Reverse Mortgage. by Jeffrey D. Smith

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1 There are finance companies that are offering the "Reverse Mortgage" to seniors (at least age 62). Seniors with a substantial amount of equity in their residence are targets of this aggressive predatory loan. There are many "celebrities" who claim a reputation for financial literacy that are peddling this nonsense loan on television and the internet. I doubt they have done their "home work" on analyzing this stupid predatory loan. Yes, I said it. A "Reverse Mortgage" is a stupid predatory loan. It preys on the elderly, who are mostly financially illiterate. The borrowers are stupid and the lenders are predators. Here are my reasons: 1. It preys on the financially illiterate elderly. The minimum age qualification is 62. This is to increase the probability that the borrower dies within a few years to reduce the lender's risk. 2. The lender uses actuarial tables and inflation rates to calculate an estimate of the upper debt limit and the number of periodic payments. The lender wants to keep the total debt within an inflation adjusted Loan to Value (LTV) ratio (usually less than 70%), so that the property can be sold upon demise of the borrower to recover the principal and the compound interest. This conservative approach greatly reduces the "benefit" for the borrower compared to alternatives that I'll discuss later. 3. The "government insured" loans are backed by the FHA (the tax payers) to protect the lender, not the borrower. It is the "Home Equity Conversion Mortgage" (HECM) program. 4. If a Reverse Mortgage is such a good investment, then why must the lender seek protection from the tax payer? Why isn't there private insurance? Because it's too risky. 5. The Reverse Mortgage uses compound interest to extract most of the equity from the elderly in the form of deferred interest. For a 30-year payout, that could amount to as much as 70% of the equity lost to compound interest. The lender invests $1 to earn $2.50 interest, plus the $1 principal must be repaid. 6. If the borrower moves out (usually for health reasons), then the loan balance is due and payable within 6 months, and is subject to the usual rules for capital gains taxation on a primary residence (assuming that the property must be sold to pay the debt). 7. A sick elderly borrower probably cannot qualify for a refinance, and the property must be sold to repay the debt. The clock is ticking, which means it will be a distressed sale for less than fair market value; probably only for the amount owed, which means no equity and no cash flow for the owner. If the housing market is in a slump, then the FHA (tax payers) cover any deficiency. The heirs get nothing. 8. The tax payer is obligated to protect the lender in the event: 8.1. The lender must pay the periodic (monthly) payments for as long as the borrower lives in the residence, which could create a future debt balance that far exceeds the property value Upon demise or departure of the borrower, the property sells for an insufficient price to cover the principal and deferred (compound) interest. Page 1 of 6 Copyright 2012 Verity Investments LLC

2 9. The borrower is obligated to pay property taxes, property insurance, maintenance and repairs from the periodic payment. That leaves very little cash flow to cover basic necessities, like food, utilities, health care premiums, transportation, etc. 10. The origination costs of a Reverse Mortgage are much larger than a conventional refinance loan. Those costs are usually rolled into the initial loan amount and then charged compound interest for the life of the borrower. Many reverse mortgages that were originated by the "Big Banks" are now in default, because the seniors (borrowers) were spending the monthly payment and not paying their property taxes or insurance. That's not a surprise, because those borrowers are financially illiterate. If they understood the Time Value of Money (TVM), then they would never consider a Reverse Mortgage. Those banks are now exiting this niche business, because of these big problems. Smaller finance companies are more aggressive about pursuing foreclosures. They are obligated to pay a minimum principal amount upon selling the property through foreclosure. That amount is rarely more than 70% of the current market value, and the disbursed loan amount plus compound interest, fees and penalties are subtracted from the net sale proceeds. This leaves the seniors with very little of their "nest egg" equity, and when combined with their financial illiteracy, that money will be spent soon, leaving the destitute seniors on public assistance. Sensible Investment Alternatives Rather than paying heavily for the privilege of eating their own equity, folks with substantial equity should consider leveraging their equity in a high yield investment: 1. Refinance their equity for investing in professionally managed income property. 2. Sale & lease-back their property to a professional syndicator. A structured seller financing arrangement can provide cash for a leveraged equity investment. Option 1 requires that they can qualify as borrowers for a refinance, and they can find a good income property portfolio (or a professional syndicator) for their leveraged investment. Option 2 requires the professional syndicator to qualify for the seller finance note that will be sold to a note buyer or refinanced with cash out to the seller. The cash out is then escrowed for investing in a syndicated acquisition of an income property for the benefit of the seller. The price paid by the syndicator is calculated according to the income valuation of the property at current market rents for comparable houses. In the event that the former owner wants to move out, the property can carry its seller financed notes with market rents. The syndicator charges "rent" to the seller to cover the cost of the seller financing. The rent, debt service, and net cash flow (after property taxes, property insurance, maintenance and repairs, etc.) are covered from the cash flow of the syndicated income property acquisition. The syndicator (landlord) manages escrowing for property taxes, property insurance, maintenance and repairs. Page 2 of 6 Copyright 2012 Verity Investments LLC

