Assets with high holding costs

2020-05-13 13.49.25-1

With all the talk of indoor transmission being more likely (than outdoor), we’re moving martial arts outside whenever possible.

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I’m going to chat you through the financials of a rental property I used to own in Tucson.

This will help you understand the situation facing airbnb hosts and other owners of assets with high holding costs.

  • Picture a condo, bought and furnished for $75,000.
  • The condo has a current value of $100,000.
  • The condo doesn’t have a loan against it but costs $8,500 per annum to hold (8.5% of value). The high cost to hold is due it being a fully furnished rental => things like taxes, HOA, cable, insurance, utilities…
  • The furnished rental does great and yields net cash flow of $4,500 per annum after all expenses, taxes and commissions => 6% of cost.

This was a good investment but I sold out, and switched into Boulder real estate, with a mortgage. Here’s what I switched into:

  • Cost to hold the house (mortgage, taxes, insurance and maintenance) => 3% per annum vs 8.5% for the condo. Without the mortgage, the cost to hold the house drops to 1.25%.
  • Worth emphasizing the debt-free annual cost to hold comparison => condo 8.5% vs house 1.25%
  • House has rights to land, condo doesn’t include any land rights.
  • House has alternative uses… can live in it for the cost to hold, or rent and receive a net yield of 1.5% (2.75% excluding the mortgage).

Both locations worked out.

I checked on the condos yesterday and they were selling at ~$150,000 pre-virus, up significantly from 2008-2010 crisis values.  Boulder housing has seen similar appreciation.

What concerned me in 2012, when I sold, was the high cost of ownership, which can bite in a downturn.

Picture the condo debt financed => this is the issue facing aggressive airbnb hosts

  • A $75,000 purchase, with a mortgage of $65,000 against the property
  • To buy the place, you needed $10,000 of equity, which appreciates to $35,000 as the capital value rises (on paper) to $100,000.
  • The paper profit is 3.5x your money (yay) => you get this from 33% market appreciation, similar to what has been seen in many markets over the last 3-5 years.
  • But… the Virus pops up and the property is going to cost you $7,500 of new cash to hold for the 1st year of the crisis => 7,500 / 35,000 is a negative 21% return on equity.

All of a sudden, the warm feeling of paper profits is replaced by the reality of writing checks, monthly, for a vacant rental.

Depending on your tax bracket, one year cost to hold might be the equivalent of the last three years profits.

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The high cost to hold can bite in different situations.

Club Memberships => $50,000 to $250,000 membership initiation fees with annual dues of $5,000 to $25,000.

You can find yourself in a contractual relationship where you are required to pay 5-20% of membership value in a downturn.

Now picture a club with 10-20% of the membership unemployed, or ill with COVID.

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In a world with: (a) very low discount rates; and (b) professional compensation under pressure, the “penalty” for paying through a downturn/crisis is accentuated.

Many asset owners are likely telling themselves they are simply facing “one bad season” and things will get back to normal soon.

Perhaps.

 

 

Corona Diary 5 May 2020

2020-05-04 10.14.02

Write a kid, it will do you good.

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“If you want to determine the nature of anything, entrust it to time: when the sea is stormy, you can see nothing clearly.” Seneca — Daily Stoic (@dailystoic) May 5, 2020

I noticed that Buffett sold out of airlines, completely. Elsewhere, I read about his concern about being an owner of businesses that consumed cash.

The quote above is another Buffett/Munger point => how difficult it is to wait, watch and be patient.

The challenge of no-action, waiting for the sea to calm => made easier by a combination of cash-generative assets and cash.

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I was asked for my opinion about inflation/deflation.

Before offering thoughts I want to share a portfolio. The ratios can be tailored to your personal situation.

