Jeff's Saga: The Conclusion?

On this blog we've been tracking the tale of Jeff. For those of you just finidng this tale, here's a quick recap: Jeff decided that real estate can only go up, and bought 15 houses in 4 months to test this theory. Then, to further prove his courage, he began posting updates to a forum frequented by real estate investors. Despite getting some negative feedback, he continued to be extremely forthwright about his investments, his strategy, and his current status.

Part one of Jeff's saga - Jeff begins his real estate investment careeer
Part two of Jeff's saga - Jeff gets a little worried

Continuing with the good humor and extreme honesty that were becoming his trademarks, in August of 2006, Jeff posted his first expense sheet. This sheet detailed the properties he owned, what he paid for them, what they were costing him each month, and how much he thought he was making on them so far. This was a goodwhile after the last post that we responded to (from Janurary of 2006, but Jeff wasn't very vocal in between).

August 1st, 2006

O.K., now I am naked before you. Please be gentle, it is my first time...

	Close date	Price	Monthly Cost	Rent	Profit	Tax Gain	Loan	Rate 1st	Rate 2nd	Blended	Freddie Mac Appreciation
3853 Tierra Zafiro Dr.	3/22	$118k	$1,101	$990	-$111	$124	30y	7.11		7.11	16%
8205 Reilly Court SW	3/30	$160k	$1,155	$1,250	$95	$157	5y	6.20		6.20	18%
8034 S. Knowley Rd.	4/25	$212k	$1,597	$1,050	-$547	$199	3y	6.88	10.00	7.50	16%
19 S. Ridge Pointe Dr.	5/16	$169k	$1,201	$1,350	$149	$161	5y	5.75	8.88	6.24	8%
6005 Lourdes Road	7/19	$160k	$1,193	$990	-$203	$148	30y	6.86		6.86	16%
4120 Queens Drive	7/27	$144k	$1,048	$1,095	$47	$150	5y	6.13	8.75	6.54	8%
809 Bonnie Court	8/19	$164k	$1,120	$990	-$130	$150	30y	6.00	7.63	6.18	16%
1119 Makian Pl. NW	9/28	$170k	$1,322	$945	-$377	$162	30y	7.20		7.20	18%
6731 Summit Drive	10/27	$178k	$1,403	$1,095	-$308	$180	30y	5.63	9.75	6.28	23%
7227 Teypana Rd. NW	11/15	$170k	$1,289	$900	-$389	$169	30y	7.20		7.20	18%
6966 W. Saw Timber Way	12/28	$214k	$1,416	$1,480	$64	$222	30y	7.00	11.00	7.44	16%
			$13,845	$12,135	-$1,710	$1,822					16%

The sheet is very telling. Jeff has mortgage payments of almost $14,000 a month! No wonder he alluded to having difficulties sleeping. Even though his rents help offset most of that, he's still getting killed. One or two bad tenants along with a vacancy would destroy him. He's playing a risky game, but at least so far it appears that he is winning. His appreciation is holding up strong netting him somewhere around a 9% return (remember, the properties are growing at 16% a year, but he's paying 7% of that value back to the lenders). But that 7% growth is on about $1.6 million of property.

A month later Jeff gives us the skinny on where his almighty appreciation sits when it takes into account the minimum appraisal amounts. Remember that appraisals don't nessecarily reflect actual value.

September 20th, 2006
There have been a few changes in how I am "tracking" my progress. First, I am no longer going to use the "midpoint" of the eAppraisal I get off of http://www.ditech.com/calculators/appraisal/form.do . Instead I am going to use the minimum value (I have reason to believe some of the values may be "overestimated"--more on this later).

The second change is that I am going to return to including the Cape Coral houses as I will be closing on two of them in the next week. This will make a total of 14 houses. [edit: highlighted in yellow]

Address	Est. Min* Value	Min* gain	Total Min* Equity	Est. LTV
Tierra Zafiro Dr.	$151	$33	$40	74%
Reilly Court	$197	$37	$48	76%
S. Knowley Rd.	$304	$92	$92	70%
S. Ridge Pointe Dr.	$182	$13	$22	88%
Lourdes Road	$195	$35	$45	77%
Queens Drive	$131	-$13	-$5	104%
Bonnie Court	$216	$52	$70	68%
Makian Pl. NW	$190	$20	$29	85%
Summit Drive	$195	$17	$27	86%
Teypana Rd. NW	$215	$45	$54	75%
W. Saw Timber Way	$303	$66	$89	71%
NE 8th Terrace	$315	$65	$65	79%
NW 13th Street	$310	$60	$70	77%
NW 16th Place	$310	$60	$60	81%
Average		$42	$50	79%
Total	$3.2m	$582	$706

Due to some cost over-runs by the builder (can you trust any builders?), plus 4-8 months over on the construction loan limits (I have to pay the interest!), plus some hidden costs on the modification to term loans, the final 3 houses will cost me 10k to 20k to close. If true, this will entirely wipe out my primary cash reserves.

