Russ Whitney brags about and advocates what he calls “overfinancing” techniques in his various books. One of the two categories of this are property improvement loans. I understand from his promotional material, he and/or his instructors do the same at some of his seminars. Are these techniques legal?

Probably not.

I will address the issue from two perspectives:

  1. Did Whitney break the law in the deals he tells about?
  2. Should you do what he advocates?

I researched this by interviewing some of the top experts in the nation on improvement loans.

I also let Whitney’s attorney read an advance copy to see if it had any errors or omissions.

Two fundamental principles of improvement loans

There are two bedrock principles when you apply for a property improvement loan:

  1. You must tell the truth, the whole truth, and nothing but the truth on the application and in any related discussions.
  2. The loan proceeds must be used only for improvement of the property in question.

Did Whitney break the law?

I think Whitney almost certainly did break the law, but I cannot say for sure without seeing the loan applications and interviewing the loan officers and such. Also, if your definition of breaking the law is being convicted, I am not aware of any prosecutions of Whitney for mortgage law violations.

That he has not been prosecuted with regard to his “overfinancing” techniques may just mean the prosecutors are too busy or are not aware of what he did. There is a lot more law breaking in the world than there are prosecutions.

Having noted that some of the pieces are missing, let me go ahead and analyze the pieces we do have.

HUD Title I improvement loans

Whitney is a big advocate of Department of Housing and Urban Development Title I improvement loans. He claims to have obtained them on a number of occasions.

The starting point for ascertaining whether someone broke the law is to ask, “What, exactly, is the law?” In the case of Title I improvement loans, it is 12 USC 1703. The original name of the law, as it was going through Congress, was the National Housing Act (1934). Title I, Section 2 of the National Housing Act as amended is another common citation for this law.

The basic idea of HUD lending is that the federal government—that is, the taxpayers—insure such loans in order to encourage private lenders to make them. If the borrower doesn’t pay the loan as agreed, and the lender suffers a loss, they can file a claim with the federal government to get reimbursed for their loss just as you might file a claim with your car insurance company after an accident.

HUD makes a federal case of everything—literally

So although you get the loan from a local bank or savings and loan, the loan is a federal matter because of the insurance provided by the federal government. The fact that it is a federal matter means that the law enforcement authority who gets called when the law may have been violated is the FBI. If the FBI does, indeed, find evidence of a violation of the law, they refer the matter to the United States Attorney—that is, the U.S. Department of Justice’s local prosecutor. If they decide to indict you, the case will be tried in federal court.

In the citation of the law above, 12 USC 1703, USC stands for United States Code, which is the official name for federal law. As is often the case with federal laws, the Congress and President put a phrase in the law that tells the cabinet department in question to create regulations to enforce the law. In 12 USC 1703, it says,

(h) The Secretary is authorized and directed to make such rules and regulations as may be necessary to carry out the provisions of this subchapter.

“The Secretary” refers to the head of the Department of Housing and Urban Development.

To see whether Whitney’s “overfinancings” break the law, we must look at those regulations. In the case of HUD Title I improvement loans, they are at 24 CFR Part 201. “CFR” stands for Code of Federal Regulations. The section that is most pertinent to Whitney’s “overfinancing” is 24 CFR Part 201.20.

To qualify for a Title I loan

It says, in part, to get a HUD Title I improvement loan:

Less formal articles by HUD on the Internet (e.g., http://www.housingall.com/STEPUP/FinImprovements.htm) state in plainer English, that if the improvement in question is do-it-yourself, you can only borrow the materials cost. On the other hand, the regulations say,

“If the borrower plans to use a dealer or contractor to carry out the improvement work, the lender shall obtain a copy of a proposal or contract that describes in detail the work to be performed and the estimated or actual cost.” (§201.20(b)(1) [emphasis added]

Whitney’s approach

Russ Whitney’s approach appears to be as follows:

  1. Think up a contracting company name that does not contain the name Whitney.
  2. Buy blank “proposal and contract” forms from a stationery store.
  3. Fill out such a form using the name of Whitney’s contracting company.
  4. Obtain actual costs of each part of the improvement.
  5. Mark the actual cost of each item up between double and six times the actual cost.
  6. Add the marked-up costs to the “proposal and contract” form.
  7. Submit an improvement loan application for the total amount of the “proposal and contract” form, which is attached to the loan application.

Assumed name

Is this legal? I think not. You are entitled to form a contracting company—although state law typically requires that you register it as a fictitious name, “doing business as,” or assumed name with the county clerk. That’s true unless the name of the company is your real name—like L. L. Bean or your real name and the nature of your business—like “Russ Whitney Contracting” or my “John T. Reed Publishing.” The purpose of the registration is to tell the world the real people behind that particular company name. Of course, if your “contracting company” consists only of you or you and your wife, and you only work on your own properties, what do you need a company name for?

Whitney used the names R&I Enterprises and R&I Contracting Company according to his books (e.g., Building Wealth pp. 89, 123). Because those names do not contain the name Russ Whitney, they must be registered as assumed names. I checked the Schenectady County Clerk’s office. He did not register those names.

In addition to other penalties, if you do not register, you may not file a lawsuit with regard to anything you did under that name. For example, if R&I Contracting Company agreed to build a garage for someone and the customer did not pay when they were done, R&I could not sue for breach of contract because they failed to register their assumed name.