  • Net Cash Generative Real Estate [See Note 1, below] => 2 years core cost of living
  • Equities => 3 years core cost of living
  • Bonds/Cash => 2 years core cost of living
  • Recourse Leverage => none

(a) I like to think in terms of “years” because it provides a big incentive to keep my spending aspirations modest. (b) The 3:2 ratio, above, implies a 60:40 equity/bond portfolio. (c) Core cost of living => cash it takes you to survive one year.

Pause and think about the above portfolio in deflationary, as well as, inflationary environments.

  1. The portfolio is not optimized for any scenario, there are aspects that will get hit hard. This is OK and to be expected.
  2. The portfolio can survive different scenarios.
  3. You can spend a lot of time tinkering at the efficient frontier but it won’t get you much in the real world.
  4. Get yourself to a position that’s “good enough” and lets you sleep at night => then go out and focus on living your life as best you can.
  5. Pay careful attention to decisions that impact time, rather than money => time you have in your week, time you have in your life, the quality of your time and what you will spend your time thinking about.

The portfolio need not contain solely financial assets: education, time, youth and other options are important sources of family wealth.

About the likelihood of hyperinflation and depression-style deflation…

  • …the levers being pulled have no historical precedent => from this morning, US Federal Government borrowing $1 Trillion per month this quarter
  • …the levers are being pulled different directions by governments, corporations, consumers and central banks
  • …the levers impact the price of goods, services and capital in different ways

The system is complex and opaque, with feedback loops, 2nd and 3rd order effects => the system is fundamentally unknowable => I should constantly remind myself of the truth of unknowability and avoid people who have a vested interest in impairing my thinking.

In lockdown…

  • my most challenging work is increasing human capital via home school, while modeling a strong marriage for my kids; and
  • not decrease human capital by becoming a casualty, myself!

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I’ll end with a picture of what I saw when I came downstairs this morning.

Our youngest, mirroring what she sees around her.

Warms my heart!

2020-05-05 06.39.53

[Note 1] Real estate that is a net cash drain can be a source of stress (for you) and fragility (for your family).

One of the two best investment decisions I made in the last 24 months was renting in Vail. The other solid decision was not redeveloping a site, at a time when people were making (on paper) $1 million per flip with high-end renovations.

Capital, used wisely, gives you to ability to not-act and be comfortable sitting in an enviable position.

2020-05-05 06.39.56

Fear and Panic

Yesterday, my local CostCo sold out of Charmin in 15 minutes.

My cognitive capacity is so lit up I can’t remember my daily calendar.

Stress makes us stupid.

So…

#1 – execute my strategy, made before the current crisis

One of the nice things about following a rebalancing strategy is you are very likely to have sold (a little) at the peak. My pre-crisis rebalancing happened January 4th and I sold enough to cushion the psychological impact of recent declines.

I rebalanced on Monday and again today.

Limit down opens => phew!

#2 – lean into fear

Since 2014, my portfolio assets have been 60/40 in equities/bonds. For the last six years, I’ve expected bonds to get hammered by rising rates. It didn’t happen. Been wrong the entire time but it didn’t hurt me.

For my long-term capital, I’d rather use a 90/10 strategy (90% in equities). The trouble is getting there. I have zero confidence in my ability to pick the right time to shift. So I created a re-weighting strategy based on VTSAX/SP500.

A simple rule: as the market moves from 20% down to 50% down, I will rebalance equities upwards from 60% to 90% of portfolio holdings.

Today’s rebalance moved me to 63/37. The 63 is held 42/21 VTSAX/VTIAX.

Simple to execute => each time, I rebalance I check the %age off the peak, if we’ve set a new low then adjust the equity weighting upwards. Otherwise, steady as she goes.

This simple strategy is not easy to do => either I want to rush more money in (FOMO) or hold money back (plain old fear).

#3 – real estate

When your neighbors are stocking up on TP in preparation for the end times… it’s generally not a good time to be selling real estate.

What about buying? Real estate prices respond much more slowly to feelings/sentiment. At the last downturn, local real estate didn’t “get cheap” until 18-24 months after the crisis.

