Straight Talk from Al Jacobs
AN INVESTMENT LESSON
In the spring of 1971 a three-line ad in the classified section of the Los Angeles Times caught my eye. It offered an attractive return for short-term loans secured by houses in Orange County, California. Having purchased and serviced real estate loans for years, it seemed worth looking into. I found something unexpected.
Behind a stained gray metal desk in a room no larger than 12' X 12' on the second floor of an old frame office building in Anaheim, sat a small man in his mid-30s. He claimed to be a real estate broker and explained he planned to purchase homes from troubled buyers, renovate them, and resell them for a profit. He admitted having neither money nor credit, so needed to arrange private financing for his program to work. He suggested we look at a house a couple of miles away, and drove over in his aging pickup truck.
There I saw a typical 3-bedroom tract house, about ten years old, in bad need of paint, cleaning, carpets, and yard work. Its likely value of about $125,000 when fixed up, and an existing 5¼% FHA loan of $80,000, made it attractive. The broker suggested $15,000 cash to the seller with take-over of the existing loan. He asked me to make a six-month, second mortgage loan of $20,000 to him as purchaser, enough he said for the seller, rehab, holding and sales costs He offered to pay interest of 2% per month—representing 24% per annum.
I saw both good and bad. On the plus side: the favorable FHA loan at a fair rate of interest—the less onerous the senior loan, the less risk to the junior lender. The offer of a high rate of return and a short holding period also seemed attractive. Furthermore the loans totaled no more than 65% of the property value. But no positive comes without a negative. The first defect: a 24% usurious return—unenforceable regardless of the willingness of the borrower to pay it. The second problem: an uneasy feeling of this character sitting on the other side of the desk. The owner of the property controls all aspects, including renovation, marketing and servicing the mortgages. What is my position? A casual observer entitled to foreclose if not paid. As proposed, this sort of involvement made no sense.
But another way existed to answer both objections. Instead of my providing the money for his purchase at a specific interest rate, I proposed to pay the seller the $15,000, take title to the property in my name, and deliver to the broker $5,000 for the rehab. The mortgage becomes mine to service and I give the broker a six-month option to purchase at $110,000. By this arrangement he need only renovate and resell within the anticipated six months for his profit. The change for me was vital, as it eliminated the dual problems of usury and control. He accepted my proposal and we formalized the agreement a few days later.
He moved speedily, putting the house in showable shape within a month, finding an acceptable buyer for $125,000 two weeks later, and closing escrow in another five weeks. Within less than three months he made $13,700 in pure profit, with no cash outlay—certainly a favorable amount for the time spent. In the same 3-month period I pocketed $8,600. We both did well.
A second house became available within a month and a third followed shortly thereafter, both renovated with sales pending in escrow by late September. I still remember my visit to the broker's office to sign the last of the documents. Things had changed considerably. The offices, containing perhaps a dozen employees, now occupied about two thousand square feet in a modern building on a fashionable boulevard. But most dramatic of all was the huge polished walnut desk behind which he sat, along with an exceptionally attractive secretary at a smaller desk nearby. While conducting our business I thought of a movie from long ago: Will Success Spoil Rock Hunter? Though generally satisfied, the feeling of discomfort returned.
In mid-October we entered into agreements on another house. By late November, with no progress reports, and phone calls to his office unanswered, I became concerned. My investigation that weekend told the story. I found the offices locked and the business obviously shut down. Visits to the house later in the day literally required my forcing entry.
Over the next two months my wife and I renovated and marketed the house. Luckily the real estate market held and we suffered no actual cash loss, though compensation for our efforts seemed below minimum hourly wage.
There’s a moral to be stressed: the importance of dealing from a position of strength. Were the initial investment made as a real estate loan, my only recourse would have been foreclosure under the mortgage. Possession of the property might have taken a year and resulted in a washout. But with ownership of the house in my name from the onset, I needed only to aggressively commandeer. This made the difference between profit and loss. Never forget this—security is crucial