Now the bad news...for you [critics]...even using this new conservative approach to valuing my homes (using the minimum value), I still come up with an estimate of an increase of $42k per house--or a total increase of $582k. Another way to look at it, I have turned my original $198k of equity (in my primary residence) into $706k of equity in 14 other houses. This is about a 350% return (albeit "on paper") in roughly 20 months of investing.

Let's start with the good news. Jeffs is looking like he's on track to break a million really soon. He has $706,000 locked up in equity already (according to his estimates), and only one house isn't growing. That's fantastic and very encouraging.

However the bad news is rather glossed over. Jeff is dangerously low in funds right now. This is a significatn disaster because we already know that he's in the negative every month. If that happens, he's going to need to figure out a way to tap into his equity somehow to cover his payments. The best possible plan might be to cash out some of thiose houses and use the money to make payments on the rest. Still, if he can weather the storm of costs, his number still look encouraging.

However, I worry about his understanding of taxes. As we noticed last month, he seems to have an overly optomistic view of how much he can "make" back in taxes. Simply put, you can't get back more in taxes than you pay. Sure losses can carry over from year to year, but in a cash-flow situation that's not much help to you. A short while later he posts again on the subject of taxes:

September 21st, 2006
The last three Cape Coral houses I haven't closed on--but I suspect when rented they will be significantly negative ($500?) before taxes. Of course, after taxes they could actually be making me 5k a month or more depending on how or if I can use the Go-Zone write-offs...so they are either terrible on cashflow (before taxes) or absolutely amazingly great on cashflow (after taxes). You pick!

In the very-likely possibility that you have no idea what GO-Zone is, it stands for Gulf Opportunity Zone. It's a package of tax reliefs and business incentives that was designed to boost the economy of the area of the Gulf Coast that was ravaged by Katrina (and other hurricanes).

I'm assuming that the $5k a month that Jeff is referring to is tied to 2 incentives. first the 50% bonus depreciation, which would allow him to depreciate the cost of his home by 50% in the first year of ownership. That means that he gets to take deductions of about $190k for his two Florida homes in the first year. The second was a Tax Loss Carryback. Essentially it allows businesses in the zone to claim deductions against taxes already paid. So you can actually claim a refund for last year's taxes. But this only qualifies through businesses, and I don't think Jeff can use it against his personal income from previous years.

You'll notice from the website that I mentioned though, that no Florida counties are listed as being in the GO-Zone. Google it yourself and you'll see that the only site that appear with "Florida Go-Zone" are real estate sale sites, not government information. I strongly urge that you see a lawyer before thinking about investing in an area with complicated incentives. Salespeople will promise you the moon, only to "forget" those promises after the sale is made.

Still, go back and look through his history. Taking the GO-Zone out of it, he was thrilled about Cape Coral before, and his numbers show more than 30% annual appreciation in that area. So why does he keep bad mouthing that area?

January 1st, 2007
I am having difficulty renting two properties. One in ABQ (slow time of the year) and one in Cape Coral (too much competition or bad PM, I can't decide). These two houses alone are costing me ~3k a month. Ouch!
...
Change in perspective or approach? I can say that I adamantly wish I hadn't bought any houses in Cape Coral! If only I would of known that they were going to be the worst performing. Except for them, I would say that I am batting a thousand. All my other houses have gone up remarkably and cost me very little each month.

Apparently Jeff is learning that NAR numbers don't tell you everything. In addition he's begun to learn that houses aren't like stocks. Where you can buy a stock, it goes up or down, and then you sell it (it really is as simple as that!) owning property can be a very complicated process. Especially when you are buying pre-construction. In February, Jeff finally let's us know why he's not been happy with 36% appreciation in Cape Coral:

February 15th, 2007
I am not batting 1000. I didn't really expect to, but admitting it anyway was hard.

My three houses in Cape Coral are going to end up being HUGE mistakes...they have lost thousands of dollars in equity and are losing $1000 a month while I rent them. While all mistakes are mine, in my defense I was clearly the victim of some pretty unscrupulous "businessmen." The builder took over two years to build my house (ONE isn't even done YET!). Now normally that wouldn't be a problem on pre-construction, but according to the contract I signed as an absolute beginner I have to pay the construction interest while they sit on their butts. Dang. Also, these houses actually went UP 50k each in the first few months I owned them (if I coulda sold), but over the last year have lost greater than 50k. If the builder would of built on time, I could of made 100k or more. Also, the lender said I wouldn't have to re-qualify my construction to perm loan, but since the builder went over the 12 month period, I DID have to re-qualify and couldn't...so that cost me ANOTHER 10k (times 3). And so on...basically I am going to lose a LOT of money these negative cashflow houses...

