New (to me) investment
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A few months ago, I heard about a type of investment that was completely new to me. I’m relatively investment-savvy (in theory, even if my practice is limited), so the fact that I hadn’t heard of it before got my attention. While undoubtedly some of you (who know more than me) have already heard about this, I figured there are probably others who haven’t yet, so I wanted to give a basic overview.
The investment is tax lien certificates. Here’s the basic scenario: counties generally collect property taxes, which they use to support law enforcement, roads, that kind of thing. These funds are already committed; the counties look at the amount the assessors say the property in the county is worth, apply the tax percentage, and that’s their budget (yes, sometimes it’s more complicated than that, but the point is that they count on property tax income to cover their expenses).
What happens when someone can’t or won’t pay their property taxes? Well, if they did nothing, the county would be out the money. That doesn’t really work for them. They could try to collect, but that takes too long (remember, the money is already committed). So many of them do something interesting: they encourage investors to come in and essentially provide a loan to the property owner, with the money going directly to the county, of course. The investor pays the amount of the outstanding property taxes and gets what’s known as a “tax lien certificate”, and the property owner then owes the investor that amount (instead of owing it to the county). They still pay the county, and the county disburses the payment to the investor, but the investor is basically loaning the property owner the amount of their overdue taxes.
Why would an investor do this? The simple answer is “interest.” The rules vary by county and state, but the gist of it is that the investor is supporte by law in charging a certain amount of interest on their loan. This interest can be well over the average return on the stock market (it can also be below that level, too, but savvy investors won’t go for those deals). This makes it very attractive.
What happens if the property owner ignores their obligation to pay back the investor? Well, first, this doesn’t happen very often, especially when you’re talking about valuable property and peoples’ homes. Usually it’s an oversight or a temporary cash flow problem that kept the owner from paying the property taxes in the first place. But what if the loan isn’t paid off anyway? The investor gets the property, free and clear.
That’s right. For the cost of property taxes (usually 1-2% of the property’s assessed value), an investor can walk with the property. Again, I’ll reiterate, this hardly ever happens. If the property has a mortgage on it and it becomes obvious that the owner is not going to pay, the bank holding the mortgage will usually pay the back taxes. This is because a tax lien certificate has first rights, ahead of a mortgage. Basically, if the tax lien certificate is not paid off in the allotted time, the investor holding it gets the property and the mortgage goes away. Obviously the bank would rather pay the property taxes and let the owner default on their mortgage than lose both the mortgage and the property.
Since the certificates almost always get paid off, most investors are in it for the interest, not the property. But aside from the (semi-remote) possibility of acquiring property at pennies on the dollar, tax lien certificates have a few other unique features that attract investors.
- A safe investment. The county enforces the terms of the tax lien certificate. If an investor buys a tax lien certificate, he or she is guaranteed to get either the proscribed monetary return on their investment or the actual property.
- Excellent returns. The returns can be very nice, depending on the county; many are well above 15%. The really nice part is that the investor knows the rate of return upfront. Most tax lien certificates are sold at auction, usually using a “bid down the interest” system where you decide on least amount of interest you are willing to receive and bid to that point. If someone is willing to take less, they will win the tax lien certificate. However, there are usually plenty to go around and by exercising strategic bidding, you can walk away owning some great investments with the rate of return you deemed acceptable.
- A full range of investment sizes. Since property taxes (and consequently, tax lien certificates) are based on a percentage of the property value, you can find tax lien certificates being sold for anywhere from a few hundred dollars to tens of thousands of dollars. This is excellent for both those just getting started and those who want to invest very seriously.
You’ll find lots (and lots!) of websites trying to sell you ebooks on tax lien certificate investing; most of those paint the picture very rosily (and with good reason). However, like any other kind of investing, there are downsides.
- Location of the property. Sometimes there is a good reason someone doesn’t care to pay property taxes. If the property is worth less than the taxes (due to it being unusable, contaminated by industrial waste, underwater, etc.), you might find yourself owning something you’ll have to pay to get rid of (very literally, in the case of contamination). The way to avoid this is to do good research. Know where the property is, what condition it’s in, and any pertinent details of its history. A physical inspection is definitely the best way to go. If you want to be really careful, limit your tax lien certificate purchases to inhabited residences. They’ll cost a little more, but remember, property taxes are percentage based, so they’re worth more.
- Location of the auction. If, like me, you live in a state where they don’t do tax lien certificate auctions, you’ll either need to travel or participate online. The online auctions are few and far between, though, and then you don’t get the opportunity to physically visit the property before you bid. This is the single reason I haven’t invested in tax lien certificates yet (I’m planning on doing so when some of the online auctions happen, but many of them are still months away).
- Timing and availability. As I just alluded to, auctions are at set times, and those times might not work for you. Some counties actually have monthly auctions, but most are yearly, so it can involve a lot of waiting. You might have times where your earmarked money is sitting, waiting, and doing nothing for you in the meantime. Additionally, if you have a lot of money to invest or are attending a popular auction, the tax lien certificates may run out before your money does. That’s more money sitting around, not doing anything.
- The legwork involved. Although the county handles communication with the property owner and collection of the back taxes, the investor usually has to do everything from paperwork (at the least) to prompt eviction (within a certain set time period). This means that you have to be very organized in order to keep track of what needs to be done when, and make sure you do it. Otherwise you risk losing your entire investment.
The downsides need to be taken seriously, but as I see it, the benefits (guaranteed return backed by real property) far outweigh the costs. As I mentioned, I plan to invest in tax lien certificates in the near future.
This has been a massively generalized overview, so if you want to learn more, I highly recommend you find a copy of “Profit by Investing in Real Estate Tax Liens” [affiliate link] by Larry B. Loftis. I borrowed it from the library and found it to be excellent. It has a great overview of the ins and outs of different systems, and then it has a state-by-state section with the specific information that I’ve found lacking on the internet. Mr. Loftis is an experienced tax lien certificate investor and I am going to use his book very heavily when I start investing in them.
Let me know if this has been helpful, and if you have any experience, comments or questions about tax lien certificates, by all means leave comments.
Here’s another equally compelling way to invest: follow demand and do what the insiders do.
Follow demand: things like oil, gas, water, utilities, etc. have near-constant and dependable demand cycles, so why not make a buck off everyone else’s use? I’ve already made tons of bucks off people’s driving habits and oil consumption with no effort on my part, except to buy into an energy index fund.
Follow insiders: if you’re going to buy stocks, it pays to watch what the execs in those companies do, since a good part of their own money is tied up in company stock. Find out what the corporate insiders are buying in large amounts, and what they’re selling in large amounts, because that tells you where you want to be and where you don’t. Insider buying means they’re buying for a reason–reasonable expectation of making a profit, and all you have to do is buy along with them and ride their coattails. Insider selling is completely the opposite–they know something we don’t, and usually know it well in advance of any public announcements, so they have plenty of time to ditch their stock before the announcement and inevitable drop in value.
This is as effortless and mindless as it gets for investing.
P.S.–I own a copy of Lillain Villanova’s tome on liens, and here’s a resource list of other lien books: http://www.xcelens.com/tax%20lien%20books.htm
I’m just waiting for the bottom to drop out of the RE market, so that more inventory will come to the lien market for better pickin’s…shouldn’t be long now, with interest rates rising recklessly.
If you’re interested in lofty frugal issues, check out my blog: Wenchypoo’s Warehouse of Frugal Wisdom.
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