallery/?video=3000106869. It will make you feel better about the competition from hedge funds.

Mr. Chang is relying on his personal brilliance and technology platform to operate a large portfolio of single, family houses efficiently. I don’t’ think that he has a lot of experience as a landlord, but how hard can it be?

He hopes to raise a billion dollars or more and focus on buying foreclosures in the $50,000 range that need another $30,000-$50,000 in repairs. A billion dollars would buy 10,000 houses at $100,000 each. How many managers would you need to rent and manage 10,000 tenants?

Mr. Chang then hopes to rent the houses to produce a good return. Returns in the range of 5-14% are often mentioned as targeted returns fro these types of hedge funds. This is not a high return for a hedge fund that often takes higher risks looking for higher returns.

Would you buy a $50,000 foreclosure that needed $30,000 worth of work in a town for away? If you did, and you hired management, what kind of return would you expect?

Hedge funds have bought tens of thousands of houses across the country. According to the February 2013 issue of Florida Trend, Florida has 300,000 homes in foreclosure and another 250,000 already owned by banks. The report states that hedge funds have acquired at least 4,000 of these homes. There are more available that they can buy.

Why Not Buy Foreclosure at Auction

If you have studied any of my courses on buying foreclosures or properties in distress, you know I avoid buying foreclosures at auction for several reasons. First, you never know what you are getting. The owner may still be in the house and they probably won’t leave it pretty. Next, you have to pay all cash. Competitors are bidding up prices. Also, often there is a reason the house is in foreclosure: a bad neighborhood, bad neighbors, bad construction, etc. Sometimes title problems arise and you have no recourse against the seller (the judge.) In short, there is way too much risk for the potential reward

Some hedge funds buy houses in decent shape and of a certain size (maybe they read my book!) However, the funds are paying all cash and hope to make a double digit return for their investors. The rents will certainly not produce that return, so they will have to sell to repay their investors and give them their profit. Because they are paying close to retail prices when they buy, and will likely pay a commission when they sell, the houses they are buying will have to appreciate about 10% before they will break even.

The funds have to rely on sketchy information to determine what to bid. They often use on-line sites or obtain a drive-by opinion of value and condition while bidding for the house. This may result in a few bargains, but will certainly result in some gross overbids.

Does Taking More Risk Make Higher Rewards Likely?

Does buying foreclosures, all over the county for all cash sound risky to you? Maybe hedge fund operators thrive on risk. Personally, my motto is not to look for an adrenaline rush from my investments. I’d much rather take several hours, if not days, to study a property and negotiate a deal with a seller. Even when the seller is not in distress, you can often make a great SAFE deal on a house that you know inside out and finance it with the owner without any personal liability. Remember Warren Buffett’s 1st Rule: Don’t lose your money.

Of course, I’m dealing with my money and that makes all the difference. Jack Miller once said, “Money managers are much more interested in making themselves money, than you money.” When you hire someone else to make your money grow, he or she tends to make money whether you do or not.

Like any syndication, the hedge fund operators take their share before the investors get theirs. In addition to overhead (salaries, managers for the managers, etc.) there will be property management fees, repairs, and problems. The total could be more than the investments produce. You can lose money on a free and clear house if you mismanage it or are burdened with too much overhead.

If Hedge Funds Spend $100,000,000 and Buy 1000 Houses In Your Town, What Will Happen to Your Market?

What happens to your market in the event a hedge fund comes to town? Would it increase or decrease prices? Would they hire a lot of people to make repairs, maintain lawns, and manage property? Would they rent them below-market or try to get the most rent possible?

In short, would it be good news or bad news for a landlord who owns property in your town? It looks like good news to me. Having a major influx of money in a market is inflationary and will drive prices up. What if you are a new investor getting started? Will the hedge funds buy all of the houses for sale for cash? They may buy all of the foreclosures and many of the listed properties.

They won’t buy houses that are not listed. In my Sarasota seminar in January, students found 13 empty houses that were not listed, but could be purchased. Several of the houses were in estates; every one was a potential opportunity. None was being pursued by a hedge fund. You can always find a good deal with a little legwork.