Contractor’s license

As far as I know, all states require building contractors to be licensed with the state. One guy told me that Texas may allow unlicensed contractors. As far as I know, Whitney never obtained a contractor’s license.

On page 68 of Building Wealth, Whitney says, “…anybody can act as his own contractor without a license as long as he owns the property.” I’m not sure it’s that simple. With rental property, there are safety considerations. Some contracting work can cause injury if done incompetently, like collapse of heavy or high structures or unsafe electrical work which can cause shock and/or fire hazard. Some plumbing mistakes can lead to disease or structure collapse.

Do-it-yourself only

Whitney says on page 69 of Building Wealth that, “As long as you are working exclusively on your own properties or properties you co-own in a partnership or joint venture, it isn’t necessary to formalize your business by filing a company name or ‘doing business as’ (DBA) with your local county courthouse.” But that’s kind of a silly statement isn’t it? It’s like saying that you don’t need to register a car wash company name if you wash your own car on your driveway. True, but why would anyone need a “company” name to wash their own car or work on their own property. For whose consumption is the company name?

On page 151 of Building Wealth, Whitney admits the company name is “for loan purposes.” And what, pray tell, might that be? Could it mean anything other than deceiving lenders? I cannot think of another legitimate “loan purpose” reason to give a sole proprietorship that works only on your own properties a name other than your own name.

Deep in the book

At Harvard Business School, they taught us that, when it comes to annual reports, “The numbers giveth and the footnotes taketh away.” When it comes to get-rich-quick books, the front of the book giveth and the later pages often taketh away. Whitney does acknowledge the regulation against borrowing the amount of “contractor’s profit” when you use do-it-yourself labor, but not until you get to page 125 of Building Wealth. It’s an “Oh, by the way” like the “Youmustbeeighteenyearsoldtoentervoidwhereprohibited” you hear at the end of radio contest ads.

He does not say, but I will, that the same principle applies to all types of improvement loans. In other words, the reasons why HUD adopted that regulation apply to all improvement loans and non-Title I lenders should adopt the same rule for the same reason. Many have.

Profit and overhead

Whitney states, correctly, that general contractors include profit and overhead in their bids. Then he rationalizes that he is entitled to call himself a general contractor and include profit and overhead in work he does on his own properties. Tilt!

There are several things wrong with that.

  1. Title I regulations only allow do-it-yourself borrowers to borrow the cost of the materials. The purpose of that law is to prevent borrowers from using Title I loans as a sort of self-created job funded by the taxpayers. Whitney seems to think that if an outside contractor is entitled to profit and overhead for working on his home, why shouldn’t he be on the exact same job? Although there is some logic to that position, it simply is against the law.

    HUD figures there is too much conflict of interest for a borrower to be allowed to pad his own cost estimate with profit and overhead. With a true outside contractor, you have an arms-length transaction and presumably the bid was the lowest from among several and competition between the contractors bidding drove the price down to fair market value. When borrowers create their own bids, there is nothing to restrain them from exaggerating or inflating the cost of the improvement.

    You might think the lender would be responsible for scrutinizing the estimates for overly high figures. No. One banker I interviewed about this said, “We aren’t estimators.” His bank refuses to do Title I loans direct with property owners because of fear of inflated cost estimates. They only work through contractors whom they have checked out.
  2. When you improve your own property, your profit and overhead are paid by the increase in building value as a result of the improvement, or at least that’s the plan. You get paid when you sell.
  3. Why would anyone borrow their profit and overhead? The purpose of borrowing is to acquire money you need to pay for something. Borrowing is undesirable. It costs money—namely, interest. You do need to borrow money for materials, if you do not have enough in your bank account, so you can pay Home Depot or ACE or whomever. But why would you need to borrow money to pay yourself? Are you going to sue yourself for nonpayment if you don’t?
  4. If you do not wish to wait until you sell the property to get the profit and overhead embedded in the property value as a result of your improvements, refinance. That is, ask a bank to lend you a second mortgage or new first mortgage. They will appraise the property. If it is, indeed, worth more by the amount of your materials, profit, and overhead, they will agree to make the loan. In fact, most improvements only increase the value by a fraction of their cost. True, refinancing costs more than a Title I property improvement loan, but tough. Title I was not created to make life easy for real estate investors. You are not entitled to defraud a Title I lender, and thereby, the federal government, because you want to save the cost of an appraisal—or avoid its hard truth coming out.

‘Proposal and contract’ form

What is the purpose of the “proposal and contract” form when you are doing the work yourself? Who is proposing what to whom? You are proposing to yourself. That’s dumb if it’s disclosed; a waste of time and money if it’s not. Almost certainly, the fact that you and the “contracting company” are one in the same is not disclosed. The purpose of the “proposal” is to make it look like an outside contractor is doing the proposing.

Same is true of the contract. What’re you gonna do? Sign a contract with yourself? “Proposal and contract” forms are just that. They contain contract language to bind the contractor to do certain work and the property owner to pay for the work. Why would anyone need a contract to force themselves to do work on their own property or to pay themselves for having done it?

I can think of no other purpose of the company name and “proposal and contract” form than to mislead the lending institution into thinking the estimate is from an arms-length, unrelated, third party and that the third party will be doing the work.

