A Little Economic History

2018-10-31 07.52.14It is much easier to position your life before, rather than during, an economic crisis.

It’s also truly amazing how fast a credit crunch can sweep across markets.

This month, a decade ago, was the mid-point for the toughest 90-day stretch of my financial life. Taking it back to October to December 2008…

  • My prospective earned income went to zero at a time when…
  • My Business/Personal cash burn rate was $10,000 a week. Simultaneously…
  • My net worth dropped by 67% and…
  • I was facing a potential claim 20x in excess of what remained. The one bright spot was my family life…
  • Our first child was born and we were very happy within our marriage.

The only reason I didn’t follow a friend into bankruptcy was a pre-crash restructuring. I had been scared by four events :

  1. The US was offering loans without income verification.
  2. The UK was offering loans without bank covenants.
  3. Down in New Zealand, I used both of the above and borrowed to pay my living expenses at a time when…
  4. I had a personal guarantee outstanding that covered most my assets, and all my net worth.

There is a line in Fooled By Randomness about Russian Roulette. It goes something like…

Even if the gun has a million chambers, there are some games you don’t want to play.

I was enjoying my life and didn’t want external circumstances to force a financial reboot at 40-years old. So… 2005-2007 was a time of significant change.

The restructuring took three years (2005-2007). It prevented ruin, but still resulted in a lot of pain when credit markets slammed shut in 2008.

At the time I was working in the UK. The entire chain of my business life went from Great-to-Insolvent in 180-days (bank, joint venture partner, developer, general contractor, sub-contractors, employer, CEO).

Just like that.

Gone.

2009-2012 were spent clawing back.

Key steps:

  • Downsized family home, spending and aspirations. Embrace Your Hubris!
  • Invested the downsized capital into a Downtown Boulder rental property. Two units, where the little unit’s rental income would enable us to live for “free” in the larger unit.
  • Invested our remaining funds in a redevelopment opportunity that I could hold FOREVER, because it was debt-free and cash flow positive.
  • Turned a loss making triathlon hobby (draining $75k annually) into a cash generating consulting business ($4,000 per month).

By 2013, we achieved cash flow break even. We were so blasted from our young family (up to three kids) that I don’t remember appreciating the significance of what we achieved.

Within my financial peer group, our story is not unique. Lots of people had a similar ride. However, they don’t necessarily blog about it.

Financial memories are short.

Remember.

You don’t get killed by prices falling — price volatility is emotionally painful but not financially fatal.

Companies, Your Personal Ethics, Friends and Families… All can get crushed by running out of cash in a banking crisis.

Where’s your cash flow statement?

Being Wrong

IMG_4015Some of what I know to be true is false.

Being (somewhat) wrong is a natural state of being.

It rarely harms me.

But when it does…

Boom!

What to do?

Pay careful attention where error has the greatest impact on my life.

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Blindspots – what are the areas where I am unlikely to be right?

In a marriage, a business partnership, an investment, a sport… the greater our personal, emotional investment… the bigger the fall when a new reality slams against our old beliefs.

Often a feeling of righteous anger comes forth, and along with it, a desire to lash out.

When these feelings arise I remember:

  1. I fooled myself. Make a note! It is going to happen again!
  2. Acknowledge, we all want to be fooled. I am not alone, nor am I the first to experience this situation. Nothing personal, bro.
  3. Further energy invested into a (clearly) losing situation is better spent creating the life I want, within my new reality.

It is easy to get hooked into a cycle of mutual retribution – it might even feel good, for a while…

…but you might not be aware of the harm you are creating.

Sleep, skin, hair, mood swings, cravings… all useful signals when we are off-the-path.

Tough to point this out directly to someone! The people who have been effective with me have said something along the lines of…

“I wonder if there might be a better way to handle this…”

“You’re right, of course, but you might feel different later…”

Attention

What’s the penalty for being wrong?

  • Marriage partner
  • My last haircut
  • Sports with a high degree of concussion risk
  • Sunscreen
  • Business partnership
  • The shirt I wear
  • Personal guaranties
  • The color of my socks
  • Borrowing money
  • What I am having for dinner
  • The ability of my children to teach themselves
  • My choice of car
  • My temper

Be willing to talk about what matters, with the people who matter to you.

What were we thinking?

IMG_0501Late-cycle is when we tend to make unforced errors in our financial life. My spidey-senses have been tingling due to a series of macro-events that I’ve noticed.

