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.

 

High Finance

2016-09-24-10-14-55Keep your ears open this week. There will be a rare opportunity to learn about finance.

For my international friends, many of the American techniques (in the news) are available in your home countries. I have been applying finance, across four continents, for more than 25 years.

2016-09-25-18-48-42The overall financial system works great. However, when I try to explain certain shortcomings to my friends, their eyes glaze over and I lose them.

I wish I was more skillful.

Whether your favorite billionaire is a Cuban, a Koch, or a Buffett, we can learn a lot from insiders. A constant refrain from wealthy insiders is “complexity creates opportunity for the system to be gamed for economic benefit.”

Finance is a complex system. The system has been gamed extensively.

  • Offshore accounts (Panama Papers type stuff)
  • Thinly-capitalized investment vehicles, with lots of debt
  • Applying non-cash losses today, while deferring cash gains to tomorrow
  • Receiving preferential tax rates on gains associated with financial work
  • Using trusts to avoid estate and generation skipping taxes
  • Using special accounts to shelter income and gains across generations
  • Income reclassification to avoid income and payroll taxes

If the collective wants to run the system like that then I’ll bow to its will. However, I’m not sure the collective knows what’s up.

2016-09-28-10-43-49-1Like professional sports, my beef isn’t with the system. What irks me is the lack of integrity when insiders pretend the system is different than reality. The politics of the people I named above are different but their observations are often similar.

I’m grateful I can explain my personal reality without fear of banishment or loss.

Living a life you can disclose saves a lot of suffering.

Intro To Margin Finance

snow_mtnBDC asked for an example for my post How Leverage Kills.

If you don’t understand debt then assume that the only time it might make sense to borrow is when your 30-year fixed-rate mortgage payment (including taxes & insurance) is less than your cost to rent. Assume that all other forms of debt will hold you back, prolong being a wage slave and reduce your retirement income.

The people that take issue with the generalizations above are probably trying to sell you something, and working on commission.

My family’s only borrowing is a 30-year fixed rate mortgage. Our mortgage payment is 60% of what it would cost us to rent. I made a calculated bet that our mortgage debt would provide a hedge against rental inflation.

Homeownership isn’t necessary for financial freedom. I bought the house because:

  • I have a young family
  • Don’t mind being geographically restricted
  • Live in a great public school district
  • My youngest won’t graduate high school until 2030
  • Our city is likely to experience above average real economic growth
  • I’m in a better part of town

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Let’s assume our investor has $100,000 and owns an asset that yields 2% after expenses ($2,000 net income).

  • Along comes her investment adviser and offers a portfolio loan – rates are low right now so the loan will cost her 3% per annum.
  • Our investor decides to borrow $50,000 and purchase more of the same type of asset.
  • Now she has $150,000 of assets, still yielding 2%, so $3,000 of income each year.
  • The loan is interest only and costs her $1,500 per annum (3% of $50,000).

Where things get wonky is if the asset’s yield disappears — for example if a rental property is vacant — OR — if the capital value drops significantly — for example if a portfolio of stocks falls 50% in a bear market.

Let’s look at the 50% asset value decline.

  • The value of the asset falls from $150,000 to $75,000.
  • The value of the debt stays the same $50,000.
  • Therefore the net equity value falls to $25,000.
  • The net cash flows stay the same $3,000 from the asset, $1,500 interest to pay, $1,500 net after interest.

If you generate enough cash to pay your interest then you can ride out the bear market and wait for asset values to return to pre-crash highs.

However… a common feature of margin lending is the bank can ask for their money back… ….and they have a habit of asking at the worst time.

Sometimes, they don’t ask, under the terms of your loan they have rights to sell you out of your position.

Let’s have a look at what happens if the bank asks for their money back at the bottom of the market.

In that case, you crystallize a 75% equity loss ($100,000 to $25,000). You are left with $25,000, which will be worth $50,000 (earning $1,000 per annum) when the market recovers to pre-crash levels.

If you didn’t borrow, you earn your 2% per annum through the bear market and end up with $100,000 (earning $2,000 per annum) when the market recovers.

Market Moves

The chart shows major bull and bear markets.

Using your own money, a habit of margin finance could wipe your investment out every 10-25 years.

Some risks aren’t worth taking, especially with money that you can’t afford to lose.


So Why Borrow?

In a bull market, it’s tempting to borrow a much higher percentage of the total investment. Hedge funds, and investment banks, can get over 90% leveraged, against shareholders funds (also known as other people’s money).