3 The former owner (tenant) is now a renter and receives a net cash flow check each month after all expenses and debt service is paid. The "rent" is not a tax deductible expense, but most of the cash flow from the income property is tax sheltered through the depreciation allowance. The benefits of leveraging the equity through a syndicated investment in income property: 1. The minimum age requirement is the legal age of assent for entering into a contract, usually about 18 years old. Anyone who can legally enter a contract and with substantial equity and sufficient financial sophistication (or advice from a qualified professional) can participate. 2. If the home owner can qualify for the cash out refinance, then after the debt is repaid from the net cash flow from the income property, the house can be refinanced again for another investment in another income property. 3. If the home owner cannot qualify for the cash out refinance, then a syndicator can buy the property with a sale & lease-back arrangement and structured seller financing. The syndicator sells the seller financing note and leverages that cash out into a syndicated income property. Alternatively, the seller financing note can be refinanced for the cash out. Either way, the syndicator is the Payor on the note, and qualifies for the note sale or the refinance. Qualifying includes the contemplated acquisition of the income property. Thus, the potential net cash flow from the income property will qualify the syndicator for the note sale or the refinance. 4. The "principal" portion of the seller finance sale is sheltered by the usual capital gains tax rules for an installment sale of the primary residence. Immediately selling or refinancing the note is also covered by the capital gains tax rules. 5. For a sale & lease-back, the net cash flow from the income property covers all of the costs of debt service, taxes, insurance, maintenance and repairs, plus spendable monthly income. Most of that income is tax sheltered due to the depreciation allowance that is provided to the equity investors on the income property. 6. After the seller financing note is paid off, the "rent" can still be serviced from the net cash flow of the income property (that's what was paying the seller financing). The former owner can live there for as long as they comply with the lease agreement. 7. The syndicator can include a "sublet" clause, to allow the tenant to move out and sublet the property for additional cash flow. Subletting to a subtenant is subject to the syndicator approving the subtenant, and will not relieve the senior tenant from the lease obligation. If the former owner moves out for health reasons or just to move to a better location, then the net cash flow continues from the income property. 8. Upon demise of the senior tenant, the lease terminates. The syndicator can rent the house to someone else to cover the seller financing note, or just sell the house. If the house was sublet, then the sub-lease can automatically "ripen" into an ordinary lease. 9. The "benefit" of the net cash flow from the income property passes to the heirs on a steppedup tax basis, without an obligation to service the lease agreement (the lease terminates upon demise) and without capital gains tax (within the "then current" limits of tax law). Page 3 of 6 Copyright 2012 Verity Investments LLC

4 Example: Reverse Mortgage For a property value of $200,000, the Reverse Mortgage generates a monthly payment of $256.50, from which is paid property taxes, property insurance, maintenance and repairs, utilities, food and transportation. If we assume these minimum parameters: Carrying Costs Requirement Annual Property Tax... $1,200 Annual Property Insurance... $600 Annual Maintenance and Repairs... $600 Annual Utilities... $1,200 Annual Food... $3,600 Annual Transportation... $600 Annual Cash Flow Requirement... $7,800 Monthly Total... $650 The total monthly cash flow of $256 is insufficient to cover the $650 monthly carrying costs requirement. This is the main reason that borrowers default on their Reverse Mortgage. They haven't calculated their total income and expense requirements, plus net spendable cash flow. Reverse Mortgage Debt Parameters Property Value... $200,000 Fair Market Value (FMV) Starting Balance... $8,000 Loan origination fees Annual Inflation Rate % Annual Interest Rate % Compound interest Compounding Term years Inflation Adjusted Final Value... $491,400 (really?) Maximum Future Debt Value... $307,125 [62.50% LTV] Total Principal Paid... $92,340 [360 $256.50] Total Interest Owed... $214,785 Periodic (Monthly) Payment... $ (gross) Annual Payment... $3, Look at a syndication scenario that leverages the equity from the cash out refinance of the house. Start with the refinance cash out parameters: Amortization Debt Parameters Property Value... $200,000 Fair Market Value (FMV) Annual Interest Rate % Compound interest Amortization Term years Annual Debt Constant (ADC) % Refinance Closing Cost... $4, % Annual Percentage Rate (APR) % on net loan proceeds Maximum Debt Present Value... $140,000 [70.00% LTV] Total Interest Paid... +$162,174 Total Payments... $302,174 [360 $839.37] Periodic (Monthly) Payment... $ Annual Payment... $10, Page 4 of 6 Copyright 2012 Verity Investments LLC