In 1984, Whitney wrote a book called Offers & Contracts Basics Rehabs Realities Overcoming the Hurdles and Pitfalls of Real Estate Investing. It was published by real estate guru Mark Haroldsen’s National Institute of Financial Planning. It purports to contain actual documents from various deals Whitney did. Pages 13-15 are a stationery store “Proposal and Contract.”

At the top, it says “Southwest Management and Development” and lists an address in Cape Coral, FL.

A search of the Florida Secretary of State’s Web site finds no registration of the fictitious name Southwest Management and Development. The only fictitious name Whitney ever registered was, oddly, the first initials and last names of three persons, one of which was Whitney, one was a partner, and the third was another person. That fictitious name registration was filed 9/30/91 and expired 12/31/96.

Someone has stamped “GENERAL CONTRACTOR” on either side of the name and address. The address is 2520 S.E. 8th Place. I do not know what that address is or how Whitney was connected to it. The date on the proposal was 3/4/83. I would appreciate someone in the Cape Coral area telling me the nature of the structure at that address and also the nature of Whitney’s connection to it.

The first line says “proposal submitted to” Whitney and his partner at 1630 Woodford Street in Fort Myers. The “architect” is listed as “RW.” To claim to be an architect, you must be licensed with the state. Generally, you also must have a college degree in order to claim to be an architect. After listing three pages of improvements to be done, the proposal says Southwest proposes to do this work for $17,775. There is a signature, which appears to be an illegible version of Whitney’s signature. The “Acceptance of Proposal” is signed by Whitney’s partner.

So we appear to have a proposal from Whitney, doing business as Southwest Management and Development, prepared by an architect with the initials “RW” and submitted to himself and his partner. Whitney’s partner signed acceptance on behalf of himself and Whitney.

Page 16 of the book has a one-page “Proposal and Contract” from Southwest to Whitney and his partner for furniture for the same building. It is dated one day later for some reason, and generously offers to add dozens of furniture items for no additional charge. Not surprisingly, Whitney and his partner signed “acceptance.”

Page 24 of Offers & Contracts has a 5/11/83 purchase agreement that lists Whitney and his partner as having the address 2520 S. E. 8th Place, the same address as Southwest.

A Reg Z notice on page 26 shows Whitney and his partner living at 4944 Normandy Court, Cape Coral on 6/30/83. Page 28 lists a contract for sale of real estate in which the company name has now become “Southwest, Management, Development, and Realty, Inc.” Florida Secretary of State records indicate that corporation was filed 8/12/83 and “involuntarily dissolved” on 11/4/88.

Page 40 of Offers & Contracts says Southwest is “A division of R & D Companies of Florida.” No such fictitious name is found in the Florida Secretary of State records.

Marking up costs

As 24 CFR §201.20(b)(1) says, Title I loan proceeds may be used only for the purposes disclosed in the loan application. Since Whitney presumably is not disclosing to the lender that there is a profit-and-overhead amount in each line item of his estimate, he may not use the loan proceeds for those purposes. The same would generally be true of any non-Title-I improvement loan as well on the grounds of contract law and prohibitions against lying to a lender or concealing material facts.

Amount of markup

Whitney says the general contractor’s markup, “can be anywhere from 25% to 400%, and more.” (Building Wealth p. 69). In one deal he brags about, he told the lender that work which actually cost $3,000 was going to cost $17,000 (Building Wealth p. 70) That’s a 567% markup.

You can take courses in estimating at many community colleges. It is a rather complex skill and art. There are a number of companies that continuously analyze construction costs. They sell their results in the form of books, CDs, and on-line services. Here’s what three construction costs books that I have say about contractor profit and overhead.

Book
Profit and overhead (varies according to size of job and nature of work)
Saylor Residential Construction Costs 6.5% to 25% of total
Means Repair and Remodeling Cost Data 5% to 40% of total
National Construction Estimator 20% of total

You can find the current editions of these or other similar books in your local book store or library.

One of the things that real estate gurus I do not recommend all seem to do is make real estate investing sound far more profitable than it really is. That’s how you sell real estate investment seminars. Whitney’s 400% to 567% markups are prime examples of that.

Other laws

The Title I law and regulation I quoted above are not the only ones pertinent to misleading a lender with regard to what work is being done, who is going to do it, and what its actual cost is. There are other more general federal laws that prohibit misleading someone in a federally related matter either by false statements or by concealing material facts. Here are the ones most often used against perpetrators of mortgage fraud.

18 USC 1014 prohibits making false statements to a federally-related lender. If the loan involves HUD, like a Title I home improvement loan, 18 USC 1012 applies. Banks are generally federal lenders because of federal deposit insurance or federal charters as well as because of federal loan insurance programs like HUD’s Title I.

18 USC 1010 prohibits the following in HUD lending:

The use of “proposal and contract ” forms with the names of companies that appear to be unrelated to the borrower may constitute counterfeiting under this law. Marking up cost estimates may constitute “overvaluing security or asset value.”

31 USC 3802 prohibits false claims and statements.

Concealment of a material fact

Concealment of a material fact from the bank is prohibited by 18 USC 1001. That law is also often cited in the sentence just above where you sign a mortgage application. The application my wife and I signed in 10/02 to refinance our home cited this statute.

