More Rich Dad, Poor Dad Nonsense

Raise your hand if you paid $38 per share to get in on Facebook's initial public offering (IPO).  Raise your other hand if you think you got ripped off.  If you have both hands up, punch yourself in the nose with your right hand, and smack yourself in the back of the head with your left hand.  You paid one hundred times earnings.  A more reasonable stock market multiple would be fifteen times earnings.  You paid $38 to get 38 cents of annual earnings.  Congratulations.  You could have done way better investing in tax free municipal bonds with a whole lot less risk.  Did you know that in paying the IPO price, you were forecasting the company's earnings to rise six times as high as they are now?  If you didn't know that you were making that forecast, investing in IPO's probably isn't your thing.

A couple days ago, I read the complaints of Facebook IPO suckers on a USA Today online article.  These suckers believed that investing in an IPO was a guarantee of an immediate profit.  These geniuses believed they had found the secret that all the smart rich people know that the average Joe doesn't.  Here's the secret they didn't know about IPO investing.  The smart rich people left the public IPO market a while ago.  It's become a suckers' market.  Why?

IPO's used to be offered at artificially low prices.  Of course, you, as the average Joe investor, would never be offered below market IPO shares.  These shares were used by brokers to reward their best and richest customers.  As IPO shares rose in the first few days after issuance, these favored brokerage customers sold their shares to the general public realizing quick, almost riskless gains.

The Securities and Exchange Commission eventually came to the conclusion that offering IPO shares at below market prices had two problems.  First, isn't the aim of an IPO to raise as much money for the issuing company as possible?  Second, doesn't offering below market shares to a small closed group of investors sound a lot like insider trading?  Didn't they have information not available to the general investing public?  The days of below market IPO's have come to a close.  Mark Zuckerberg wasn't just being a rich sociopath.  He was carrying out his fiduciary duty to maximize the IPO proceeds for his company.  Give the guy a break.  He had a wedding to pay for.  Soon he'll have alimony and child support.  If you bought Facebook shares, you bought into the Rich Dad, Poor Dad idea that there are mysterious secrets that only the rich know.  If only you learn those secrets, you'll get rich too.

One of the ideas, that until recently seemed to be discredited, was the scheme to buy real estate with little or no money down.  Then you almost immediately resell to someone else for more money.  After the real estate crash, the idea seems laughable, but a lot of people tried this.  I can tell you exactly how many of my really affluent clients made money this way.  Exactly zero.  I can tell you a lot more of my less affluent clients went bankrupt trying.  With the decline in real estate prices over the past few years, this scheme is reappearing in some strange forms.

 

The most original real estate scheme I have seen lately involves buying properties from distressed owners and then reselling to buyers, who can't get conventional mortgages.  The promoter of this arrangement enters into a sale contract with a desperate property owner.  In some cases, the mortgage is already behind but not in the ideal circumstance.  The promoter signs a purchase contract with the stipulation that he will continue to make mortgage payments to the seller's mortgage holder.

Next, the promoter sells the property, for a higher price, to a purchaser, who can't qualify for a mortgage with a bank.  Of course the promoter gets a higher interest rate from his buyer than he pays the bank holding the mortgage for the original owner.  The promoter makes money in at least two potential ways.  First he makes money on the interest spread between what he is paying the bank versus what he collects from his buyer.  Second, he makes money from selling the property to his buyer at a higher price than he paid.  He's not worried that much if his buyer defaults and he has to reclaim the property.  Either his buyer will eventually refinance and take the first bank out of the arrangement leaving the promoter with his profit on the sale, or the promoter will collect an interest spread until some eventual buyer is able to refinance.  This is a pretty sure fire way to make money with little or none of the promoter's money involved right?

 Well.... there are some minor issues.  First, almost all mortgages have a “due upon sale” clause.  When a homeowner sells a house, the entire amount of the mortgage is due immediately.  I wrote “almost all” since there might be a mortgage out there without one, but I haven't seen one personally since the assumable mortgage became as extinct as the Brontosaurus in the seventies and eighties.  The due on sale clause keeps banks from doing business with hidden borrowers, who don't meet the bank's credit qualifications.  Thus, when the promoter buys the house, the mortgage is due immediately.  Of course, no one notifies the bank about the sales, and I doubt any reputable title companies are involved at closing.  All of the agreements are done in private.

You might ask, “Who is getting hurt in this harmless little paper chase?  The bank still gets paid.”  The answer is no one if you can sleep just fine at night violating the law and everything works out just right.  But what if the scheme doesn't go as planned?  What if the promoter can't find someone to buy at a price high enough to pay off the bank?  What if the promoter's buyer can't make the payments and the promoter can't find another buyer right away?

The promoter didn't know this, but he is what's called an intermediary in the terms of commercial finance.  He is bearing a risk in exchange for an expected profit.  He is the bridge between two people, who can't obtain credit, the original seller and the final buyer.  The promoter is risking his money by guaranteeing the performance of two parties, who can't obtain conventional credit.  If you have one of these deals, leave me out of it.  This deal that can work nine times.  Then the tenth deal blows up and kills the profit of the first nine and more.

Here's an interesting question that I'll bet my lawyer friends can't even answer.  If this scheme unravels, who owns the house?  My guess is that the bank owns the house from the moment of the first sale based on the due upon sale cause.  However, I'm not at all certain.  What I do know is that there are a lot of risks the promoter doesn't know he is taking.  If the bank finds out about the scheme, even if the promoter finds a buyer at a good price, the bank may be entitled to the profit as the actual owner.  The bank is almost certainly entitled to the promoter's interest rate spread as well.  If this is what a sure fire profit looks like, I stick with tax free muni's.

The author of Rich Dad, Poor Dad writes that he isn't recommending any of the investments he writes about.  But he uses them as his examples of the smart thinking that separates smart rich people from the average Joe.  I have a lot of other problems with the advice in the book.  I'll write later about some other issues – such as his use of corporations.  I suspect his accountant wishes he never wrote the book.  I would love auditing his tax returns for the IRS on a contingency basis.  That's a smart money idea.

This weekend I'm celebrating the seventh anniversary of my relationship with my future wife, Jennifer Aniston.  Please raise a toast with your favorite adult beverage to our happiness.  I'm certain Jen is celebrating in her own way – maybe filing a renewal of the restraining order.

Thanks for reading!  As always, for real accounting and tax advice, please visit the S&K web site at www.skcpas.com.