And I would of bailed on these houses--took my loses--if I hadn't been given assurances by several professionals that I could get Go-zone depreciation bonuses on these houses. Turns out that is unlikely (not absolutely sure STILL), so sticking with them was an even bigger mistake.

So Jeff signed a contract that bought him the rights to the home, but where the construction company has no incentive to finish on time (Jeff is paying the interest on the construction loan). So without the incetive of payments hanging over their head, the construction company has discovered that (unsurprisingly) their initial projections are off and they'll be behind schedule. For more on this topic, read my post on Moral Hazards. The lessons is that you need to make sure that the people you are doing business with have a strong incentive to fulfill their role and do it well.

And remember how he thought it was extremely unlikely that +45% appreciation could swing into -5% appreciation? Well, his homes have grown by $50k and fallen by the same amount. His inability to sustain such large losses and maintina such a large portfolio is giving him problems with financing. And he took the word of far too many "professionals" (on whether he'd need to re-finance, if he could qualify for GO-Zone, etc.). Here's a handy hint, the more professionals you have to consult, the more you place your well-being in their hands.

Jeff lets us know how bad things have gotten a short while later:

February 27th, 2007
>> Just curious if you have changed your investment philosophy since
>> the 2005 post, now you are negative 3-5K + per month?
>> How many months can you hold on with your 14 investment properties
>> with such a large negative cash flow?

I am embarrassed/disappointed to report that I am well into my "back up" reserves. They will hold me for another year or so depending on vacancies. A sale of one of my SLC houses will hold me for another year or so...

Remember that Jeff's "backup reserves" is his $200k HELOC on his home. So he is now cash-poor, and going deeper into debt every month trying to cover his houses. This HELOC is going to be payable monthly, adding to his negative cashflow. Remember, a HELOC is fine if you have positive cashflow but need an infusion of cash (for a new roof, for example), but using a HELOC to offset negative cash flow is a recipe for disater, you are simply magnifying your cashflow problem.

On the positive side, Jeff is keeping a postive mindset, because he's not sunk yet:

February 27th, 2007
You guys (and others!) seem far too gleeful about my losses on the Cape Coral homes. Try and keep in mind that I bought 14 homes that year, Cape Coral is only 3 homes. My other 11 homes have an average equity position of over 25k for a total equity position on those homes of 370k. And I no longer have to pay any Federal income tax...

Am I sad about the Cape Coral homes? Yes.

Am I sorry I took the plunge and did something crazy? No way. I will cry all the way to the bank.

That's good news, but there is some alarm in there as well. His estimated equity position of $370k is about half of what he estimated 5 months ago. That's a stunnnig drop, and there's still no guarentee that he will be able to sell at his estimated prices (it is entirely possible that he could sell for higher than his estimated prices, although given the mood of the market in 2007 is seems less likely).

Shortly after this post he comes clean on how he felt he was taken advantage of by the other parties involved (brokers, builders, PMs, etc.):

March 11th, 2007
[...]they told me:

1. This property will be built in less than 12 months
2. There will be no cost to refinance the loan, the cost of construction to perm is already built into the cost of the original loan
3. There will be no out-of-pocket holding costs, these also are built in the original loan
4. This property will rent for roughly $300 a month negative cashflow (I never believed this of course)

Basically, they promised that I would close on this loan in less than 12 months, and that I would have to bring no money to closing. Instead, because the builder went over the 12 months (it has been 25 months on one house that has about three more to go). I am paying about $1700 a month holding costs on a house under construction, and I will have to pay about 8k-10k for a refinance on this loan. Times three houses.

Ouch. Sadly, if the builder DID build as he promised, because of the nature of the market, I could of sold these puppies for a slight gain at that time. But because he is a year OVER his promised time, the market has lost 50k or so in that time and I am left holding three losing assets...

The first thing that I want to point out is that Jeff's stated philosophy is to never sell. In fact, at the end of 2005 he came up with this answer as to his philosophy "Holding good... selling bad". So I'm not convinced that he would have sold those home for a profit if the builders had completed on time. I don't feel horrible about the delays either because builders and contractors are known for delaying. It appears that the 12 month period was "promised" but not put into contract. Jeff, never believe any salesman's promise unless he'll put it in writing. It's a good lesson for us all.

I have slightly more sympathy about his loan situation, but not much. I come from the old-school of thought that says "If you are an investor, then you should known what the hell you are investing in". I'd feel horrible if Jeff were just a normal Joe who wanted a home to raise his family in and was getting killed by payments he didn't understand. But an investor who doesn't understand the terms of his loan? That's inexcusable to me.