Some of the forms Whitney Information Network, Inc. has filed with the Securities and Exchange contain the phrase, “ATTENTION—INTENTIONAL MISTATEMENTS OR OMMISSIONS OF FACT CONSTITUTE FEDERAL CRIMINAL VIOLATIONS (SEE 18 U.S.C. 1001)”

On page 75 of Overcoming the Hurdles and Pitfalls of Investing in Real Estate, Whitney says, regarding a deal where he is putting a third mortgage on the property right after the bank second, “…you’ll note on the ‘Projected Rent Role [sic]’ statement there is no mention of a third mortgage. Is that dishonest? No!

Yes, it is. It is concealing a material fact in a federal matter. It is a felony punishable by a fine and/or five years in prison or both.

Whitney goes on, “It is not the bank’s business if we have a third mortgage.

Who is Russ Whitney to make this determination? The money that is being loaned belongs to the bank’s depositors and shareholders. Ultimately, the taxpayers’ money is at risk. If you cannot tell the truth, the whole truth, and nothing but the truth to the lender, then you are behaving unethically and probably illegally.

Whitey continues, “As long as their money is protected in the second mortgage position the bank’s loan is safe.”

The fact is a third mortgage makes the loan far more risky. The main cause of foreclosure is lack of borrower equity. A third mortgage reduces or eliminates borrower equity. That, in turn, reduces the borrower’s incentive to keep the payments current in the case of difficulty with this property or another or financial difficulty in any other aspect of the borrower’s life. Whitney would not know that because he was never a lender and apparently never studied sound lending practices.

Whitney: “I just want you to understand that business is business.

What does that mean? Nothing. The fact is page 75 of Overcoming… is Russ Whitney’s tortured attempt to rationalize mortgage fraud. I left out more of the same on that page.

Mortgage applications generally ask for the whole story of the transaction. You are required to sign the loan application saying that you have told them the whole story. They often ask if there is any secondary financing or loans junior to the loan they are making. If you sign it and do not tell them the whole story, you have committed fraud as well as violating the federal law against concealing material facts. The fact that the real estate industry has a name for this tactic—“sneaky second” or “sneaky third” in this case—indicates it is well known to be improper behavior.

Whitney knows what would happen if he told the whole truth. Continuing on page 75, he says, “If I approached the banker and told him I bought the Spanish mansion for $90,000 with no money down and I need to borrow $15,000 to boot, what do you think my chances would be for a loan? Exactly, zero. This is a chess game. A battle of brains and wits.

So there’s the proof of intent. Whitney knows if he tells the whole truth, he won’t get the loan. So he tells less than the whole truth—maybe lies depending on the wording of the loan application and/or discussions with the lender. The “chess game” comment is more rationalization. In games like chess, you sometimes feint and bluff. But borrowing thousands of dollars from a federal lender is not a game of any sort. It is a transaction where the stakeholders on one side—the bank’s owners and depositors and the U.S. taxpayers—entrust the person on the other side—Russ Whitney—with a substantial amount of their money.

Applying for a loan is not a “battle of brains and wits.” Defrauding lenders is a battle of brains and wits.

‘I don’t want to lie to him’

Page 87 of Overcoming…:

I anticipated that the banker might come right out and ask if I put $60,000 down on the property. [It was a nothing-down deal.] I don’t want to lie to him, so how do I answer? …one lender did ask. I, of course, had the answer. I told him we did some trading on some ‘things’ which resulted in the equity reduction on this property.

Once again, Whitney is well aware of what he is doing. He feels the need to add,

What about morality and ethics in this case? Well, I told him the truth. We did do some trading. The seller traded us the property for no money down and we both traded agreements on not recording the third mortgage immediately.

Judges call this sophistry—fallacious reasoning; reasoning sound in appearance only. The bottom line is the lender would not have made the loan if they knew the whole truth so Whitney concealed the whole truth. His statement that he traded “things” is simply false, his strained explanation notwithstanding. Making an argument like this at your trial would likely get you chewed out by the judge in addition to your losing the case.

We did what has to be done to expedite it and make them feel good about lending the money.”

In other words, we defrauded the lender. “Expedite” is a wholly inappropriate euphemism. It means to speed up. In this case, as he admitted earlier, he would have been stopped cold had he told the whole truth, not just slowed down.

On page 37 of Overcoming the Hazards and Pitfalls of Financing, Locating, and Analyzing of Real Estate, he says,

I have had people ask me if that is ethical or not. I don’t know.

He doesn’t know?! Isn’t that kind of important? Don’t you make sure something is ethical before you do it? Actually, I have read a bunch of Whitney’s books and listened to a bunch of his tapes and I found no indication anywhere that he is concerned about ethics.

The next sentence on page 37 of that book is,

I have been doing it for seven years and have not yet lost any sleep over it.”

First, we’ll have to take Whitney’s word for that. Second, the ability of a person who misled a bank to sleep afterward carries no weight in court. His student asked him a very good, legitimate question and Whitney responded, in part, with an irrelevant comment. If Whitney did, indeed, sleep well after misleading lenders, it may merely mean he lacked the sort of conscience that prompted his student to ask the question.

Continuing that paragraph,

…I think one could certainly substantiate that even though he owns the house, he is his own contractor and does invariably deserve to make a profit for his time and effort; it is quite ethical.”

I disagree. If the loan in question is Title I, the regulation specifically prohibits borrowing more than materials cost. Even in non-Title I improvement loans, I suspect that the lender would not make the loan if they knew the borrower was making a “profit” on it. If you make full disclosure and the lender still approves the loan, more power to you. But all this nonsense about contractor names, “proposal and contract” forms, and marking up estimates 25% to 567% would almost certainly guarantee rejection if known by the lender.