When you guess right with other people’s money, the “house” will get rich quick. I worked in a business that received 20% of the profits generated.

When you guess wrong, the clients take the losses.

More on leverage in Part Four of my free eBook Live Long & Prosper – specifically pages 46 to 51.

The Do-Something Investment

Ax_snow1I saw that Clinton’s son-in-law took some big losses at his hedge fund by making bets on Greece. People are speculating that the Clinton family lost a lot of money in the deal.

While the scale might be different, I see this error in every family that I get to know.

We err by making an investment to help someone “do something.”

Some examples from my own investment history:

  • I’m self-employed and have often been tempted to buy myself an office so I can have a place to do something
  • I’ve offered to back friends in start-ups so they can have the funds to create a business and do something
  • I backed myself in a low-return business, where I didn’t understand the market, so I could have something to do
  • I guaranteed the debt of a friend’s business so he could borrow additional money for his start-up
  • I purchased a property so a friend could have a job acting as my property manager

To limit the damage, I have two questions that I ask.

First: What is the purpose of my family balance sheet?

  • Maintain independence and dignity of elders
  • Educate the kids
  • Share experiences with each other
  • Produce a growing stream of cash flow to fund my future living expenses
  • Support a feeling of security and freedom of occupation

You might have a different list. I’d encourage you to write your list down because the checklist might help prevent expensive errors.

Second: How well have I done with predicting my life on a ten-year prospective basis?

While my life has been rewarding, it’s path has been unpredictable on a ten-year rolling basis.

The unpredictability of life means there is value in maintaining a straight-forward balance sheet that isn’t concentrated in any individual, geography or company.

Put plainly, I’m nearly certain to continue to get the future wrong – especially when I try to predict my family’s needs, desires, location…

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Let’s say an investment can get past those two questions.

It is time to keep it real.

#1 – Are we backing the best members of our team?

The best people don’t need the help of connected parties.

Because…

There is plenty of money available for good people with good ideas.

Therefore, by definition, most family investments are focused on the weakest members of the team.

Don’t do it.

#2 – Can we afford to lose our maximum exposure immediately?

Concentration kills.

If you can’t afford to lose your full exposure, immediately, then don’t do it.

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If you’re struggling to say “no” then

  1. say “yes” to spending time to help raise funding from a third party
  2. lease instead of buy
  3. focus on enjoying each other’s company, rather than investing together
  4. make an introduction to an expert in the industry to facilitate a working apprenticeship
  5. pay for expert instruction

These options have had a great rate of return in my life.

The Yellow Brick Road, not taken

the_roadOne of the best lessons of my life is:

The cost of the status quo is hidden

We never get to see what we miss by NOT changing.

In my early 30s, I made a decision to leave my life in finance and it turned out well. However, I will never see the life that I missed by leaving early.

Recently, I came across a glowing account of Blackstone’s acquisition of Hilton Hotels. The story is written in the style of the hero’s journey.

As I read the article, I realized that the hero was my best-case scenario from an old life in private equity. In the article there is a photo of the hero, sitting in a chair, he has set a personal best performance that’s going to be tough to replicate. In business, and in sport, I’ve had a few of those moments.

Flying back from a Couples Retreat, I asked my wife to read the article. She found it to be an amazing story.

I said, “You just read my best-case scenario from the life I had before I met you. I’m so grateful I got out.”

Similar to what I see when I watch elite sport, my view of elite finance is different than most.

I saw…

  • Buy at the top with other people’s money
  • Pay off bank employees to pass my losses through to their shareholders/taxpayers
  • Provide massive financial incentives for management to work their tails off
  • Let time bail you out
  • Bask in the glow of my peers’ envy

When you look at the life you’re living, what do you see?

The Billion Dollar Dinner

2014-09-20 17.17.34Early in my finance career, I was invited to a very nice dinner. The occasion was to celebrate the firm passing the $1,000,000,000 mark for assets under management. In the early 90s, a billion dollars was a lot of money…

Roll forward 25 years and a billion dollars has become a salary for the best hedge fund managers. What an amazing industry.

In my article on fees, I introduced the concept of a “two and twenty” fund. The partnership received 2% of the assets under management (annually) and 20% of the gains. I didn’t run the numbers at the time, but the partners were celebrating ~$400,000,000 of fees and potential profit sharing. Huge sums of money created by the smartest room of people with whom I’ve ever shared dinner.

I can’t remember much about the dinner but I probably drank too much. I had some bad habits in my early 20s and the partners warned me to dial down the boozing! I wouldn’t discover the medicating effect of exercise until five years later.