Unfortunately, it's killing Jeff too. A month later he comes back and shares this with us:

April 25th, 2007
Well...as many of you know I own three terrible houses in Cape Coral Florida. Through a series of misjudgments and being taken advantage of (and lied to), I am losing ~$1000 on month on each of these houses when they are rented. I am just sick about them and often cannot sleep--like now.

I have been hitting my personal residence HELOC for the negatives, but can only take that so far. I would just like to "walk away" from these homes but of course I am too embarrassed to do that (so far) and I suspect it is not an option anyway... What are my options? These houses appraised at ~315k (closed in last year) but might only sell for 230k right now. I owe 264k.

Jeff is beginning to learn his lesson on why buying 15 properties with No Money Down can be a gamble, and the type that hurts you. He's also learning that an apprasal really doesn't mean anything. And while he wants to claim that he was taken advantage of, I'd say that unless they broke laws, his ignorance is his own fault. Getting into a loan that he didn't understand and paying interest on the builder's loan is just silly, but he let himself get into it. As a real estate professional, I can't buy his argument.

Later on he comes forward with information that a class action suit is forming against the builders in Cape Coral. I was going to brush over this, but it raises an interesting point:

April 25th, 2007
There is a class action suit with 100 more investors (in addition to the already existing 100 suits) being brought against those responsible for the illegal acts. To join this suit cost $2500. The lawyers don't promise anything, but claim they have a very strong case based in a large part on the illegal contracts. They say it is possible to have the original contracts "set aside." That is, the builder will get the house back...and I will get my money back as if nothing ever happened.

Is joining this class action suit (and coughing up $2500 more dollars--per house) a no-brainer? Or is this class action idea simply throwing more good money after bad.

I'm not a lawyer, but this looks a bit fishy to me. Typically in a class-action suit, the lawyer will get involved for a piece of the reward. They typically don't ask for money up front (or at least not much). In this case, the lawyer running the class action suit has already raised over a quarter of a million dollars for this case (100 homes at $2,500 a piece). That's a hefty war chest over a builders lawsuit.

Does that mean that this isn't legit? Of course not, I don't know much about this type of legal action. However, before I joined a suit like this I would go to an independant lawyer and pay him a consultation fee to have him look the suit over. If he thought it was legit and would be productive then I'd consider it. But mostly I'd be looking for information that this would be a un-winnable case or that I'd be very unlikely to get anything out of the builders (in which case that only person who goes home happy is the $250,000-richer lawyer).

Jeff also lets us know that his other properties might not be as picture-perfect as he had originally thought:

April 26th, 2007
I am moving forward on my eviction in West Jordan [Utah]. When the nice tenant is out, can I just pay a flat fee for a MLS listing and then offer 3% to the buyers agent? Is that what is happening in the market right now (do you know)? Or how should I try and sell this house from a distance?

Unfortunately, the last thing that we hear from Jeff is a very upsetting farewell:

April 30th, 2007
>> Where are you Jeff?

I have been ill...

I can't sleep, I can't eat, when I do eat it comes up. This morning I started the day with a shower and threw up in the shower...

I am barely functioning, I try to read everyone's posts...

To those of you that insist that these houses were a mistake, you were right.

To those of you offering constructive advice and support, thank you.

I try to read everything but the words are just swimming, I'll try again later...

It was one hell of a ride. And given Jeff's good nature and honesty on this site, I can't help but feel horrible for him. His situation is his fault, he basically took out a huge loan and put it all on black. But I can't begin to imagine the despair he must feel now. The wreckage from these homes will loom over his life for years. Even the properties that are worth more than he originally paid for them might not sell for many months. His personal residence is heavily leveraged with a $200k HELOC that's mostly maxed out.

The worst part is that events like this can tear a family apart. Jeff made is perfectly clear that the real estate investing was his idea, his "job". His wife clearly didn't approve, but trusted him to take the risks that he did. Jeff took their future, gambled it, and lost. Even in an open and communicating relationship, that sort of event can destroy trust, and potentially the relationship.

I wish the best for Jeff, I realy do. I hope that he can sell all of his properties and make enough back to cover his loans and losses. I hope that he can get his life back on track, and I hope his marriage survives this.

But I think his tale can be a great caution to us all. Go back and re-read the story. It's 90% elation and excitement and growth, followed by 10% crushing defeat. And that's all it takes. When you are playing with that much leveraged money, one small event can cripple you and bring you to your knees.

If you are serious about real estate, don't be Jeff. Start small. Study, read and learn about what you are getting into. Read the fricking loan documents. Take your time. And move forward at a pace that your finances can survive. I can't retell the same story over and over again enough. Do not over-leverage yourself. Please.

If I see any more updates from Jeff, I'll post them, but I doubt he'll return.