What is the Real Cost of Hiring Management?

You can hire a property manager in many towns for 6% or 7% of the rent that they collect. Not much pay, but someone will take the job. At my recent Snowmass Summit, a group of well-seasoned investors (about 400 years of combined land-lording experience) discussed the real cost of hiring a manager.

The consensus was that outside management would cost you at least 20% of your gross cash flow and many thought it would cost closer to 30%. This does not include the out-of-pocket expenses of repairs, taxes, and insurance. It is just the amount of cash flow you would lose by hiring the best manager that you could find to manage your house. We know the cost is this high because we have all done it.

Why is the Cost of a Hired Manager So High?

Two factors drive up the cost of hiring a property manager: inefficiency and incompetence. Even great managers cannot perform miracles. If you order me to rent a house that is not in good shape, or is in a marginal neighborhood, or charge above-market rent, I will not be able to operate efficiently. The tenant that will take the house at a high price or in a marginal area will probably not maintain the house, may be a collection problem and will often bail as soon as they find something cheaper. All of these issues cost money. The cost of a tenant turnover is often as much as two months rent. Add that to the lost rent caused by the turnover and your management costs rocket skyward.

Although there are some very good managers (I have trained more than a few), not many will work cheap. A 10% commission is not enough to compensate a good manager who would rather work for his or herself and keep it all. The managers that you can hire for 10% or less may try hard, but because of the challenges listed above, they are fighting an uphill battle.

Anytime you try to get above market rent, it takes longer to rent the property and your tenants will move when they find cheaper accommodations. My operating costs without paying myself for management run just under 40% of my gross rents, and that is with less than 1% annual vacancy. Some years I have 0% vacancy. It may take two months to rent a house trying to get the top rent in your market, and then have another two months empty when the tenants move out. A turnover a year will increase your expenses by 20% or more.

Looking to The Future

Hedge funds continue to compete against each other, bidding up prices and paying more than the property is worth today.  They are in a hurry to spend the billions of dollars that they have raised, with the money sitting in a bank earning little interest. After the funds get their first year’s “real net rental income” they will find that it is far less than they projected. The combination of these factors will soon result in funds looking for an exit strategy.

While I don’t like buying foreclosures that need a lot of work, I do like buying from a fixer who bought a foreclosure, fixed it up, and now wants to sell. Hedge funds are those fixers. Funds are buying foreclosures and will fix them up. When they sell, some of their houses will be opportunities. If they dump a number of properties on a market and depress the prices temporarily, it will be a buying opportunity

Hedge Fund Houses – Good Tenants Beware!

A smart tenant will not move into a hedge fund house for a small savings, because they will know that they will have to move again soon. That is too much trouble to save $100 a month. There is a big difference between renting from an owner-manager who can make smart decisions quickly, and an employee whose job is to squeeze as much cash flow from a property as he can. A good tenant will recognize that.

Hedge funds buy a lot of their inventory at foreclosure sales. As they compete with each other (there are several hedge funds buying in major markets) they drive up prices well beyond what a seasoned investor would pay. When they buy a house that needs repairs before it can be rented, they often do the minimum amount of work necessary to obtain the first tenant. The fund now owns a house that they probably paid too much for, that has been patched, not rehabbed – and then try to squeeze as much rent out of it as possible to meet their projections.

Competitive Bidding Driving Up Prices

In Atlanta, funds are now paying $100,000 and more for houses that individuals were buying for $50,000 before the hedge funds ran the prices up. Because they need to buy a lot of houses, when they lose a house to their completion, they raise the price they will pay by increasing the amount of rent they think they will collect.

A rule of thumb used is to pay 120 times the rent for the house. The computer models say is it rents for $1,000 a month pay $120,000. If they can’t buy it for $120,00, they can adjust the rent to $1,100 a month, and now the computer says to pay $132,000.