Fortunately, I had good habits that balanced the bad.

Always make the needs of your boss your #1 priority. The only exception to this rule is if your boss’s boss makes a request!

When I started in London, they carved off a piece of hallway to create a cubicle for me. My chair was the only desk that could be seen from the Managing Partner’s office. When my boss had a task for me, he’d lean forward and yell,

Byrn, Heel!

Yes, I was treated like a dog.

And I loved it.

I’d stop whatever I was doing and scamper into his office for instructions.

The other habit that served me well was saving 50% of everything I earned between 12 and 30 years old.

My parent’s divorce left me with a deep fear of running out of money. As a result of my fanatical savings, I had capital to invest later in my career. In fact, I invested so much in the partnership that the regional heads changed the rules to restrict the investment of junior partners! Envy is part of the finance game and it worked out well for everyone.

With the size of the numbers bouncing around, you’d be forgiven for thinking that I’d retired a wealthy man. I made good money but decided to leave most of it on the table to try my luck at triathlon. It was a decision which, rightly, seemed totally bizarre to my family. I left the firm with a net worth of 20 years living expenses.

Always compare financial wealth to spending and remember life’s about time, not money. I didn’t become a wealthy man until I cut my spending, moved to a low cost location and began to pay attention to what gave me satisfaction.

Far more valuable than money, perhaps the moral of today’s story:

  • Save as much as you can, and work your tail off, early – the freedom later is worth it
  • Everyone needs to learn basic financial accounting and the time value of money – in a world dominated by greed and envy, financial literacy is invaluable. I use these skills every day.
  • Getting paid a lot didn’t satisfy me. I had no idea what motivated me until my life was reset via divorce, unemployment and massive financial loss. I could have made a ton of money sticking with the status quo and that would have been a mistake. Finance could have cost me my health and turned me into a dick.

The best advice I received on my career was from a man, now gone, that was at the dinner that night (link is to my blog about my mentor).

Learn, make money, remember to leave.

When most everyone was telling me that I’d make partner if I stayed in London. An honest man took me out to breakfast and shared advice about living a good life. A good person in an amazing industry. He wasn’t the only one and I miss the team from my early career.

To my friends in Private Equity, thanks so much for the good times and memories we shared.

A Fiduciary’s Reading List

I’ve completed William Bernstein’s recommended reading from his eBook, If You Can.

The reading humbled me. With a 1st Class degree in Econ / Finance, and 20 years experience in international investing, I was left feeling intellectually arrogant and ignorant. Each of these books challenged my beliefs while explaining financial history.

I’d recommend making these books compulsory reading for your advisers and key family members.

Good people can be found in the field of finance. I appreciate the significant time that each of the authors spent to educate willing readers.

The Millionaire Next Door – introduces the key concepts of wealth, saving, investment and taxes

Your Money & Your Brain – a solid summary of the latest on behavioral psychology as it relates to finance and investment – why I will always fool myself

The Great Depression: A Diary – an inside look at what it is like for a conservative, professional family to live through a depression – 2008-2010 was easy compared to the 1930s – could your family survive on minimal income for multiple years?

All About Asset Allocation – the early chapters were the most useful – simple explanations of the role that volatility plays within a portfolio – reading this book, you’ll be tempted to seek the perfect portfolio mix – my decision has been to keep it simple

Common Sense About Mutual Funds – a wealth of information – Bogle picks apart the industry by making his case for simple and low-cost investing – the book makes one wonder how brokers and financial advisers can sleep at night – readers will learn about the industry structure that silently fleeces its customers

Side Note: if you worked in finance from 1980 to 2000 be sure to adjust your brilliance for volatility and leverage using Bogle’s updated charts. We had one heck of a tailwind. Humbling!

How A Second Grader Beats Wall Street – don’t be fooled by the child-like title – this book will save your family tens of thousands of dollars in fees and taxes

Devil Take the Hindmost – a history of financial speculation – hedge funds in the 1860s & derivatives in the 1600s (!) – as Taleb says, we’re never going to get rid of greed, the challenge is to build the system so the greedy don’t inflict suffering on the good

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To Bernstein’s list, I’ll add Estate & Trust Administration for Dummies – a good primer to get you thinking outside of your own self interest.

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If you are in an advisory, or trustee, relationship then tick off one book per meeting with your professional team.

Read a book, take notes and discuss how the book impacts your family (or your firm).

Challenge yourself with exposure to the best ideas available.

Studying new approaches can be painful but we all benefit from a bit of cognitive dissonance.