I suspect we’re going to see the residential market stop dead for a few months.

After that? I have no idea.

#4 – family

My family has been watching me stock the house for three weeks. They were amused but now we are ready.

I’ve been reassuring the kids they are going to be OK. There’s a lot of fear around.

At school, our youngest heard that “old people” were dying. She took me to one side and asked if I was going to be ok => Yes, Sweetie, I’m going to make it.

That said, a finance background is useful for understanding the impact of compounding. Our state saw a 33% increase in positive tests today. Keep that going through the end Spring Break and we will have 4,200 positives in 16 days (from 44 at Noon today).

Notwithstanding an absence of positive tests in Boulder County, I’m going to start home schooling on Monday. A significant burden on myself but a small price to slow the spread.

#5 – community

Will Colorado’s experience follow Italy, Hong Kong or Taiwan? I don’t know.

What we know for certain is there will be a large, sudden burden on the lower end of our communities. Consider giving a sizable donation to your local food bank.

We also know we will save lives by staying away from each other.

#6 – immunity

Something simple, but not easy, for readers of this blog => cut your training in half.

Take your program, cut it in half and watch what happens with the infection rate in your state.

If your state is on a log-scale infection rate then it will become apparent far more quickly than any fitness loss.

Your immunity will get a boost from this change and you’ll preserve all the health benefits from exercise.

#7 – cash, debt and leverage

If you have an emergency fund then this would be a good time to make sure it is liquid. I have three-months expenses sitting in my checking account.

Not willing to lean into the market downturn? Consider using surplus cash to pay down debt.

If the downturn persists then do you know what can ruin you? There are many types of leverage => I’ve written about this a lot.

 

 

 

 

Diversity of Thought – Things we can’t imagine

2020-01-05 14.39.11-1.jpgA popular theme in the media is handwringing about the divisive nature of political discussion. Everything would be much better “if we could just get along.”

I’m not sure.

Social systems tend to overshoot, overreact, over-everything. When we have widespread agreement (think totalitarian states) humans tend to drive the bus off the road.

Can you name an area where we have wide-spread agreement across the political spectrum?

I can.

Deficits, borrowing, bonding.

Left-right, north-south, east-west, up-down, local-state-national-continental => near total agreement on the benign nature of government debt.

Because disagreement limits the size of potential errors, total agreement worries me.

A surprise in my 2019 was my state’s voters not approving a change to our taxpayer’s bill of rights. It is the only constraint, on the ambitions of government, I noticed last year.

We should not expect government (or friends & family) to “do the right thing” in advance of a crisis. Human nature isn’t designed to work that way. An increase in our collective tolerance of regulation and taxation (ie pain) doesn’t happen until after a crisis.

Our collective problems won’t be addressed until after they blow up.

My individual risks, however, can be addressed right now.

A collective belief in the benign nature of debt is self-reinforcing. While the debt cycle expands, asset values are inflated, consumption is pulled forward and economic growth is nudged upwards. Because of its ability to feed on itself, debt expansion can continue for a very long time, particularly with interest rates near zero. Ultra-low rates enable lenders to fool themselves about the credit quality of the marginal borrower.

What to do?

Life is not filled with only bad news! Am I able to take advantage of unexpected positive surprises?

It’s counterintuitive but I’m positioning myself to borrow a lot of money. My 2020 project is creating an option to borrowing 30-years fixed at an interest rate that none of us can currently imagine.

How might unexpected negative surprises wipe me out?

Consider who is getting out of hand with their current borrowings. What’s the credit quality of… your employer? your family? your largest customers? your local/state/national government?

Do you work for a high-leveraged company, in a state with massive unfunded pension liabilities, while rolling your credit card balance each month?

Hidden liabilities lie (mostly) hidden. Ponzi schemes, unfunded retirement benefits, promises for future spending, fixed price contracts… think about your life. Where do you have exposure to a single person, CEO, manager, employee, fund, investment? In an easy-money environment, it is possible to hide significant liabilities.