According to the Florida Trend article, “The investment groups all share the same strategy: Pay cash for clusters of foreclosed, bank-owned or other wise discounted homes, generate healthy cash flow by renting them, then exit in a few years when demand from traditional buyers increases and the homes can be sold at a healthy profit.http://www.floridatrend.com/article/15187/landlord-inc

The article states that they are raising money with promises of double-digit returns, and are now borrowing money by pledging the rental income. “Last October, Waypoint Real Estate Group, an Oakland based investment firm, borrowed $245 million from Citigroup to help build its portfolio of homes for rent. The deal, according to the Wall Street Journal, may serve as a precursor to the development of the first security backed by home-rental payments.”

Here we go again: people who work on Wall Street love slicing up the pie and selling it off, collecting commissions on as many transactions as possible. If they borrow and pledge the rents from the property, now when it sits empty, they may not have money for expenses, taxes, and insurance. Could funds be the next wave of distressed sellers?

Keeping Good Tenants if Hedge Funds Buy Houses in Your Town

Try to identify a hedge fund purchase (foreclosures in many markets) and follow it, calling the rental agent to see how much rent and deposit is being charged. Go see the house to assess its condition. Ask for a long-term lease and see how the agent reacts. If you could rent a house for ten years from a hedge fund, they would have to buyout your lease when they want to sell.  Wall Streeters may be good with a calculator, but they know little about real estate.

The unknown creates fear. Know your competition. I think you will find that funds are renting an inferior house at a premium rent. Your tenants want to rent from a real person who will respond to their needs and allow them to live there for a long time.

Rent and Price Cycles

House prices and rents do not rise or fall in tandem. When house prices start rising, generally more people become interested in buying. More buyers can mean fewer tenants, and stable or even dropping rents. Today’s market is complicated by the lack of available credit for investors and owner-occupants who would love to buy at these prices. If we had more loans available, prices would move up sharply as many people compete for a limited supply of houses.

Because we have household formations running ahead of new construction, prices should increase in the coming years. Once construction catches up with demand, look for prices to peak and get ready for the next cycle.

From what I have read, the top seven house-buying hedge funds have plans to spend just over 3 billion dollars buying and repairing houses. As we are into the recovery part of the market cycle with the number of foreclosures sales dropping, I suspect that soon they will bid house prices up to a level that will fail to meet their return parameters. At that point they will quit buying.

82,000,000 – 100,000 = 81,900,000

There are more than 82 million detached, owner-occupied, single, family houses in the US.www.census.gov/hhes/www/housing. If the hedge funds raise ten billion dollars, they can buy 100,000 houses at $100,000 each. That still leaves 81,900 houses for the rest of us. While ten billion dollars sounds like a lot, Apple has 137 billion dollars in cash reserves and the US Treasury is buying 85 billion dollars worth of U.S. bonds every month. A billion dollars is a pretty common number on Wall Street.

But buying a house and managing tenants, is not something you learn in MBA class. Houses purchased one at a time, on great terms, and rented to long-term tenants who respect your house and respect you can produce much higher than double-digit returns. Hedge funds will not realize these returns – but you can.

Heading for Another Bubble?

I met with a group of bankers today and they ask me if I thought the current wave of buying in our town would result in another bubble and price drop. I said, that unlike the last boom, where buyer were borrowing much or all of the purchase price, today’s buyers are often paying cash and buying to hold for the rental income. Prices are unlikely to drop because the demand for housing is greater than the supply. If prices did drop, then owner would simply have less equity; they would not be upside down on their loans or in foreclosure.

Conservative money (think bankers) is slow to enter any market. It wants to make sure of the trend before buying. Bankers are being very cautious about lending money, even to borrowers with good credit. The new government regulations and the current administration make them nervous. When loans become more available, then prices will jump.

Builders in our town are getting about a 30% premium for new houses that are farther out of town than my rentals. They are selling because they can offer financing as part of the package. The availability of financing is the key. You can offer financing when your sell and get a higher price.

Prices are likely to rise dramatically in the coming years. Now is the time to buy and borrow. It is hard to do if your only option is to buy with bank financing. Controlling the appreciation is the key to benefit during times of inflation and there are a lot of ways to do that without begging a banker for a loan.

By RJ Palano