In the last issue we discussed some of the key risks faced by “wrap” real estate investors. You may want to re-read the article as I’ll be relying on several of the concepts raised there. In this issue I’ll be introducing the concept of Safety Scoring, a technique I’ve developed to measure and manage default risk.

Consider two potential wrap properties. Property A has an outgoing monthly payment of $500 and an incoming payment of $825. Property B also brings in $825, but has an outgoing payment of $700. All things being equal, which property would you prefer to add to your portfolio?

Obviously, the answer is Property A. It has a higher monthly spread, and would also be less painful to carry should it be vacant or otherwise non (or slow) performing. In a perfect world all occupants would pay us on time every month, and we would not have to worry about this issue. But in the real world our lenders require on-time payments no matter what.

And in the real world all things are not equal. So let’s introduce a few variables. Let’s say that you have to bank qualify to buy Property A, and it will require a 10% down payment. Its annual return on investment (ROI) will be a solid 60%. Property B, however, can be bought “subject to” the seller’s existing mortgage without any qualifying or cash down. As a result, the ROI will be infinity. So now which property do you prefer?

That’s a tougher decision. Wrap investors tend to focus strictly on ROI when evaluating potential deals. However, I would argue that there are other factors that should be considered, including the additional risk that would be added to the portfolio by acquiring the property. That risk is primarily represented by what I call the property’s “Safety Score,” or “S score” for short.

The S score is simply a measure of a property’s monthly profitability in relation to its outgoing payment. When analyzed at the portfolio level, it tells the investor how well, on average, the portfolio will be able to sustain itself without having to dip into reserves. To derive the S score you simply divide the monthly spread by the outgoing payment. So, Property A has an S score of 0.65 (the $325 spread divided by the $500 outgoing payment), which is high.

The inverse of the S score will tell you, on average, how many performing properties you will need for every nonperforming one to be able to make all your monthly payments. So if we divide one by 0.65, we get 1.54 performing properties for every nonperforming one, or about three for every two. It would be hard to imagine a portfolio ever experiencing this high of a default rate. So a portfolio with an average S score of 0.65 would be very “safe” indeed.

Property B, on the other hand, has an S score of only 0.18, meaning that you’d need (on average) about 5.5 performing properties to cover each nonperforming one. Depending on your qualifying procedures and other factors, it’s probable that at least occasionally you’d have to tap into reserves to make all the payments.

So does that mean we should avoid all deals offering low S scores? Absolutely not! I buy houses like Property B all the time. I also have lots like Property A, which pretty much typifies the “VA repo” deals I did while they were available. The key is to manage your portfolio so that there is synergy between the properties, and to manage the associated risk according to the S scores you’re dealing with.

For instance, one way I’ve chosen to manage low S score properties is to place them in an entity containing high reserves. Specifically, I’ve set up an LLC that is owned by my Roth IRA account. (For a great discussion on how to properly do this, I recommend speaking with Stephanie Olsen at The Ark, Inc. – www.thearkinc.com).

The bulk of the IRA’s assets sit in cash or other liquid assets, just as they did before I began buying real estate with them. And the properties I’m buying for the account require neither qualifying nor cash to buy. As a result, I don’t have to touch any of the principal in the account. But I do keep a certain amount in cash available, because I do occasionally have to dip into reserves. But it’s not a big deal. I just write the checks, and the account gets built back up once the occupant issues are resolved.

An important issue to consider with low S score properties is that it may be difficult to quit your job and retire on them. That’s because with these properties, there may not be much surplus cash flow in some months to cover your living expenses. In the case of my IRA account, however, I’m not really concerned about the monthly cash flow. My only goal is growing the account to a “bazillion” or so dollars by the time I’m allowed to access it.

So with all of my wrapped properties, every month each will experience one of three possible outcomes. Under scenario A, the buyer pays me on time. That’s good. In scenario B, the buyer pays me late and adds a 10% late fee. That’s even better. And in scenario C, the buyer stops paying me altogether. I take the house back in about a month, and within a short time get it remarketed to a new buyer, with a new down payment and usually at a higher monthly payment and sales price. While I’d like all of my occupants to succeed, Scenario C is often the best financial scenario of all.

And in the long term, things get even better, because one of two things will happen. For most of my properties, I’ll make monthly cash flow until I’m cashed out and receive a nice capital gain that can finance two or three new deals. But some of my properties will never cash out. That’s because I’ll have a succession of “buyers” who will stay in the house a few years each and then move on. Thirty years from now I’ll wake up to find free and clear houses which have appreciated to boot. In either case, I’ll be extremely glad I loaded up on all those properties, no matter what their S scores were!

So how should you apply the above analysis to your own situation? First of all, you need to determine the type of S score environment you’ll be facing. If you’ll be buying primarily lower priced properties with low interest rate loans, your S scores will likely be high. On the cheaper properties it’s not unusual for my selling prices to be about 50% higher than my purchase prices. Combined with my interest rate spread, this often produces incoming payments nearly double the outgoing payments (i.e., S scores of nearly 1). Now that’s a “safe” investment!

On the other hand, if you’re buying properties with high LTVs and at higher interest rates, you’ll likely be faced with low S scores. And the same would hold true for most higher priced properties, no matter how they’re financed. The following are some suggestions in dealing with low S score properties:

• Tailor your occupant qualifying strategy (and it definitely is a strategy) to your specific legal environment, your typical remarketing time, and your personality. If you’re faced with long processes that make you miserable, then use some common sense:
  
  
  • Get higher down payments, for two reasons: more down usually means lower likelihood of default, and if the buyer does default, you’ll have more cash to cushion the blow and cover your payments.
    
    
  • Use more stringent qualifying standards, and act quickly when problems arise.
    
    
• Maintain adequate reserves, including some or all of the buyer’s move in money.
  
  
• Buy properties with money partners, who will be responsible for maintaining the mortgage payments while a house is not performing. This spreads out your risk.
  
  
• Mix in some higher S score properties with the lower S score ones
  
  
• Consider doing some prudent “quick cash” deals along with the wraps, and keep some of the profits from those deals in reserve.
  

I realize that safety scoring is an advanced topic that may not be very meaningful to most “newbies.” Most newbies should probably just do a few deals first and ask questions later! For these folks, “psychobabble risk” and “paralysis by analysis risk” are probably a lot more dangerous than anything related to safety scoring! Nevertheless, safety scoring should play a major role in your strategy as you grow your wrap portfolio.