Things we can’t imagine are likely to be underpriced.

Kinda tough to imagine the unimaginable! What seems impossible to imagine? Inflation, interest rates at historical norms, rapid nominal growth, credit crisis in a large sovereign, large hot-war…

For me, the goal is not to predict the outcome. My main goal is to protect my lifestyle from shocks and surprises.

To make it real, I ask, “what could blow up ski season?” Health, injuries, illness => my current risks are more human, than financial. Think beyond the money.

To focus on new ideas requires us to reduce the noise in our lives. Are you engaging in a policy of constant distraction?

There is a lot we can do to manage our exposure to the errors of others. Bad companies, bad relationships, bad government… many of us have the ability to pack up and leave. I’ve lived and worked in eight different countries, on three continents. Gradually working towards a situation where the main person who can hurt me is myself!

As a young man, I spent many years exposed to the errors of a single individual (my bosses and my business partners). More common is exposure to the errors of a single corporation.

With preparation, you can benefit in times of stress, but first you must survive.

Rent vs Buy in Vanity Markets

2019-12-07 09.28.44A vanity market is one where the main benefit you gain from ownership is telling your pals that you own.

Similar to my observation that I was wired to buy a “big” house, there are other purchases our ego gravitates towards: cottage at the lake, ski chalet, big-city pied-a-terre, beach house, farm…

Our ego’s weaknesses depend on our cultural background, childhood memories, current mood and social situation.

My ego can lead me far astray, particularly with non-yielding real estate, and depreciating assets.

I’ve been battling with myself since I first visited Vail, Colorado. I’ll illustrate with real figures from the neighborhood of East Vail. It is a niche market, which I’ve been following for 16 years.

The “buy” => $1 million buys you the opportunity to spend another $375,000 to renovate, and furnish, a property that was build in the 1970s. After your renovation is done you pay ~$25,000 per annum in taxes, insurance, HOA and running costs.

The “rent” => $25,000 to $40,000 all-in rental cost for the same property.

Something we noticed about skiing, most skiers don’t ski.

Put this observation another way… there’s a lot of empty real estate around.

I’m sure every empty place has a history of buyers, who were certain they’d use the property more often than they do.

A useful rule of thumb is to assume that every $1 million, in a vanity property, costs your family $50,000 per annum. Renting makes (some of the) opportunity cost real, and allows you to calculate the cost-per-night of what you’re using.

Above is what you can see and calculate.

What about what you don’t see?

#1 => the option to change your mind, without cost or hassle. This is a powerful argument when framed correctly.

Honey, the kids are going to grow up and leave. When that happens, our life will change in ways that are impossible to predict. We should maintain the flexibility to change our minds.

#2 => the option to buy in a downturn. About once a decade, property values snap downward. Waiting does not feel like a valuable option but it is. I’ve seen brief, 50% markdowns numerous times.

#3 => what I think I will like does not match what I actually like. I am a master at fooling myself. Fooling myself with regard to location, views, amenities, garages, layouts… you name it.

Renting “forces” me into different types of properties. Because mistakes are so expensive, I write down the lessons from every new property.

Here’s the best lesson of all…

Assets don’t create the life you want to lead.

Focus on shared experiences with the people you love.

2019-12-07 13.11.17

Family Real Estate 2019

2019-12-01 17.07.49I like investing in residential real estate for several reasons:

  • The market is dominated by unsophisticated buyers/sellers, who are often driven by external events and emotions;
  • The availability of long-term fixed-rate non-recourse finance; and
  • Favorable tax treatment.