The word “deserve” is a dangerous one to use in this context. It rationalizes improper behavior. No one ever deserves to make a profit. If you work hard and smart and you are lucky, you make a profit. But the word “profit” implies that you are an independent businessperson. Entrepreneurs have an opportunity to make a profit, but they never deserve it.

Finally, there is no “profit” here. This is a loan. If you are to profit on the improvement, it will happen when you sell the property. Whitney’s habit of encouraging readers to view excess loans as profits is extremely ill-advised. The correct phrase in the real estate industry for this is “mortgaging out” or a “cash-out mortgage.” Mortgaging out or cashing out is a very difficult trick if you make full disclosure to the lender. If you pull it off ethically, you might get a compliment from a fellow knowledgeable investor, but no one will call it a “profit.”

‘My roof is leaking’

One of Whitney’s students told him he could not get a regular home improvement loan because he already had two mortgages. Whitney insisted he could and went to his hotel room to make the calls and prove it. He said of the student, “He was right.” Whitney was only able to find a couple of non-Title I lenders, each of whom insisted on second mortgages.

Whitney says, “I then told the banker that I already had two mortgages on my home and my roof was leaking.” The lender agreed to an unsecured $7,500 property improvement loan to replace the roof.

You have to admire Whitney’s persistence. There’s just one problem. The “my roof is leaking” statement was a lie. Had Whitney actually obtained the loan on this basis—or had his student—it would be fraud.

‘…You must be a little deceptive with your banker.’

The fraudulent nature of what Whitney advocates, and claims to have done, is starkly evident on pages 125 and 126 of Overcoming the Hazards and Pitfalls of Financing, Locating, and Analyzing of Real Estate. Here is what he says, along with my comments in [red brackets],

“I must share some other realities with you…There are many instances where you must be a little deceptive with your banker.” [Being deceptive is illegal. It is fraud. There is no distinction in the law between being a “little” deceptive and being a lot deceptive. Furthermore, I see no basis for Whitney’s use of the word “little.” Exaggerating improvement costs by more than double, using loan proceeds you said were going into the property improvements for down payments on other properties, etc. are fundamental and major misrepresentations.]

“If, on the home improvement loan, you indicate that you are going to do the contracting yourself and take some of the money as profit, your chances of approval will diminish. I generally portray that I will not only use all of the loan money to get the work done, but that I will probably kick in a thousand or two of my own money.” [This is a barefaced lie. You can go to jail for this.]

Mail fraud and wire fraud

When the government prosecutes this sort of stuff, they also often invoke the mail fraud statute 18 USC 1341. Mail fraud is a misnomer. You do not have to mail a fraudulent document to be guilty of mail fraud. You cannot avoid mail fraud by using Federal Express or hand carrying everything. All you need to do is commit fraud, and anyone in the deal send or receive anything by mail as part of the transaction. Wire fraud is similar (18 USC 1343). The feds also often invoke the money laundering statute (18 USC 1956) in mortgage fraud cases.

If you commit mail fraud or wire fraud more than once in a ten-year period, you can be charged criminally or civilly under the federal racketeering statutes: 18 USC 1961-4. A bank could actually sue Whitney civilly under 18 USC 1964 if he did two deals that involved mail fraud in a ten-year period. Furthermore, if they win, they get triple damages.

Another statute the government frequently invokes with regard to mortgage fraud is 18 USC 371 or conspiracy. This would be a hazard to both Whitney and the previous owner/second mortgage lender. The essential elements of federal conspiracy are two or more people not only conspiring to defraud someone connected to the federal government, but actually doing some act to bring the conspiracy to fruition.

Actual prosecutions

The HUD Inspector General publishes an annual report. In part, it details prosecutions of the above crimes. You can read it on the Internet. Here are some examples from the 2002 report.

An LA federal grand jury indicted Louis Reyes on one count of conspiracy, two counts of wire fraud, and one count of money laundering. Among other things, Reyes falsely stated that Title I loan proceeds would be used to improve the properties in question.

In a Texas investigation code named Operation Straw House, the feds obtained numerous convictions. In that case, proceeds of Title I loans were used to pay bills of the borrowers unrelated to the improvement of the properties in question, as well as cash being pocketed by the borrowers instead of spending the money on improvements.

The 1/6/03 Sports Illustrated “Catching up with…” column featured Chuck Foreman who had been on the cover of the magazine on 10/18/76. Foreman played seven years for the Minnesota Vikings and went to three Super Bowls. He had three straight 1,000-yard rushing seasons as a running back and was All-Pro five times. But he also did this:

“In February 2000 he was charged in connection with a 1995 scheme to defraud mortgage companies and later admitted he had used falsified documents to obtain two loans totaling $157,800. …Foreman, who assisted prosecutors in their investigation of similar real estate cases, pleaded guilty to one count of mail fraud in March 2000 and was sentenced to three years probation in February 2001.”

Whitney used improvement loans for other purposes

Whitney frequently makes statements that indicate that he did not put all of the improvement loan money into improving the property in question. The whole contractor’s-profit-and-overhead concept constitutes at least some of the loan proceeds going somewhere other than into improvement of the property. That, in turn, means that the lender was misled, which sounds likes fraud.