5 Then calculate the syndication parameters for the investment tranches: Syndicated Investment Parameters 1 st Loan to Value Rate % 1 st Loan Annual Interest Rate % 1 st Loan Amortization Term years 1 st Loan Incentive Fee Rate % rolled in 1 st Loan Net Proceeds... $528,111 1 st Loan Annual Debt Service... $39,171 2 nd Preferred Equity to Value Rate % 2 nd Preferred Equity Interest Rate % 2 nd Preferred Equity Amortization Term years 2 nd Preferred Equity Incentive Fee Rate % rolled in 2 nd Preferred Equity Net Proceeds... $150,889 2 nd Preferred Equity Cash Flow... $14,503 3 rd Common Equity to Value Rate (ETV) % 3 rd Common Equity Net Investment... $75,444 3 rd Common Equity Total Investment... $135,800 3 rd Common Equity Return on Equity Rate % (net yield) 3 rd Common Equity Return on Equity... $18,107 [60.00% ownership] 4 th Syndicator Premium Fee... $30,178 [4.00% MAO] 4 th Syndicator Operating Reserves... $15,089 [2.00% MAO] 4 th Syndicator Escrow Closing Cost... $15,089 [2.00% MAO] 4 th Syndicator Annual Cash Flow... $12,071 [40.00% ownership] Investment Property Operating Data Gross Scheduled Income (GSI)... $163,932 Vacancy and Credit Loss... $19,672 [12.00% GSI] Actual Rental Income... $144,260 Other Income... +$8,197 [5.00%] Effective Gross Income (EGI)... $152,456 Gross Operating Expense (GOE)... $68,605 [45.00% EGI] Net Operating Income (NOI)... $83,851 [55.00% EGI] Capitalization Rate (CAP) % [DCR ADC LTV] Maximum Allowable Offer (MAO)... $754,444 [NOI CAP] Debt Coverage Ratio (DCR) Debt Coverage Margin (DCM) % Cash Flow Margin (CFM) % Leverage to Yield Senior Tranche Loan to Value (LTV)... $679,000 Senior Tranche Annual Debt Constant % Senior Tranche Annual Debt Service... $53,673 [90.00% LTV] ADC ADS Common Equity Cash Flow Before Tax... $18,107 CFBT Common Equity House Debt Service... $10,072 Common Equity Net Cash Flow Annual... $8,035 [house DCR ] Common Equity Net Cash Flow Monthly... $669 Page 5 of 6 Copyright 2012 Verity Investments LLC

6 The gross Return on Equity (ROE) is 40%, which is split between the syndicator and the common equity investor. The common equity investor realizes 13.33% net effective yield. We have covered the monthly net cash flow requirement of $650. However, by tweaking one parameter, the gross Return on Equity (ROE), we can also provide for some net spendable cash flow. Changing the ROE from 40% to 50% changes the DCR from to This one change increases the 3 rd common equity net yield from 13.33% to 16.67%. The Capitalization Rate (CAP) is now %. Adjusted Investment Property Operating Data Gross Scheduled Income (GSI)... $178,681 Vacancy and Credit Loss... $21,442 [12.00% GSI] Actual Rental Income... $157,239 Other Income... +$8,934 [5.00%] Effective Gross Income (EGI)... $166,173 Gross Operating Expense (GOE)... $74,778 [45.00% EGI] Net Operating Income (NOI)... $91,395 [55.00% EGI] Capitalization Rate (CAP) % [DCR ADC LTV] Maximum Allowable Offer (MAO)... $754,444 [NOI CAP] Debt Coverage Ratio (DCR) Debt Coverage Margin (DCM) % Cash Flow Margin (CFM) % Leverage to Yield Common Equity Cash Flow Before Tax... $22,633 CFBT Common Equity House Debt Service... $10,072 Common Equity Net Cash Flow Annual... $12,561 [house DCR ] Common Equity Net Cash Flow Monthly... $1,047 The common equity Cash Flow Before Tax (CFBT) increases to $22,633. Subtracting the House Debt Service $10,072 leaves $12,561 Net Cash Flow Annual. The monthly net cash flow is $1,047 from the income property. Subtracting the monthly carrying costs of $650 leaves $397 positive cash in pocket after paying all expenses and debt service. Take note that these cash flow calculations are after the syndicator receives his split of the net cash flow before tax. Also, the syndicator's split is subordinated to the common equity investor. If the cash flow decreases, then syndicator's portion is reduced to zero before the common equity investor suffers any loss of income. The professional syndicator can deliver a far better benefit to the home owner compared to a Reverse Mortgage. The professional syndicator provides a valuable service by finding and managing the investment income property, and managing the escrow of the taxes, insurance, maintenance and repairs. The syndicator can also offer bookkeeping services (through a licensed CPA office) to monitor the budget for food, transportation, etc. You can review my affordable course "Introduction to Income Valuation and Syndication" at for more information on becoming a professional syndicator. Page 6 of 6 Copyright 2012 Verity Investments LLC