There are some drawbacks:

  • It is extremely expensive to buy and sell => a mistake will cost me 10% (gross), if I am lucky. If borrowing, even conservatively, then I can lose 35-50% of my equity in a year.
  • It is lumpy => if you need the money back then it is very difficult to gradually drawdown your investment.
  • It is illiquid => if we _really_ need to cash out then we won’t be able to cash out
  • Humans are hardwired to over-buy => as soon as I could afford a huge home, I bought one. It took me years to get my capital back. I was very lucky => I purchased with a large margin of safety (no leverage, big site, big building, prime neighborhood).

Taking the above, together, real estate is a useful core holding for money that won’t be needed for 10+ years.

2019-11-14 14.33.15

I follow two types of markets:

Markets where growth in prices is driving by “wealth feelings” in the top 0.01% of society => Vail mountainside homes, Boulder view properties. These properties have done well, appreciating to levels where implied yields are -2% to 2%.

I prefer to invest in traditional markets => markets where price growth is backed by a combination of real-economic growth (ability to pay), construction inflation (replacement cost) and discounted cash flow (net yields above my cost of capital).

Both markets are influenced by the availability of credit. Both markets benefit from scarcity and desirability in location selection.

Remember that even a “cash buyer” is influenced by easy credit. Credit conditions influence the value of ALL assets => wealth effects. These wealth effects cut both ways => highly wealthy people can feel “poor” when their balance sheets are shrinking.

2019-12-02 06.29.25

When I buy, I create a margin of safety by seeking:

  • Land for cheap => is there extra land I could sell off or am I buying in a very desirable location.
  • A lot of square footage for cheap => ideally, I’d like to get the land for “free” by paying less than the replacement cost for the building. Even if you never build, it helps to know building costs.
  • Distressed seller => life happens, often at inconvenient times.
  • Closed credit markets => by ensuring I have the ability to hold through tough times, I can use unallocated capital to buy during down markets.

I’ve been preparing for my next deal by improving my credit worthiness:

  • Building up a capital reserve.
  • Improving my credit rating – paying credit cards early, taking advantage of a 60-month 0% car loan offer, always paying my mortgage on time => taken together these strategies added 80 points to my credit score from 2012 to 2019.
  • Reducing leverage => paying down my mortgage and car loan. Closing out my second mortgage.

2019-11-21 08.02.40

We’ve seen significant house price inflation in Boulder => supported by: (a) rising construction costs, (b) local economic growth, (c) inward migration of wealthy coastal buyers, and (d) easy credit terms.

In 2019, I looked at deals to increase investment in Boulder (buying apartments and renovating houses). In the end, we decided to decrease investment in real estate through a sale-and-leaseback of our home. 

The leaseback costs me some tax (today) and positions me to borrow long at favorable terms. The option also costs me the future capital appreciation of my home, which won’t be mine any more. We retain exposure to the Boulder market through rental properties we own.

I’ve structured the deal with vendor finance, allowing a gradual drawdown of the proceeds. The net monthly cash flow covers our cost of living through my youngest daughter’s high school graduation. Having our cost of living covered protects my ability to control my schedule => highly valuable to my family in a way that’s difficult to quantify.

This is the cheapest way for me to sell real estate and positions us to buy when conditions swing in our favor.

Raise money before you need it.

 

#RWRI Thoughts on the business model and cleaned up notes

RWRI has a fantastic business model.

  1. Make the faculty your friends and investment committee
  2. Get paid to meet for a week each trimester // you have a no-cost central office, you are getting paid to bring your international (virtual) business together for a week
  3. Record your talks to capture new ideas, spontaneous content
  4. Train the students who will take your work forward when you are gone
  5. Receive feedback about how your work is being used in the world
  6. Up-sell your most passionate (book) customers => Robbins model
  7. Create an environment where you expand your network with people likely to engage and help you => HUGE self-selection bias in student population
  8. Invite world-class speakers in areas where you’d like to learn

This business works well for its owners and they are (more than) smart enough to see that.

Keep it small, sell out each meeting, avoid the temptation to expand and remember why you started.

I cleaned up my handwritten notes via the creation of a Google Doc.

Mistakes remain my own.