In fact, down payment money for rental property purchases is akin to venture capital, one of the riskiest types of financing. Congress passed the National Housing Act in the depths of the Depression to help small property owners and to create jobs, not provide venture capital to greedy convicted felons. Institutional lenders like banks and savings and loans are generally not allowed to make any venture capital type investments.

Here are some of Whitney’s comments indicating that his improvement loan proceeds did not go into improvements.

Source
Whitney comment
p.5 Overcoming the Hurdles and Pitfalls of Investing in Real Estate “We applied for the [Title I] loan and…received the $15,000. …the work only cost $5,000. We compensated ourselves $5,000 a piece for two week of labor.”
p.6 Overcoming “I applied again to the trust company for another FHA Home Improvement Loan for $12,000. I needed some more investment capital. I used about $4,000 for improvements and kept $8,000 for some investments.”
p.37 Overcoming “My cash was very low…I had literally no income at all. I didn’t feel really pressured yet, though. I knew I could go out and find some properties, then arrange a Home Improvement Loan and start rolling again.”
p. 70 Overcoming “…we could put a home improvement loan on them and pocket some tax free money…”
p.74 Overcoming “…plus a $15,000 home improvement loan (of which only $7,500 would go to renovation)…”
p.87 Overcoming “…borrow $15,000.…I will probably get the job done for $6,500 to $7,500 and pocket the rest. You keep the difference as a consulting fee, or whatever you want to call it. Just make sure you get paid…”
p.111 Overcoming A list of 9 “Techniques for starting capital” includes “Home Improvement Loans” as number 2.
p.20 Overcoming the Hazards and Pitfalls of Financing, Locating, and Analyzing of Real Estate “We have a house for no money down, which is overfinanced for $10,000, of which we get to keep $4,000 (because the rehab only cost $6,000…)”
p.20 Overcoming… Financing, Locating, and Analyzing of Real Estate “I…applied for a home improvement loan of $9,000…and only used $3,000 to complete the work…and put $6,000 in my bank account…”
p.20 Overcoming… Financing, Locating, and Analyzing of Real Estate “…I went and bought my own ‘contract and proposal’ forms and wrote my own estimates for the cosmetic [improvement]s. I jacked the estimates up to cover the entire …$30,400. Consequently, whatever is left after I sub the work out at a cheaper cost, I get to keep. In this instance, that figure was a handsome $9,000.”
p.85 Overcoming… Financing, Locating, and Analyzing of Real Estate “Home Improvement Loan—Here lies a source of seed capital that generated over $60,000 for me in my first year of rear estate investing at age 21. I have used the FHA Title I loan several times.”
p.86 Overcoming… Financing, Locating, and Analyzing of Real Estate “The Title I is an excellent source of seed capital and continuing capital.”
p.122 Overcoming… Financing, Locating, and Analyzing of Real Estate “…look for some FHA Title I or regular home improvement monies to generate yourself continuing seed capital.”
p. 69 Building Wealth “Here’s how you would do it and pocket some of the easiest money you’ll ever make. (This example is drawn from my personal experience with numerous home improvement loans.)”
p. 70 Building Wealth “I have marked up $3,000 worth of work to a retail price of $17,000 on a consistent basis and never had a lender question the figures. That means I’m able to pay myself as much as $14,000 to get the work done on my own property. Remember, when you form your own contracting company, you’re taking the markup yourself instead of giving it to someone else.”
p. 71 Building Wealth “Depending on how much of the work you do yourself, the actual costs of the improvements could be as low as $3,000 to $7,000, which leaves you with as much as $7,000 in cash as your general contractor profit.”
p.72 Building Wealth I made $117,000 in spendable cash in my first year of real estate investment by acting as my own general contractor and securing home-improvement loans on my properties.”
p.122 Building Wealth “The secret cash machine of the 90s” subhead for two-page discussion of home-improvement loans
p.122 Building Wealth “Home improvement loans are basically designed to finance home improvements, but for the creative thinker they can be consistent and profitable sources for sizeable lump sums of cash.”
p.123 Building Wealth “You can take out a home-improvement loan on the house you live in, improve your property, and still be able to generate capital for another project.”
p.123 Building Wealth “…home-improvement loans…have provided me with millions of dollars in working capital over the years.” [Reed note: Millions? At $10,000 a pop, that would take at least $2,000,000 ÷ $10,000 = 200 improvement loans.]
p.123 Building Wealth “…two ways to generate quick cash with a home-improvement loan…act as your own contractor and take the contractor’s profit from the improvements…”
p.127 Building Wealth “Used correctly, a rehab/construction loan can finance your down payment and all of your rehabilitation costs, and put some tax-free working capital in your pocket for your next investment.”
pp.19-20 Building Wealth Keys to Real Estate Financing Locating & Analyzing Says he got a $33,000 loan to pay for costs related to moving a house, used $16,200 for that purpose, $4,000 for a down payment, and pocketed $12,800 “Net Profit to Me”
p. 23 Building Wealth Keys to Real Estate Financing Locating & Analyzing $9,000 home improvement loan, $3,000 to complete the work, $6,000 “in my bank account”

Remember, when you apply for a property-improvement loan, you tell the lender that you will put 100% of the improvement-loan proceeds into the improvements you described in your loan application. If you do otherwise—like use the money for “profit and overhead,” “working capital,” or “seed capital”— you have almost certainly broken a number of laws.