  • Wars of choice (trade, diplomatic and conventional) on multiple fronts
  • Tax cuts and borrowing increases into a strong economy
  • Rising interest rate environment — across all durations
  • Blockchain implosions
  • A study noting 76% of newly-minted IPO companies were loss-making at listing

I last felt like this in 2005. Then, and now, the party can continue for a long time.

What to do?

Rebalance – once a quarter, reset to my target weightings.

Consider leverage – don’t borrow to buy stuff you don’t need. Pay cash, or wait.

Stay invested – Stay the course. Each time you make a change, you introduce an opportunity for error to enter your life.

Do you remember 2009-2012? It probably seems like ancient history to many. There will be great times for new investments in all of our futures.

Geographic Reappraisal – Real Estate October 2017

This business insider article about an SF Bay Area house that sold $1 million over asking caught my eye.

Here in Boulder, we’re up 100% over the last seven years. Most of the increase has happened in the last 2.5 years.

Notwithstanding our big local increase, the “coasts” and luxury vacation markets look expensive from here.

The coasts look even more expensive when I factor in…

Schooling – Can I use the local schools? If not then my cost of living jumps by $25,000 per kid, per annum, after tax see the linked article – public, in-state education will save my family $1 million per kid.

Tax Base vs Legacy Liabilities – How heavily taxed is the location? How large are the legacy liabilities (health care and pension) from former city, county and state employees? The large cities of the oldest parts of the US look awful in this regard.

Other costs of living – Cali always surprises me when I run the numbers. I suspect it’s similar in places like New York and Seattle. Costs are 50% more expensive for the rest of my budget.

I am not recommending that you sell. I’ve made a decision to hold through the next recession.

However, the relative trade into “states with great lifestyles” strikes me as attractive — North Carolina, Montana, Idaho and Colorado.

If you are considering taking-the-leap…

Live where you don’t need to leave — can I create a long-term, year-round, local life here?

When I worked in international finance the “top guys” had homes in three or four countries. That kind of overhead has two negative impacts on your life: (1) your ethics are easier to purchase; and (2) you’ll need (at least) an extra decade of full-time office work.

Kill your commute — can I live within an easy walk, or a short ride, of where I spend my time?

When I was thinking about moving to Cali, I plotted my life in Google Maps. I did the same thing for my prospective life in Palo Alto. That gave me two geographic “triangles” and I calculated real estate and family costs inside the triangles.

Finally, surround yourself with people that live a life you’d like to follow. I do best with an active, outdoor life in a location with abundant sunshine.

This last point is important — know what you want — know where you do best.

What Makes Real Estate Assets Cheap – Tame Your FOMO

Because we are hard-wired to be poor investors, your family’s best bet is dollar-cost averaging in low-cost index funds. Consistent investing, over your working life, it’s as close to a sure thing as you can get.

Despite, and because of, the above truth, many people are going to dive into the real estate market.

When the masses get into trouble, you can do very well by applying this post.

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Wait for…

FINANCIAL DURESS — Once a decade, debt markets rapidly contract and everyone has a freak out.

DIVORCE — Corporate, professional or personal — vendors will hurt themselves to damage former partners

MOMENTUM — Collectively, our long-term memory is about three years long. The Great recession ran from December 2007 to June 2009. It took three years years for us to “forget” the asset price run up of 2005-2007.

If you don’t have two-out-of-three then wait. Discounts are coming!

Do work…

INFORMATION — I assume the vendor knows far more than me, and probably you

How can we improve our knowledge?

Wait & study — while waiting for the next crisis… live in the location where you’re thinking about buying. The cost of the rental will pay for itself through better information.

Fundamental Value — do this with every large investment (or purchase)…

A./ What is the net cash flow the asset can generate after current taxes, all operating costs and the investment required to keep it producing cash?

B./ What is the total capital required to purchase? Include every_single_dollar.

C./ How does the implied yield (A/B) compare to the yield on 30-year US Treasuries (currently ~3%)?

Example… across 2014 and 2015, I was unsure if I should sell, or hold. The common wisdom was long-term rates were going to rise and prices would stagnate. Tempting to switch asset classes…

I calculated my cash yield was roughly equal to the, then, 30-year rate.

I considered…

1./ My sites were exposed to the upside from Boulder County economic growth

2./ My alternative investments had lower yields than my existing investments

3./ I would crystalize significant deferred tax liabilities

4./ My existing position was good enough to meet my goals

I decided to sell a negative-yielding asset and hold the cash generators.

