Equity Arbitrage article requested - Posted by John Behle


#1

Posted by John Behle on November 16, 1998 at 16:23:06:

The following article details what I call EQUITY ARBITRAGE. I mentioned it in a post and have had many inquiries, so here it is.

HOW TO LOWER YOUR HOUSE PAYMENTS
by John D. Behle

(The following article is an excerpt from Mr. Behle’s book “Mortgage Magic”)

Would you be interested in a way to lower your house payment and pay your house off early? If you’re not, then you picked up the wrong book. What you must have meant to pick up was “The Financial Bondage Report” published by the International Society of Pessimists. It is filled with thousands of excuses and rationalizations about why it is impossible to succeed financially in today’s world and socially unacceptable to even consider the idea of trying. Their motto is “Whatever the mind of man can conceive and believe, we’ll find 10 excuses why it’s impossible to achieve.”

On the other hand, I’ll bet you’re one of the “Napoleonic Optimists” that says “I see only the objective–the obstacle must give way.” A little like the young boy with the grin on his face digging through the pile of “natural organic fertilizer” that says, “You can’t fool me! There must be a pony in here somewhere.”

USING YOUR CREATIVITY

Let’s talk about a creative way to use real estate paper to:

  • Lower your house payment
  • Pay your house off early
  • Increase your net worth
  • Acquire some safe secure “paper” that can make you tremendous profits

If you have a little equity in your home or in some other real estate, this technique can be of great benefit to you. What it involves is borrowing money from the bank at one rate and investing it safely and securely at a higher rate of return. This difference in rates will produce a cash flow which can be used to lower your out of pocket monthly payment or can be applied towards the principal of your loan to pay it off earlier than scheduled.

FOR EXAMPLE

Harvey has a property with a value of $100,000 and a present first loan of $40,000 at 8.5 percent and a monthly payment of $322.09 per month. The loan has 300 months left to go.

What Harvey is going to do is put on a new first or second loan to turn a portion of his $60,000 equity into cash. In this case the cheapest way to do it would probably be to put on a second loan instead of a new first loan. If the interest rate were higher or the loan balance were lower on the first loan, then it might be cheaper to put on a new first loan. This is because of the “blend” or average of the interest rates. If Harvey borrows $40,000 at 16.5 percent then his average rate ends up being 12.5 percent, which may be lower than he could get on a new first loan.

Now if Harvey borrows this $40,000 at 16.5 percent interest over a 15 year term, his payment will be $601.48 per month. If he invested this money in discounted mortgages (paper), he would be able to get around a 24 percent rate of return or “yield.” Harvey’s $40,000 would buy mortgages (paper) with a face value of $72,400. The payment coming in would be $823.31, which would mean a difference in the cash flow of $221.83 per month. Harvey would have reduced his out of pocket monthly payment by over 68 percent or if he applied the cash flow to the loan, his property would be free and clear in less than 10 years (instead of the original 25). Now let’s slow down and look at this step by step.

STEP BY STEP PLAN

Here’s Harvey’s original loan: $40,000 at 8.5 percent, $322.09/monthly for 300 months. Harvey added to it a new second loan for $40,000, for total loans of $80,000. $40,000 at 16.5 percent payable $601.48 monthly for 180 months.

Then Harvey invested his loan proceeds in discounted paper at a 24 percent yield. $40,000 at 24 percent payable $823.31 monthly for 180 months. This gives Harvey a monthly cash flow of $221.83

$823.31 (income) less $601.46 (loan payment)= $221.83.

Now what does it all mean? What it means is that Harvey is making 7.5 percent interest on the bank’s money, which translates to over $200 per month that Harvey can use in one of four ways:

l. Reduce his out of pocket payment monthly.
2. Pay his loan off 15 years early.
3. Invest in more real estate paper.
4. Squander it on wine, women and song.

If Harvey chose plan 1, 3, or 4, his property will be paid off in the same amount of time as when he first started, yet he will have $221.83 each month to spend or invest.

If he chooses to apply this excess cash flow to reduce his loan, then the second loan will pay off in about 80 months. He would then have an extra $823.31 to apply each month toward principal reduction on his first loan. The first loan would then pay off in about 36 months for a total of 116 months or less than 10 years to pay the property off entirely.

In addition, Harvey has increased his net worth by $32,400, since he only borrowed $40,000, yet bought an asset of $72,400. He also has $72,400 worth of “paper” that he can make profits on in other ways.

ANOTHER EXCITING PROSPECT

This $72,400 worth of paper that Harvey purchased is not secured by any loans or encumbered in any way. It is a free and clear asset which could act as collateral for a loan. Harvey bought this paper at a 25 percent yield and could probably go to the bank and borrow against it at a lower rate, such as 18 percent and reinvest the proceeds.

Let’s see how this would look. This first line shows Harvey’s asset and the second line shows his loan against that asset. Line three shows his cash flow he is left with and line four shows the paper he purchased with the loan.

l. $72,400 @ 11% 180 Mo. $823.31
2. $40,000 @ 18% 180 Mo. $644.17
3. $823.31 (income) less $644.17 (loan pay.) $179.14
4. $72,400 @ 11% 180 Mo. $823.31

Harvey now has borrowed a total of $80,000 and has used it to purchase $144,800 in real estate paper. His new worth has increased by $64,800.

LEVERAGE IS FUN

Usually, in most investing, leverage can be a dangerous and precarious situation. With real estate paper though, there can be 100 percent financing, and still be a positive cash flow. In fact, each time Harvey borrows money his cash flow increases as well as his net worth.

Here then, is one of the great advantages of real estate paper - Cash flow. The three greatest problems in real estate investing, most people would agree are:

l. Negative cash flows
2. Balloon payments
3. Management

Let’s look at how "paper stacks up against these problems.

l. Paper has a positive cash flow even after being financed
100 percent.
2. Balloon payments are in your favor.
3. Management can be as easy as having a sharp letter
opener and lots of deposit slips for your bank.

FINANCING AND IMPROVING

As mentioned in the chapter “Three Steps to Wealth,” paper can be financed at least as easily (if not easier) than real estate. It also can be improved in many different ways after the purchase.

Some ideas seem to violate the “too good to be true” theory, so if you’re wondering if it really works, let’s look at a deal closed recently.

A call came in a while ago from my newspaper ad. A lady wanted to sell a $10,000 note and had been quoted around $4,200 by most people, which was a 24 percent yield. She said she couldn’t sell for less than $5,500 which was an 18.4 percent yield.

I found a way to buy the note for $5,500 in cash, which for her was an 18.4 percent yield and for me a 24 percent yield. A financial institution made me a “non-recourse” loan for $7,200 at 18 percent with similar terms to the note bought.

The results:

  • Seller sold the note for an 18.4 percent yield ($5,500).
  • I bought the note for a 24 percent yield ($5,500).
  • The financial institution made a good solid loan at 8 percent.
  • I pocketed $1,700 cash.
  • I acquired a very good note.

I know you may be confused about how $5,500 can be both an 18.4 percent yield and a 24 percent yield at the same time, so I’ll share a portion of the secret now (a full article later). I made a slight modification to the note at closing time that made both the property and the note more saleable and more valuable. It was a total win-win situation for everybody involved.