Wording of the application form

As I have mentioned, the actual loan application you fill out invariably contains pointed questions. Answering them inaccurately violates multiple laws.

If your files contain any improvement loan applications—Title I or otherwise, I would appreciate it if you would send copies of them to me so I can get the exact questions asked during the period when Whitney was seeking these loans. I already have one source: one of Whitney’s own books. His Real Estate Forms Book contains some samples.

FNMA residential mortgage loan application Form 1003 (Revised 8/78) “I/We fully understand that it is a federal crime punishable by fine or imprisonment, or both, to knowingly make any false statements concerning any of the above facts as applicable under the provisions of Title 18, United States Code, Section 1014.”

Department of Housing and Urban Development Federal Housing Administration Credit Application for Property Improvement Loan Form Approved OMB No. 63R-0037 (Revised 3/76) “PROCEEDS OF THIS LOAN WILL BE USED TO IMPROVE THE DESCRIBED PROPERTY AS FOLLOWS:” and “WARNING—Any person who knowingly makes a false statement or a misrepresentation in this application or causes such a false statement or misrepresentation to be made shall be subject to a fine of not more than $5,000 or by imprisonment for not more than 2 years, or both, under provisions of the United States Criminal Code.” And for persons who sold the improvements to the property owner, “I/We certify that the above statements are true, accurate, and complete to the best of my/our knowledge and belief.” and I/We certify that 1. I (we) am (are) the person(s) who sold the job. 2. The contract contains the whole agreement with the borrower. 3. The borrower has not been given or promised a cash payment or rebate nor has it been represented to the borrower that he will receive a cash bonus or commission on future sales as an inducement for the consummation of this transaction, that the improvements have not been misrepresented, no promises impossible of attainment, no encouragement of trial purchase, no promise that the improvement will be used as a model for advertising or other demonstration purposes, and no offer of debt consolidation.”

‘The bank was treating me more coldly’

On page 8 of Overcoming…, Whitney says “The bank was treating me more coldly, too.” He surmises this was because of his youth and aggressiveness. It could also be that the bankers suspected that Whitney was not giving them accurate estimates of improvement costs and was not putting all of the loan proceeds into improvements..

Lenders like young, aggressive businesspersons—who are honest and competent. Like professional baseball teams, they try to identify such businesspeople as early as possible so they can build relationships with them. If they don’t, they fear they will lose them to the competition.

Honest mistake

As I said, estimating is a complex art and science. Even if you make a good faith effort to be accurate, you will inevitably make mistakes—either over or under. As long as you make a sincere, good faith effort to get it right, no one is going to prosecute you for being a little off.

The problem with Whitney, is that he obviously did not make a sincere, good faith effort to give the lenders accurate estimates of the improvements costs. On the contrary, he deliberately, grossly overstated the costs of the improvements in order to use improvement loans for other purposes like down payments on other properties. In at least one case—aluminum siding on 3160 Guilderland in Rotteram, NY—his statements make it appear that he did not do the promised improvements at all. That is immoral, unethical, and illegal and you could go to jail for doing it.

Assumption of Title I loans

On page 5 of Overcoming… and elsewhere, Whitney says he sold a property and had the buyer assume his Title I mortgage. I am not sure that is allowed. I would have to see whether the mortgage contained a due-on-sale clause.

‘You should have enough cash flow to cover the payments’

Whitney says this or similar words over and over. He is right to admonish readers to make sure they can make the payments on a property improvement loan. But his statements or implications that this is easy or normal are bull.

As even investors with very little experience know, it is extremely difficult to buy rental property that has positive cash flow. In almost all normal deals, the cap rate (net operating income divided by purchase price—net operating income is all income minus all expenses other than the mortgage) is lower than the weighted annual constant (loan-to-value ratio of all mortgages on the property multiplied by the weighted average annual constant of the mortgages—annual constant is the total payments for the year divided by the loan balance). When the cap rate is lower than the weighted annual constant, you have negative cash flow. Trust me, properties with normal, 75%- or 80%-of-value mortgages that have positive cash flow are extremely rare.

Mind you that’s with 30-year first mortgages. Improvement loans generally have higher interest rates and much shorter terms. That means they have much higher payments as a percentage of the amount borrowed, which is another way of saying they have higher annual constants.

Here’s an example. Here is what the annual payments and annual constant would be on a self-amortizing (no balloon payment), $10,000, 10% home improvement loan for various terms.

Term

Annual payments
Annual constant
30 years
$1,044.38
10.448%
15 years
$1,278.87
12.79%
10 years
$1,572.70
15.73%
7 years
$1,975.68
19.76%

As you can see, it is almost twice as hard to have positive cash flow with a 7-year improvement loan as a 30-year mortgage. Yet there are virtually no 30-year improvement loans, and Whitney blithely tells you to make sure that your net operating income covers the payments and repeatedly says you “should” be able to do this. When elephants fly!

You will find that unless you make a bargain purchase at a substantial discount below market value—like 25% or more—your rental property will have negative cash flow with just an 80% of value first mortgage. To buy for nothing down as Whitney advocates, and then borrow a property improvement loan to boot, will drive your negative cash flow through the roof! See my article on positive cash flow. To learn how to buy properties for at least 20% below market value, see my two-volume book on the subject.