NOBODY predicted what happened next, long rates fell by a third, and local real estate values rose by 50%.

FWIW, long rates are back up but fear of missing out (FOMO) is driving the market upwards.

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When is our margin of safety highest?

  1. Let prices, and transaction volume, fall for two years
  2. Look for a distressed seller
  3. Look for a deal where the cost to own is less than the cost to rent
  4. Confirm your taxed, net cash yield is greater than the 30-year treasury rate

Your FOMO will tell you that the above will NEVER happen.

WRONG!

Since I graduated university (1990), very favorable conditions have happened FIVE different times where I was living.

It takes a long time to build capital and two great deals (in 50 years) will let you meet your goals.

Tame your FOMO and choose wisely!

Effective Real Estate Ownership

When you buy real estate, what’s your goal?

We want to live in a fabulous place, while getting rich on asset appreciation.

It sounds great but the choice of moving into an affluent community increases expectations, and cost of living.

“So what?”, you say.

The hidden cost can be time for our kids and marriage.

In the Great Recession, I changed course…

We aim to create a portfolio of assets enabling us to live for free in an effective public school system that’s close to nature.

In your teens, you will start to make investment decisions… how much to work, spend, save, donate and borrow. You have 50 years to create your portfolio!

Live for free:

  1. In high-school: with your parents
  2. As a young adult: a place where your roommates subsidize your cost of living
  3. Next: a house with many bedrooms — the first place I owned had the capacity to support me via roommates
  4. As soon as I “could afford it” — I made a mistake with a large, expensive to own, flash property!
  5. …but I found myself unexpectedly unemployed and we couldn’t afford it
  6. Eventually, we wised-up, downsized our home, and bought rental properties that covered our mortgage and healthcare.

When my wife is 65, the mortgage will be paid off, the kids will be educated and her retirement self-funded by the residual real estate portfolio.

How much of our cost of living can be permanently covered, or hedged, by this decision?

Most people aspire towards material goods, appearances and spending.

I urge you to patiently buy time, personal freedom and shared experiences.

Most of effective investing is learning, saving and waiting.

 

Real Estate Switching Costs

Real estate has had a good run since 2010.

It can be tempting to cash in profits.

Financial Case Study

My neighbor is just about at the point where he can net $1,000,000 dollars on the sale of his house. He’s retired and this represents a very substantial sum for him. One million dollars is also kind of a magic number emotionally as he never expected to be a millionaire.

For him to net $1,000,000 he will need to sell his place for about $1,067,500 gross.

He bought the house many years ago so, even after his primary residence exclusion, he’s going to have a tax bill of $70,000.

There will be other costs (moving, cleaning, etc…) adding up to $2,500.

So his certain costs today are $67,500 + $70,000 + $2,500 => $140,000

Putting this into his personal context…

Having paid off his mortgage by the time he retired, he has the ability to live on $1,500 per month. So he’s looking at a certain bill that’s worth 7 3/4 years’ living expenses.

He’s also a young retiree, with parents still alive.

So he might be living another 30+ years.

Key Questions

How might the switch make things better? Whatever they are… they are uncertain benefits to be weighed against certain financial costs.

How will surplus cash be invested? Given the choice between prime residential real estate and an investment account… most retirees prefer the hidden volatility of real estate.

Do I want to leave my community? When I left Christchurch (NZ), I left behind a fantastic group of people. Community has a far stronger association with a meaningful life than cash in a bank account.

Certain types of people make new friends easily. I’m not one of those people! What type of person are you?

What Can Go Wrong

Bull Markets — Assume that you can only “move out of town” once. In our case, we lack the financial resources to repurchase our existing real estate at current market prices. If we sell, and prices rise, then we will be priced out of the market.

Neutral Markets — Real estate is expensive to transact. In the example above, the vendor is paying 13% of gross proceeds in commissions, taxes and expenses. In any new purchase I assume that I “lose” (on paper) 10% of the gross purchase value at completion. In other words, I am going to need a 10% market increase to get my money back.

Bear Markets — Can I afford to be locked into this market for many years? Vacation markets, cities reliant on a single industry (oil and gas) and secondary locations… buyers can be locked in for five plus years. Am I OK with that risk?

The Good Enough Portfolio

There’s a lot to be said for an attitude that an existing position is “good enough.”

Each time I make a choice, change or modification it’s an opportunity for expense and error.