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.

 

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.

Small, Negative Suprises

Sneaky SquirrelPart of being human is a tendency to over-react to small losses.

As this error has cost my family (big) money, I’m going to share a case study that illustrates the point.

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One of my jobs is to manage a small portfolio of local real estate. From time-to-time items come up that need to be sorted. Each of those items represents a small dose of unexpected pain.

In most years, there will be a dozen items that require action. Total cost of these items is on the order of one-month’s living expenses.

To give an idea on scale of the “pain”, the portfolio is worth ten-year’s living expenses and, annually, it generates cash equivalent to seven-month’s living expenses.

Combining the above, you could calculate that the portfolio has a cash yield of ~5% on net realizable value.

When compared to all of the alternatives, this investment is one of the best places to invest.

But the random, little bits of pain hurt — jammed sewer lines, flooded basements, six-foot high marijuana plants, missing tenants, leaking toilets… none of this is unusual, or unexpected.

The small doses of pain hurt so much I’ve been considering selling the portfolio and switching into a less attractive investment.

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To escape the small and random pain, I am willing to accept certain, large and immediate pain! A discount on market value and payment of significant tax liabilities. The total cost would be more than two-year’s living expenses.

In a fantastic investment, with less attractive alternatives, I’m willing to pay 25x more than the cost of the pain to make it go away.

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Rather than pay two-years living expenses to make the pain go away, I’ve hired a property management company to insulate me from the pain.

Annual cost is 0.6% of net realizable value and less than a month’s living expenses.

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Beware of quick reactions triggered by small, negative surprises.

They are often irrational.

 

 

Wealth Habits: Capitalizing Luxuries and Time

IMG_4160Over the last year, I’ve sold two paintings and a piece of jewelry. My family had owned these items for a long time and they have given us a lot of pleasure. However, each September, an insurance bill arrived and gave me a fair amount of pain.

So now the items are gone and last week my insurance bill arrived. I noticed that my insurance savings are enough to take my wife to visit any museum in the world, annually, forever.

By getting through the pain of change (the sale)… I created a situation where we could share experiences together (future trips).

The cost of the status quo is often hidden.

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Similar story.

I’ve been thinking about buying a boat, a sprinter van and/or a truck.

Despite evidence to the contrary, at some level, I think these assets will make it easier to spend time with my kids.

These assets are expensive to own, depreciate and require time to maintain.

How to counter the urge to purchase?

Assume depreciable assets are free to own, lease, keep receipts and track total time/spending in a year.

Cat SailAn example for the boat:

  1. As a teenager, I spent many summers working on the water. In those years, what was the total number of days that I would spend on the water? My peak days were 60 per annum. This year was closer to 25 days.
  2. Based on my rental history for the last two years, what’s the average cost per day of renting, rather than owning? Let’s assume it is $1,000 per day.

Based on actual days on the water, how many years expenditure would I capitalize with a purchase? In my case, it is 10-25 years of expenditure based on how you slice the numbers and the size of vessel. Also, worth noting that I was on seven different vessels in 2015.

The above analysis is essential before you buy a vacation home, consider becoming a ski-family or purchase a large depreciable asset.

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Think back one decade, or two… have your preferences changed? Mine have changed tremendously and I have discovered that I am a lousy judge of what I’ll want in ten years’ time!

How might a large capital purchase impact the freedom you have to allocate your time?

By staying variable in the family budget, I can:

  1. free significant time in my daily schedule
  2. finance childcare
  3. budget for shared experiences
  4. immediately ratchet down spending, when required

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2015-09-20 17.53.02The final step is to pay attention when you are enjoying a “luxury” expenditure.

Notice the changes (if any) with your inner experience.

My benchmark is the way I feeling during a walk in the forest that’s ten minutes away from my desk.

Live where you don’t need to leave.

Real Estate – Should I buy or sell?

2015-09-14 13.55.37

In May 2014, I shared a template for reviewing your real estate. Let’s revisit that property – (prior values in parenthesis).

  • Today’s Zillow value $1.2 million ($850,000, +26%)
  • Recent Assessment value $1.05 million ($830,000, +27%)

Zillow and the county assessor have revised values up by more than 25%. You’re wondering if there is a bubble. You receive an offer of $1.1 million, should you sell?

In the article from May 2014, the “owner’s value” was $925,000. This offer is ~20% higher. Seems straightforward to sell, but pause to consider…

  1. How has the investment changed over time?
  2. What are you going to do with the money?
  3. What are the tax consequences of selling?

2015-09-11 15.25.11Investment Review

The big story in Denver/Boulder real estate has been increasing rents. The current rental income for the property is ~$60,000 per annum. Taxes, insurance and repairs cost $10,000, so the net cash flow is $50,000 per annum.

Previously, cash flow before interest and depreciation was closer to $25,000 per annum. So there has been a near doubling in the annual cash flow from this investment, but pause to consider…

Is the cash flow sustainable?

In this case, the cash flow is not sustainable. Houses wear out, roofs need replacing, plumbing needs repair and appliances break down. So let’s adjust the $50,000 per annum to $40,000 to reflect sustainable cash flow.

The offer is $1.1 million to buy $40,000 of sustainable cash flow. That is an implied yield of 3.6%.

How does that stack up?

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Alternative Uses of Funds

US Treasury Yields

  • 5 year, 1.6%
  • 10 year, 2.3%
  • 30 year, 3.1%

Vanguard Select Fund Yields

  • VTSAX (US Equity) – 2.0%
  • VBTLX (US Bond) – 2.2%

If you are the seller then you should ask yourself “What am I going to do with the sales proceeds?”

If you sell real estate that yields 3.6% to buy bonds that yield 2-3% then the value of your investment is likely to be eroded over time. Most obviously, because rental income tends to increase over time, while interest payments are set for the duration of the bond.

High-quality assets with growing income streams are attractive.

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Taxes

If you sell at $1,100,000 (to a buyer without an agent) then what’s your net realizable value?

Using numbers consistent with the May 2014 article, you would net about $1,025,000 (before any mortgage pay off).

You’d also want to adjust the sustainable cash flow from the property to reflect taxes you pay on the income. To make things simple, let’s assume a sustainable cash flow after taxes of $32,500 (yielding ~3.2% after tax).

The above numbers would change, possibly significantly, based on the size of mortgage payoff and your personal tax position.

It’s worth having a professional walk you through the detail.

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Overall

When I look at the above, I see a market that has increased 25% in value. Seems like a lot.

  1. Rental growth is in line with the increase in value.
  2. Alternative investments are yielding less than this asset.
  3. The asset is located in a zip code with real-economic growth that is higher than the US average.

So the market seems fairly priced – at least to me, today.

What should the buyer and seller do? In these market conditions, they are likely fine either way.

What’s going to happen to future rents and prices? I would be suspicious of anyone that claims to know.