In other words, Whitney’s improvement loan techniques are not only arguably unethical and illegal, they are also impractical in the sense that you cannot afford to make the payments on all that debt from your rents unless you made an extraordinary bargain purchase.

‘Motivated sellers’

Whitney often claims to have purchased property at great bargains because the seller were “motivated.” All sellers are motivated. Indeed, the various reasons Whitney cites for the seller selling in the various deals he brags about sound quite normal to me. They are not distress situations.

In the real world, the only way you get a bargain from a motivated seller is if he or she must sell in an enormous hurry—like they have to close in a couple of daysand you move with enormous speed to tie the deal up before the other buyers arrive. The situations Whitney depicts come nowhere near that. We have all read about sellers receiving multiple offers on properties. That happens when the asking price is only a couple of percent below market value. Imagine the crowd you attract when you put a property on the market for 20% below market value.

Shoddy construction work

If you read various property improvement loan Web sites, you will find that shoddy construction work is a big concern. That’s why some lenders only work through contractors they know well.

How does what Whitney did and what he recommends come out in that regard? I think if you look up shoddy construction in the dictionary, Russ Whitney’s picture will be next to the definition. Listen to what he says about getting work done on his properties and yours.

Source
Whitney comment
p.9 Overcoming the Hurdles and Pitfalls of Financing, Locating, and Analyzing of Real Estate “…go to a discount carpet outlet and check the remnant carpets. You can get big enough remnants to cover any normal size living room or bedroom.” [Reed comment: This means every room has different color wall-to-wall carpet.]
p.9 Overcoming the Hurdles and Pitfalls of Financing, Locating, and Analyzing of Real Estate “In middle and lower income units, I saved money by not using padding and installing the carpet myself.”
p.9 Overcoming the Hurdles and Pitfalls of Financing, Locating, and Analyzing of Real Estate “…if you make a wrong cut the first time or make a mistake, you will still get the same amount of rent…I’m sure the tenant will not come look at the unit and say, “hey buddy, there’s a mistake there in the carpet. I want the apartment for twenty-five dollars less per month.’ I have made many mistakes on all different types of things from panelling to painting…”
p. 25 Overcoming… Financing, Locating, and Analyzing… Buy used mattresses for your rooming houses
p.64 Building Wealth “…plenty of people around who are looking for part-time work…students…other people…who will do painting and other fix-up work on weekends at very affordable rates.
p.64 Building Wealth “You don’t have to pay a painting contractor $20 or $30or more an hour when you can get a teenager to do the same work for $8 an hour.”
p.71 Building Wealth “Either install them yourself or hire a handyman to do the job; there’s no reason to use a licensed electrician.”
p.71 Building Wealth “Purchase carpet…and use your handyman for this job, too.”
p.67 Building Wealth “Become a Highly Paid Contractor Without a License or Ever Hammering a Nail—Even if You Don’t Know Anything About Construction” subhead
p.7 Overcoming the Hurdles and Pitfalls… It was too expensive to put aluminum siding on the whole building, so I had the front done to dress it up. We painted the other three sides to match.”
p. 14 Overcoming… and County clerk’s office Had fire in 812 Grant Avenue. “I really didn’t want to go through the hassle of fixing the property, so I gave it to [my handyman]…” [Reed comment: Even though the fire “burned the interior of the apartments pretty bad,” according to Whitney (p.14 Overcoming…), the deed to the handyman was almost two years after the fire and indicated that the property taxes were in arrears and that Whitney had been cited for housing code violations in the property.]

Improvement lenders are concerned about shoddy construction because they want the property value to be enhanced by the improvements in order to provide increased security for the mortgage if the loan is secured. Also, borrowers who are unhappy with improvements sometimes irrationally decide they do not need to make the payments on the loan because the work was shoddy. Since the lender did not do the work, they are understandably not happy about being blamed for it or for not getting their loan money back with interest. Lenders want to avoid shoddy improvement construction because they know an ounce of prevention is worth a pound of cure.

I believe it’s safe to say that the descriptions above of the way Whitney improves his properties would not be well received by Whitney’s lenders.

Paying yourself

A reader tells me he attended Whitney’s “Millionaire University” and that at that session, Russ told the students to pay themselves a paycheck ot of their business account weekly then put the money back in the account. This was to genrate cancelled checks to prove income to qualify for loans. The student says he got into an argument with Whitney’s staff members about the ethics of this.

Good for him. Sounds not only unethical, but also illegal to me. If it is not an attempt to mislead, what is the point of doing it?

Should you follow Whitney’s advice?

Should you follow the Whitney approach to improvement loans.?

No way!

You could go to jail! You could also lose your good reputation. Loan officers are not as dumb as Whitney implies. Nowadays, lenders are also smarter about ferreting out this sort of fraud—sometimes requiring inspections of completed work, receipts, and so forth. There is also the issue of making the payments if you do manage to defraud some lender into lending you more than the cost of your improvements.

It is outrageously irresponsible for Whitney to brag about and advocate his “overfinance” improvement-loan techniques without warning you of all the stuff I have told you about in this article. He is charging “admission” to send you into a “minefield” that he misrepresents as a “picnic ground.” I am warning you that it is a “minefield” and giving you a “map” of where the “mines” are. No charge.

Property-improvement loans make sense in many situations—for improving properties only. For them to make sense, you must make a higher return on the improvement than the interest rate, furthermore, you must be sure you can make the payments on these high-annual-constant loans.

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